Hello, and welcome back to our course on corruption. Today is week three, lecture three and we're going to talk about indirect costs. Indirect costs that flow from a firm or an individual engaging in corruption. Thomas Schmerhorn and Dienhart have created a taxonomy of costs of this sort. Not just for corruption, but for actions, affirms and individuals in general. They divide these costs into three categories. The first is level one cost, the second is level cost, the third is level three costs. And this is a pretty useful way of thinking about kind of indirect costs that flow from corruption. Now level one costs are costs that are assessed by a government or disciplining body, or some established institution according to some very established set of rules. So for example a fine that's imposed for a firm engaging in corruption. That would be considered a level one cost. And level one costs of course are the costs with which we are most comfortable, most familiar, what we know the most about. You will often see in business minutes, in memos that go between managers, references to level one costs. If we engage in this kind of behavior, we will accrue this sort of cost, right. They're easily predicted, easily measures. Level two costs are costs associated with the level one costs. So for example, the cost of defense, right, should there be a trial that is going to be levied to impose this fine. The cost of remediation, all right. So the government finds that there's been a certain kind of misbehavior, what's the cost of fixing that misbehavior? The cost associated with investigation. There's been an allegation of corruption in a firm, perhaps in an office, in a country, on a different continent than the main office. What's the cost of investigating whether or not corruption occurred and the cost of investigating what was the breakdown in management that led to that act of corruption occurring? Level two costs are predictable in a sense. We know that they're going to happen. They're not quite as predictable when we talk about what the amount of those costs will be. I can tell you with some degree of certainty the cost of defending, for example, the accusation that a person has violated traffic law. Because those kinds of defenses are going to be pretty similar in any given jurisdiction. But when we talk about something as complicated as a defense against an allegation of corruption, it's absolutely predictable that there will defense costs involved. But it's not quite as predictable what those defense costs will be. And so, when we look at the minutes of business meetings or we look in memos of flow from manager to manager, we sometimes see reference to level two costs, but we don't see the same degree of certainty. And we don't see the same degree of caution, regarding the fact that these costs will be imposed. Finally, level three costs, and level three costs are costs that are associated with the acts that led to level one and level two costs but they’re imposed from society at large. And they’re imposed not really with reference to established rules, but more so with reference to established or even implied norms and understandings. So a firm pays a bribe. That bribe is associated with a party that it turns out is associated with terrorism. Well in some countries where terrorism is understandably quite socially objected to, people might associate that firm with terrorism, and sanction that firm and pose tremendous social cost on that firm. Right, the reputation of that firm will be severely damaged. Again it's worth paying attention to the source of these costs. Level one cost generally imposed by government, or sometimes by some other form of disciplining or governing body. Level two costs of flow from government or governing body sources but also flow from society. Level three costs are imposed by society. Level one costs, rule oriented, easily predictable. Level three costs, norm oriented, not very predictable. I mentioned at the beginning of our time together that I'm a professor of legal studies and business ethics and this is where the two clearly come together. It's almost as if law flows into ethics. And they really are one iteration of the same thing. Unfortunately, for businesses, the law side is well, well, well documented. Literally, thousands of cases in any given jurisdiction that provide guidance as to what these costs will be. The ethics side, again, there's not a good body of precedent that allows a business firm to make prediction as to what those costs will be. Let's work through through a very well known example and parse out the costs to level one, level two, and level three. Many people are familiar with Enron, which was a very large firm that dealt with many aspects of energy, particularly providing energy in ways that had recently been deregulated. Arthur Anderson was one of the largest accounting firms in the entire world. People called them the Big Four. They were one of the Big Four. And Arthur Andersen worked with Enron in auditing Enron statements to the public to shareholders and to the government. When Arthur Andersen worked in the auditing of Enron's statements to these stakeholders, Arthur Anderson made decisions about what would be included in the audit reports, and how those audit reports would be worded. Enron was perpetrating a number of fraudulent acts. Their fraudulent acts upon the government are easily characterized as corrupt. Arthur Anderson, therefore, in working with Enron to make these statements to various stakeholders, could be characterized as having acted corruptly. Now you'll note that I'm very careful not to say that they were acting corruptly. And from a legal perspective, there is some dispute as to whether or not their acts technically fell within the criminal definition of corruption. That's the law side. From a social perspective, there's really no question. And a laymen, a person who's not looking at this as a legal matter, but is simply looking at this, does this fall within our understanding of corruption, would say that Arthur Andersen acted corruptly. So we're going to parse what happened to Arthur Andersen in terms of level one costs, level two costs, and level three costs. Now recall that level one cost are the easiest to quantify and the easiest to predict. It's easy for us to say, well if you do this, if you're caught, if you're prosecuted, you'll probably be fined this much. And in fact, Arthur Andersen was fined about half a million US dollars. Half a million US dollars is a relatively significant amount to most people. But to one of the big four accounting firms at that time, it was, in relative terms, inconsequential. It was a fine that looked like it meant something, but it really wouldn't affect the operations of Arthur Anderson in anything other than a very trivial way. Level two costs can sort-of be predicted. And we have a rough idea of what is cost will be. But they're not as easy to predicted as level one costs and there certainly not as easy to quantify, ab initio, as level one costs. And in the case of Arthur Anderson, their remedial fees, their defense fees, their investigative fees, they amounted to several million US dollars. Now, several million US dollars is a much high number than half a million US dollars. But again to a firm the size of Arthur Andersen, it was relatively inconsequential. This was something that certainly didn't endanger the firm. However, we need to account for level three costs. Level three costs are very difficult to predict, very difficult to quantify, but they are real costs. And in the case of Arthur Andersen, an interesting thing happened. Arthur Andersen's reputation was damaged, and customers began to defect. In particular, the State of Texas, the state in which Enron as located and the state that was therefore most damage by the collapse of Enron, enacted a law that prohibited the use of Arthur Andersen for public services. That was a blow to Arthur Anderson, but a blow they probably could have recovered from. The state of California however followed the state of Texas, enacted a set of rules that prohibited the use of Arthur Anderson for any public services. And that was a blow from which Arthur Anderson could not recover. Arthur Anderson, soon after the creation of the California rules, dissolved. No one, no one would have predicted even six months before the end of Arthur Anderson, that their involvement in these particular acts would have resulted in literally the death of the firm. But it did. And that's one of the reasons we need to recognize the fact that there are level three costs. And when we're assessing indirect costs that are imposed on firms for engaging in corrupt acts or individuals who engage in corrupt, to understand that level three costs may be serious and may be extraordinarily damaging. I want to return for just one second to those level one costs. The United Kingdom, the United States, Germany, at the time that I'm recording this, are probably the most active in terms of imposing level one costs. The level one costs are imposed all over the world. Nigeria for example, a country that recognizes that it has a problem with corruption among its government officials. It collects several million dollars a year in fines imposed on firms, often firms from outside of Nigeria, that engage in corruption. The fines vary around the world, from a few hundred thousand dollars to several billion dollars. Level one costs, easily predictable and they're out there. It's the level three cost that we want to really, really understand and be concerned with. Corruption and the revelation of corruption damages reputation. Reputation is something that in some senses can be quantified, generally about a third of the value of a firm is intangible and much of that is related to reputation. Reputation is something though, that is inchoate. Warren Buffet, who in North America is one of the most respected investors, considers reputation to be far, far more valuable than actual revenue. And he considers reputation to be far more fragile than the material wealth of a firm. Clearly, reputation and the loss thereof is a potential level three cost always associated with acts of corruption by a firm or by an individual. Corruption also diminishes trust. It is a misunderstanding of corrupt relationships to think that a business firm buys trustworthiness from a government official when a firm pays a bribe to that government official. It's also a gross misunderstanding of how the general public will react to revelations of that bribery, to think that it will not diminish trust. We know that people do not trust firms that pay bribes. And we suspect that people do not trust firms that engage in other forms of corruption. The relationship between trust and the general conduct of business is thoroughly documented and thoroughly explored. Pat Dowden, who is the president of the Center for Business Ethics, which has done extensive research on the relationship between trust and business, particularly in emerging economies in Central and Eastern Europe, former Soviet Union, has found a very strong relationship between customer trust and business success. And a strong relationship between the loss of trust and a diminishment of the ability of the firm to do business. So when we talk about indirect costs, there are some that are quite predictable. Pay a bribe, you're going to pay a fine. But there are inchoate and unpredictable costs that are real and that are significant. And among those costs, corruption damages the reputation of a firm, and corruption diminishes the trust that stakeholders including customers will have in that firm. All of this can have a serious impact on the ability of that firm to conduct the business that it wishes to conduct. Thank you, and I look forward to seeing you in our next lecture.
