Norm-based behavior and corporate malpractice

Journal of Economic Issues, March, 2007 by Miguel A. Duran

Jeffrey Skilling held high-level posts in Enron until a few months before it filed for bankruptcy at the end of 2001. When he was a master's degree student at Harvard, one of his professors asked him what he would do if he knew the company he worked for were selling products harmful to its customers' health. Skilling apparently answered: 'Td keep making and selling the product. My job as a businessman is to be a profit center and to maximize return to the shareholders" (Fusaro and Miller 2002, 28). Even if this is nothing more than an MBA student's opinion, it is making the "right" point "to a certain extent": companies are not philanthropic societies and raising profits is one of an entrepreneur's main targets. However, when we look at the question, Skilling's answer is rather disturbing. Whether the hypothetical company his professor referred to finally went bankrupt or not, the undesirable consequences' which would have resulted in the meantime raise the familiar question of trust in the operation of the market. That is: how far should laissez-faire be expected to generate desired results? The invisible-hand principle underlying economic policy over the last two decades provides a clear answer: collective good is achieved through agents pursuing their self-interest, on the assumption "they will not choose to break the rules of the market" defining "what behavior is proper or what is improper" (Fusaro and Miller 2002, 147-8). However, the question still stands: if our trust in the market depends on assuming that agents behave "honorably," does the logic of the market guarantee that most agents will in fact behave so?

To discuss recent cases of corporate malpractice in light of this question, this paper focuses on norms. However, the aim is not to reassert the already known conclusion that the numerous accounting scandals that have come to light in recent years are the result of either breaking or stretching the rules--be they legal norms or unwritten moral ones. Although it may at first glance seem paradoxical, this paper has the opposite goal: it attempts to provide a possible explanation of these cases of business malpractice in terms of norm-based behavior by agents.

In broad terms, there are two possible interpretations of recent misbehavior in corporate America. The first could be called the "rotten apples" theory. In this view, problems stem from a few executives taking advantage of shareholders' trust and damaging the reputation of their peers. That is, the corporate realm faces an agency dilemma because of a few "rotten apples." No general problem exists in relation to the operation of the corporate governance system--which includes executive officers, accountants, directors, auditing and consulting firms, investment banks, securities analysts, and shareholders. The only weakness of this system is that it has some legal flaws that certain agents have used to their advantage. According to this interpretation, the solution lies in correcting the flaws, giving exemplary punishments to the cheating executives, and improving the incentives system. In this way, public trust in financial markets would be restored and market competition would still guarantee outcome efficiency (Securities and Exchange Commission (SEC) 2003A, 1). In brief, corporate malpractices are exceptions stemming from legal loopholes. They do not call into question the "renewed faith in the efficiency and stability of market structures" (Hake 2005, 595) governing the interpretation of economic events and the liberalization policies adopted since the 1980s.

The second possible interpretation does not entirely contradict the previous one: there is no doubt the corporate management system has flaws that need to be redressed. The 2002 Sarbanes-Oxley Act constitutes the most ambitious legal reform in this regard. However, the number of scandals, their scale and the amount of money involved are so huge that what has happened in the corporate realm can be interpreted as a systemic failure. In other words, the second interpretation--to be developed below--suggests that corporate misbehavior and the crisis of confidence it has engendered could be understood in terms of a system-wide explanation grounded in how the market itself operates. Under this approach, the straightforward relation of causality, which in principle can be established between loopholes in accounting law and deceitful behavior becomes more complex. In this regard, it seems advisable to embed the explanation of widespread deception in how agents interact with each other within the marketplace.

In order to develop this second interpretation, the workings of the market will be analyzed in terms of a critical reconstruction of Hayek's ideas built on the notion of "spontaneous norms." Two points are noteworthy in this regard. First, Hayek is a complex and often contradictory author. Accordingly, this theoretical reconstruction does not aim at being "the" interpretation of his thoughts. Indeed, it is a critical interpretation of his "implicit economics" (Vaughn 1999). Second, since Hayek has been one of the most influential advocates of the free market economy, the possibility of using his conception of the operation of the market process to interpret corporate misbehavior is nothing short of ironic. This implies an unconventional consequence: his writings may enable us to understand what could be considered the opposite of what they were written for. That is, they can help explain why market forces sometimes bring about undesirable results, thus raising doubts about the liberalization policies of the 1990s to which Hayek helped give theoretical support.