Enron: a brief behavioral autopsy

I. INTRODUCTION

People see what they want to see in the Enron (Global Crossing/ WorldCom/etc.) corporate corruption scandal. Conservatives see a triumph of capitalism. (1) Those of a more liberal persuasion see stark limitations of capitalism. (2) Republicans blame the scandal on Democrats. (3) Democratic leaders, unsurprisingly, blame it on Republicans. (4) This is an example of the confirmation bias, the tendency of people to gather and process information in a manner that fits their preexisting viewpoints. (5) When an ambiguous article on the death penalty is shown to different groups of people, the confirmation bias will cause both supporters and opponents of the death penalty to tend to view the article as supporting their (opposite) points of view. (6) And so it is with corporate misdeeds. (7)

It should come as no surprise, then, that business law professors generally view the Enron scandal as evidence that business law and business ethics should have more of a presence in business school curricula–both graduate and undergraduate. (8) The quantity and quality of business ethics instruction must improve. (9) The business school commitment to teaching business ethics must change from the current token attempts (10) that often mirror Enron’s token commitment to its famed “RICE” code of ethics. (11)

Nor should it be a surprise that I, having recently read an insider’s account of the Enron saga–Brian Cruver’s Anatomy of Greed: The Unshredded Truth From an Enron Insider, (12) see in the Enron scandal support for my attempts in recent years to apply behavioral decision theory (13) to legal issues in an attempt to create more realistic policy prescriptions than have been derived from the Chicago School law and economics reasoning that has dominated the interdisciplinary approach to legal analysis in recent years. (14)

In this essay, I will attempt to use the disclosures of Cruver’s book and other sources (15) and the insights of behavioral research to argue that law and economics theory has two major shortcomings. First, it tends to ignore the behavioral decision literature that demonstrates clearly that law and economics is built on a raft of inaccurate assumptions that can lead to faulty policy prescriptions. (16) Second, it does damage by eliminating any space in its adherents’ scheme of thinking for ethics and morality. (17) After addressing these points, I will briefly explore the steps Congress has recently taken to address the implications of the Enron scandal. (18) Ultimately, I hope to shed a modest amount of illumination upon the Enron scandal and to introduce the reader to the field of behavioral decision theory. (19)

II. LAW AND ECONOMICS VS. BEHAVIORAL DECISION THEORY

For twenty years, law and economics has been the dominant interdisciplinary school of thought in the legal academy. (20) Recently, several scholars, including myself, have imported behavioral decision theory into legal analysis, often in response to perceived limitations inherent in Chicago School law and economics analysis. Unsurprisingly, and perhaps illustrative of the confirmation bias, I find support for the value of behavioral decision theory in the Enron Scandal.

A foundational principle of law and economics analysis is that people behave rationally. (21) This assumption leads law and economics scholars, including some who currently sit on the federal bench, to various policy conclusions. For example, it leads them to conclude that companies will fully and honestly disclose all relevant financial information because companies that do so can raise capital more cheaply. (22) It leads them to conclude that we should assume that auditors always act honestly because (they make the further assumption) the only rational way for auditors to act is honestly for the reason that their reputation for honesty is their most valuable asset. (23) In its unvarnished form, this rationality assumption leads to the conclusion that the Enron scandal could not have happened, because it was completely irrational for the companies’ officers to mislead, commit fraud, help their employer commit corporate suicide, and court lengthy prison sentences. Had they thought rationally about where their actions would take Enron Corporation, Kenneth Lay, Jeff Skilling, Andy Fastow, and other Enron leaders likely would have acted much differently than they did. Their actions did create fabulous personal wealth, but they are not in situations they wish to be in today.

In a series of articles, I have pointed out that the foundational assumption that people make decisions as if they are homo economicus (“Chicago Man”) (24) is indisputably wrong. (25) Therefore, I have argued, the notion that auditors will act rationally, that corporate managers will act rationally, and that their firms will act rationally is simply wrong. I have predicated much of my argument upon a stream of behavioral decision literature commenced many years ago by Amos Tversky and Daniel Kahneman called generally the “heuristics and biases” literature. The essential notion is that rather than act as Chicago Man theoretically does, most people make many decisions that are affected by various heuristics (mental short-cuts) and biases (mental tunnels) that lead them to results that are often less than optimal. (26)

For example, in arguing that it is quite plausible that auditors would not act rationally in auditing their clients, I pointed to a number of these heuristics and biases:

* First, the evidence has long been clear that people (unlike Chicago Man) are, at best, boundedly rational in that they “seldom have complete and perfectly accurate information and never have perfect capacity to process that information rationally.” (27)

* Second, people often display rational ignorance in that, unlike Chicago Man, they often choose to make decisions based on much less than full information. They willingly “satisfice” rather than optimize their decision making outcomes. (28)

* Third, people tend to be subject to the confirmation bias in that they seek out and process information in such a way as to confirm preexisting beliefs rather than in a more optimally neutral manner. (29)

* Fourth, people are often subject to the hindsight bias, the tendency to regard things that have occurred as having been relatively predictable and obvious. (30) This is related to the notion of curse of knowledge–the fact that knowledge can affect judgment. For example, peer reviewers are more likely to evaluate a particular audit procedure negatively if they are told of allegations that the auditor lacked independence. (31)

* Fifth, most people (again, unlike Chicago Man) are subject to cognitive dissonance, meaning that once they have committed themselves to a particular position or belief, “the subsequent discovery of information that indicates harmful consequences flowing from that commitment directly threatens their self-concept as good, worthwhile individuals. Thus, cognitive processes will work to suppress such information if at all possible.” (32)

* Sixth, most people suffer memory limitations, including, a tendency to remember things as they wish to remember them and to be overconfident in the accuracy of their memories. (33)

* Seventh, people tend to be influenced by overoptimism and overconfidence. (34) Thus, for example, people tend to overestimate their own knowledge and ability to make accurate judgments. (35)

* Eighth, people’s judgments (unlike those of Chicago Man) tend to be subject to framing effects in that their answers are affected by how problems are framed. (36) Thus, by properly framing their presentation, sophisticated fraudsters have more luck fooling auditors. (37)

* Ninth, most people (unlike Chicago Man) tend to be affected by the representativeness heuristic, the tendency to judge probabilities via nonstatistical methods, for example, by relying on salient examples rather than base rates. (38) For example, people in the market for a new car tend to rely more heavily on the salient example of a friend who had a bad experience with a particular model of car than on a comprehensive survey by a consumer magazine. (39)

* Tenth, people tend to be insensitive to the source of information, crediting information even after they have evidence that its source is not credible. (40) Even trained auditors tend to overweigh client explanations for suspicious accounting entries. (41)

* Eleventh, people’s judgments are affected by the anchoring and adjustment heuristic

* Twelfth, the self-sewing bias means, among other things, that people’s judgments, including judgments of fairness, tend to be influenced by their self-interest. Even if people are trying to be fair, what seems fair to them is inevitably influenced by what is in their own best interests. (44) Thus, the more revenue an auditor gains from a client, the more difficult it is for that auditor to withstand the client’s request for improper accounting treatment. (45)

* Thirteenth, people’s judgments tend to be influenced by sunk cost effects in that while economists say it is irrational to allow sunk costs to influence judgments, people do so every day. (46)

* Fourteenth, people are subject to time-delay traps in that they have difficulty appreciating the long-range implications of decisions. Therefore, they tend to value immediate over delayed gratification. (47)

* The time-delay trap is related to a fifteenth concept, bounded willpower. Even when they appreciate the long-range implications of activities such as smoking or drinking, people often lack the willpower to refrain from those activities. (48)

While even this lengthy laundry list of human decisional foibles is far from complete, it should substantially undermine the Chicago Man model of the rational actor that is fundamental to much of law and economics analysis. I was able in my article on auditors to tap into a huge stream of empirical literature by accounting professors that demonstrated the applicability of these various heuristics and biases to the decisions made every day by auditors. (49) My point was not that auditors are always irrational, just that it is irrational to assume that they are always rational, especially in the face of specific evidence of an audit failure. (50)

If individuals do not act rationally, then their organizations will tend toward irrationality as well. Although I did not give this subject full treatment, I noted three points in my article on auditors. First, the behavioral literature is clear that people’s decision making is shaped by heuristics and biases when they act on behalf of organizations as well as when they act on their own behalf. (51) Second, I noted that Professor Langevoort has demonstrated that structural and behavioral factors tend to make corporations systematically overoptimistic. (52) Third, I noted the phenomenon of subgoal pursuit–the tendency of heads of subunits within organizations to act as advocates of their own subunit’s best interests at the expense of the interests of the larger organization. (53)

III. A BEHAVIORAL LOOK AT ENRON’S COLLAPSE.

According to traditional economic analysis, regulation of Enron was unnecessary because Enron, like other rational actors, would voluntarily act honestly in order to reduce long-term costs of raising capital, (54) and its officers would not derail promising individual careers by engaging in financial fraud. (55) The facts disclosed by Cruver’s Anatomy of Greed illustrate that the behavioral factors that I have highlighted carry substantial explanatory power regarding the Enron scandal. They help explain why neither Enron nor its officers acted rationally.

First, and perhaps foremost, is the self-serving bias. People tend to see that which they wish to see because their judgments are heavily if unconsciously influenced by self-interest. (56)

A growing body of behavioral research indicates that acting
contrary to one’s self interest is not a natural or easy thing. It
is not just that people consciously say: “I’m looking out for me
screw the other guy,” although they sometimes do. Rather, a menu of
cognitive biases and limits on rationality affect how people
perceive, process, and remember information, and, consequently, how
they choose among alternative actions, assess risk, and make many
other types of decisions. (57)

The self-serving bias worked particular evil at Enron. Cruver explains why:

Enron, more than any other “energy” company, dealt in commodities and
derivative structures and deal terms that were far too unusual to
have an established price. It was an issue of liquidity: if the dea
required a price on something that was rarely bought and sold (making
it illiquid), and there wasn’t much of an established market, then
the price had to be made up. (58)

When Enron employees valued proposed deals, which affected the numbers Enron could put on its books, which in turn determined whether or not employees met their bonus targets, which in turn determined whether millions of dollars in bonuses were paid to the very people who were deciding what the numbers should be, even assuming good faith (and at least some of the Enron officers must have been acting in good faith), the self-serving bias must have had an impact. This is especially so because Enron employees were often not choosing between legitimate Option A and legitimate Option B

Second, when Cruver learned of the Enron system and saw the huge potential for abuse, he was comforted by the fact that Enron’s own division of Risk Assessment and Control (RAC) was responsible for reviewing the deals and their attached numbers. Given the novelty and complexity of Enron’s ever evolving business ventures, RAC should have been more wary, but the behavioral phenomenon of overconfidence raised its ugly head. Throughout Enron, employees believed they were the best and brightest and the hubris of officers such as Skilling and Fastow clearly played a role in the company’s downfall. (60) At RAC, for example, Cruver reports, “people had built up a tough outer shell–and it was a shell that would be tough to crack. It was like [RAC] believed they already had everything under control.” (61)

Third, consider the behavioral factors that propel companies toward overconfidence. Even when company officials intend to be honest, they often produce overly optimistic financial figures for a variety of behavioral reasons. In another article, I summarized Professor Langevoort’s thesis in this way:

Langevoort essentially argues that (a) due to natural concerns
about raises, promotions, and terminations within the corporate
structure, good news flows to the top more quickly than bad news
(b) corporate cultures often operate to cause managers to
misperceive risks and to harbor unrealistically optimistic beliefs
about the corporation’s prospects
conservatism and decision simplification, coupled with groupthink,
encourage corporate management groups to underestimate risk and
otherwise unrealistically view the firm’s competitive environment
(d) for various reasons, optimists tend to be hired and to advance
faster through corporate ranks, and the resulting overoptimism
coupled with the human being’s natural illusion of control leads to

a “can do” culture that ignores reality
to a course of action, which they often do based on sketchy,
preliminary information, it is psychologically difficult for them to

change course

to see what they wish to see are pervasive in business
factors can coalesce to cause upper level managers to place a
recklessly positive spin on information they receive from lower
levels. (62)

This systematic tendency toward over optimism was especially strong at Enron due to the fact that (a) potential bonuses were literally “unlimited,” (63) and (b) Enron adopted an aggressive employee review system–a semiannual weeding out known as the “rank and yank.” (64) In this unique employee evaluation system, every six months 15% of employees were to be given unsatisfactory ratings that largely doomed their careers at Enron. These behavioral factors led to a very simple situation where, despite its well-known RICE code of ethics, the real rule was an unwritten one: NO BAD NEWS. (65)

Fourth, the problem of subgoal pursuit permeated Enron. Cruver himself was hired into a start-up group, as noted earlier, to begin marketing derivatives that would protect clients from risk that might come if firms that owed them money went bankrupt. According to Cruver,

… if you were futzing along in a stagnant area within Enron, then
the fastest way to break out and make zillions was to start a new
group. Waterston had done just that, pitching our credit-risk idea to
Skilling and getting a green light. Waterston knew that such an
all-or-nothing strategy would be high risk and that such adventures
had a 95% failure rate, but hey, he was in his late thirties so this
was his time. (66)

Thus, because of subgoal pursuit, individual units of Enron tackled huge, risky projects and a number of them–a large power plant in Dabhol, India, a large power plant in South America, a large water business (Azurix) in England–went under, helping drag Enron down. (67) The risk profiles of the individual units did not match the optimal risk profile for Enron itself.

Fifth, cognitive dissonance played a role in Enron’s demise. Enron proclaimed itself the best corporation in the world. Enron’s CEO repeatedly told critics that they “just didn’t get it.” (68) Enron’s employees believed that they were the ’90s version of the “Masters of the Universe” who roamed Wall Street in the 1980s. (69) With those beliefs firmly held and repeatedly expressed, it became extremely difficult for Enron employees to process contrary information. Professor Langevoort has explained how cognitive dissonance makes it hard for lawyers who have taken public positions to accept critical information about their clients. (70) I have made a similar case regarding auditors who have certified their clients’ financial statements as full and fair. (71) Similarly, it was extremely difficult for employees of “the world’s greatest company” to see its flaws. As Cruver explained, after he learned from his supervisor Middleton that many Enron deals were inflated in value so that officers could make their bonuses,

I had to assume [Middleton] was right about the underlying cause of

the inflated deals, but I wasn’t so sure about the effect. Maybe

people were trying to push these deals past him, but surely someone

in charge within RAC or at Arthur Andersen had control of the overall

situation. This company was profitable, and you can’t just pull

profits out of thin air. (72)

Of course, we know now that Enron was pulling these profits out of thin air, but no Enron employee would want to believe this, nor be prone to question when their CEOs were repeatedly telling them that nothing was wrong. Certainly there should have been some seeds of doubt planted when CEO Skilling resigned, but when Kenneth Lay resumed the CEO position and assured the employees and the world that “[t]here are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues…. There is no other shoe to fall,” (73) they would tend to believe the company line. In addition to cognitive dissonance, part of the problem was anchor and adjustment–employees’ beliefs were anchored on the vision of Enron as an invincible corporate giant and new information would tend not to be processed in such a way as to move employees sufficiently far from that belief. Even stock analysts whose beliefs were anchored on Enron as a success had great difficulty adjusting as negative news continued to stream in

A related problem is a behavioral phenomenon known as the false consensus effect that causes honest people to impute their honest motives to others. (75) Those Enron employees who were honest would not tend to believe that some of their colleagues and bosses could be dishonest. (76) Finally, people have a basic inability to tell when they are being deceived. (77) Enron employees desperately wanted to believe Ken Lay–he was, after all, a family man (78)–so they did, to their ultimate regret.

I could go on. I haven’t even touched upon the auditors, (79) the lawyers, (80) or the bankers. (81) There’s enough in the Enron saga to keep behavioral psychologists and organizational behavior theorists up to their eyeballs in case studies for years to come. The point I seek to make is that behavioral decision theory has substantial explanatory power in the Enron debacle. (82)

IV. LAW AND ECONOMICS VERSUS BUSINESS ETHICS

Not only is law and economics largely a failure in its attempts to produce descriptive and predictive accuracy

If economic actors are taught to value ethical and moral behavior by

their families, religious institutions, or MBA programs, then it is

reasonable to expect these values to be observed in economic

decision-making. However, if economic actors have been taught by

their culture to value their personal well-being, narrowly defined in

terms of finance and/or status, above all else, then market

principles suggest that ethics and morality may be traded-off for

goods that are more utility maximizing. (86)

Despite a well-publicized code of ethics (that was observed mainly in the breach), Enron, as described by Cruver, was an organization where money was the only yardstick and ethics had little place in anyone’s decisional calculus. This mindset started at the top with Kenneth Lay, who once said: “I don’t want to be rich, I want to be world-class rich.” (87) He achieved his objective. The primacy of personal wealth continued with Enron’s 401(k) plan handout for employees that featured George Bernard Shaw’s observation that “[l]ack of money is the root of all evil.” (88) It was continually drummed into employees with the “rank and yank” review process. Those who didn’t make their numbers were demoted and destroyed, and those who did make their numbers received bonuses so fabulous that Houston luxury car dealers knew to come to Enron to exhibit their wares every bonus period. (89) The centrality of money was cemented with the stock options that allowed Tom White to leave Enron to be Secretary of the Army, salvaging $14 million in severance payments and stock payments, (90) and allowed other Enron officers to profit in the tens of millions and even hundreds of millions of dollars. (91) While amassing huge personal fortunes, these officers presided over a company where, Cruver points out, although there was a code of ethics “[t]he reality was that perception led the way.” (92)

As William Bennett has observed, “capitalism requires capitalists with moral and ethical tethers.” (93) Unfortunately, Cruver paints a picture of an organization where the only thing that really counted was money and where the code of ethics was only window dressing. (94) When corporate officers only talk the talk and do not walk the walk, codes of ethics are essentially meaningless. (95) Indeed, ethical action may well have been suspect inside the Enron machine, for “[w]hen economic rationality takes on the imprimatur of truth, human behavior that is inconsistent with economic rationality becomes suspect both as irrational, in the sense that it operates at odds with consensus reality, and immoral, in that it is less likely to result in an efficient solution, a moral imperative in an economic theory based on presumed scarcity.” (96)

Ultimately, Enron illustrates Pouncy’s point that “[i]ndividuals will find it difficult to ‘do the right thing’ when the right thing is not among the options presented by the institutional processes in which they are participating.” (97) A theory known as social proof provides that we all tend to take our cues for proper behavior from those around us. (98) Social proof helps account for the success of laugh tracks on TV shows, (99) mass suicides, (100) and the tendency of bystanders not to help a person in peril when others seem unconcerned. (101) Watching others for cues has been shown to guide decisions to sign form contracts (“if everyone else is signing this, it must be okay”), (102) to return a lost wallet, (103) to engage in promiscuous sexual activity in a safe versus unsafe manner, (104) and to engage in various other forms of activity. (105) Social proof causes securities analysts to initiate and abandon coverage of certain firms, (106) so it is little wonder that it affects the actions of employees who are hired into a corrupt corporate culture. (107)

Organizations such as Enron reap what they sow. They usually become victims of the ethical corner-cutting that they encourage their employees to practice against competitors. (108) Thus, Lou Pai made (up) his numbers, took $350 million in compensation, and walked out the door leaving Enron with numerous projects that in reality were losing money. (109)

Cruver himself was a quick study in the Enron culture. When Enron’s financial difficulties became apparent and the company urged economy measures in travel expenditures, Cruver tells us that “[p]ersonally, I continued taking business-related trips, staying in the best hotels and eating in the best restaurants.” (110) He rationalized flouting the advisory with an “everyone does it” and an “I was working hard so I deserved it.”

When Enron’s bankruptcy filing became imminent, Cruver remembered an Enron program allowing employees to order Dell computers to enable them to improve their computer skills. Employees were to repay a portion of the purchase price after leaving the firm, unless Enron was forced to terminate their employment for business reasons. Realizing that such a termination was about to take place, Cruver “decided it was time to get a free computer.” He then ordered a new computer at no cost to himself

When Enron laid Cruver off and then mistakenly continued to pay him, he went through various machinations to lay his hands on the checks and to cash them, rationalizing that Enron would not be able to make the severance payments he had been promised when hired and promising himself that he would stop accepting the mistaken paychecks when the amount exceeded his promised severance package. (112) He and friends who were beneficiaries of the same mistake agreed to keep quiet about the mistake and to pocket the funds as long as possible. (113)

Cruver then started selling Enron memorabilia on e-Bay. (114) There may have been nothing really wrong with that until he started selling Enron e-mails to which he had been privy. (115) These were e-mails that embarrassed Enron and it appears that Cruver was still accepting the mistaken paychecks at that point, so he should have owed a more sensitive duty of loyalty. (116)

Finally, of course, Cruver gained at Enron’s expense by writing his book and selling the attendant movie rights. We can be glad he did, I suppose. The victim of his disloyalty was so richly deserving.

V. SARBANES-OXLEY

Congress responded to Enron and similar scandals by passing the Sarbanes-Oxley Act (117) in July 2002. If economic actors are rational, Sarbanes-Oxley should solve most corporate financial fraud problems. After all, Sarbanes-Oxley addresses the incentive structure of virtually all the important actors in what experts have called the “corporate reporting supply chain” (118)–officers, directors, auditors, attorneys, and securities analysts.

For example, Sarbanes-Oxley requires CEOs and CFOs to certify each periodic report containing financial statements that is filed with the SEC and subjects them to criminal penalties for knowing or willful violations. (119) It also requires them to reimburse their companies for any bonus or other incentive-based compensation received during a period in which their employer must restate its accounts due to misconduct (even if the CEO and CFO are not involved). (120) The law punishes any corporate official who fraudulently influences, coerces, manipulates, or misleads the company’s auditors. (121) And, Sarbanes-Oxley requires officers (and directors) to promptly report their trading activity in their company’s shares (122) and requires the SEC to require issuers to establish codes of ethics for senior financial officers. (123)

Sarbanes-Oxley increases the requirements for public companies’ audit committees (all members must be independent and at least one must be a “financial expert”), (124) and gives those audit committees increased authority (such as the power to hire and supervise the company’s independent auditors). (125) Increased authority likely will lead to increased liability, which is designed to focus the directors’ attention to a greater degree than the Enron directors were engaged. (126)

Sarbanes-Oxley ends the audit profession’s self-regulation, creating the Public Company Accounting Oversight Board (PCAOB) and charging it with registering public accounting firms that audit public companies

In Sarbanes-Oxley, Congress requires the SEC to issue minimum standards of professional conduct for attorneys that will require them to report evidence of violations of securities laws or breaches of fiduciary duty to the client’s chief legal counsel or CEO and, if these parties do not respond appropriately, to the firm’s audit committee. (129)

Additionally, to minimize the tendency of financial analysts to skew their advice in order to gain underwriting and other business for their firms, Sarbanes-Oxley requires the SEC to issue rules designed to protect the objectivity and independence of securities analysts. (130) Investment bankers are not to have the right to preapprove analysts’ reports and recommendations nor to supervise them or set their compensation. Analysts are protected from retaliation and threats from investment bankers in their firms, and securities analysts are also required to disclose compensation that might prejudice their objectivity. (131)

VI. CONCLUSION

In the provisions described above and others, Congress in Sabanes-Oxley took salutary action against corporate fraud. Rational wrongdoers should be deterred. Of course, rational wrongdoers would have been deterred by the civil and criminal provisions already on the books that will likely send Enron’s Michael Kopper and Andy Fastow, WorldCom’s Scott Sullivan, Tyco’s Dennis Kozlowski, and others to jail. (132) Unfortunately perhaps, it is not a rational world and the behavioral insights offered in this paper help us realize why these frauds occur in the first place and let us know that even beneficial legislation like Sarbanes-Oxley offers no panacea.

Nonetheless, Sarbanes-Oxley may be applauded for at least three reasons that are consistent with the behavioral literature. First, in several ways (limiting auditor provision of nonaudit services and isolating securities analysts from investment bankers, for example), Sarbanes-Oxley minimizes existing conflicts of interest in a way that should reduce the pervasive influence of the self-serving bias. Henceforth, auditors and securities analysts who wish to be honest will have an easier time of it than they have had in the past. (133)

Second, although some of Sarbanes-Oxley’s provisions largely duplicate current rules (134) and others merely increase already severe penalties, (135) the passage of this high-profile law implicates three related biases–the vividness bias (people tend to perceive as more dangerous risks that are based on emotionally interesting information rather than more probative abstract data), (136) the availability bias (people tend to perceive as more dangerous risks that they can readily recall), (137) and the saliency bias (people tend to perceive as more dangerous risks that are illustrated by colorful, dynamic or other distinctive stimuli). (138) Some worry that the public generally overestimates vivid, salient risks, such as those stemming from nuclear power or cancer, in part because they are readily available for recollection because of broad coverage in the media. (139) The forceful and highly-publicized Congressional declaration that CEOs must do that which they were already bound to do (certify accurate financial statements), supplemented by some rather vivid “perp walks,” will likely serve to concentrate executives’ attention in a more effective manner than has been accomplished in the past. (140)

Third, Sarbanes-Oxley sends a message regarding the law’s resolve. Just as law often reflects society’s underlying values, law can cause those values to change. (141) Sarbanes-Oxley will likely influence in a beneficial direction what both business people and others view as acceptable business behavior in the future.

(1) Conservatives see in the Enron saga a triumph of capitalism in that the government did not bail Enron out when it collapsed. See, e.g., Robert L. Borosage, Enron Conservatives, THE NATION, Feb. 4, 2002, at 4 (noting that Bush administration Treasury Secretary Paul O’Neill called Enron’s rise and fall a “triumph of capitalism”).

(2) See, e.g., Kris Zickert, Nationalize All Utilities, THE OREGONIAN, Mar. 16, 2002, at E5 (arguing that the Enron debacle illustrates “the inherent corruption of capitalism”).

(3) See, e.g., Peter Beinart, Backward, THE NEW REPUBLIC, July 22, 2002, at 6 (noting that Republicans are suggesting that former President Clinton is “to blame for today’s corporate scandals”).

(4) See, e.g., Anne E. Kornblut, Bush Team Defends SEC Chief on Business Scandals, BOSTON GLOBE, July 8, 2002, at A3 (noting that Senate Majority Leader Tom Daschle had blamed the Bush administration for fostering a “cozy, permissive relationship” of lax regulations toward corporate America that contributed to Enron and other scandals).

(5) In testing a hypothesis, people tend to preferentially select information that supports their point of view. See SCOTT PLOUS, THE PSYCHOLOGY OF JUDGEMENT AND DECISION MAKING 232-33 (1993) (noting several studies confirming the confirmation bias)

(6) See generally Charles G. Lord et al., Biased Assimilation and Attitude Polarization: The Effects of Prior Theories on Subsequently Considered Evidence, 37 J. PERSONALITY & SOC. PSYCHOL. 2098, 2108 (1979) (exploring this phenomenon).

(7) Coffee recently pointed out that Enron “is becoming a virtual Rorschach test in which each commentator can see evidence confirming what he or she already believed.” John C. Coffee, Jr., Understanding Enron: “It’s About the Gatekeepers, Stupid,” 57 BUS. LAW. 1403, 1403 (2002). As may be deduced from his title, Coffee finds problems with the financial system’s gatekeepers–auditors, attorneys, and other reputational intermediaries–at the core of the Enron debacle. Id. Other academic commentators’ conclusions also likely reflect their predispositions. See e.g., William W. Bratton, Enron and the Dark Side of Shareholder Value, 76 TUL. L. REV. 1275 (2002), available at http://papers.ssm.com/abstract=301475 (arguing that the Enron scandal teaches that an unhealthy commitment to maximization of share prices exacerbates old pathologies that have traditionally caused corporate financial frauds)

(8) See Robert A. Prentice, An Ethics Lesson for Business Schools, N.Y. TIMES, Aug. 20, 2002, at A21 [hereinafter Prentice, Business Schools] (arguing that Enron and other recent scandals involve breaches of law more than ethical lapses and demonstrate the need to teach more business law in business schools).

(9) See Eric Orts, Law Is Never Enough to Guarantee Fair Practice, FIN. TIMES, Aug. 23, 2002, at 9 (arguing that the Enron collapse demonstrates the need for teaching ethics to business managers).

(10) See Amitai Etzioni, When It Comes to Ethics, B-Schools Get an F, WASH. POST, Aug. 4, 2002, at B4 (alleging that current business school efforts to teach ethics are token only and claiming that more needs to be done).

(11) RICE stood for Respect, Integrity, Communication, and Excellence. See generally Gregory J. Millman, New Scandals, Old Lessons: Financial Ethics After Enron, FIN. EXECUTIVE, July 1, 2002, at 16 (noting that Enron had a code of ethics, but not a culture of ethics).

(12) BRIAN CRUVER, ANATOMY OF GREED: THE UNSHREDDED TRUTH FROM AN ENRON INSIDER (2002). As its forward by my colleague Steve Salbu indicates, Anatomy of Greed is intentionally in the tradition of Michael Lewis’s Liar’s Poker–an insider’s tale of an important business scandal emblematic of the excesses of an era, breezily written with vivid language, liberally sprinkled with sexual references and descriptions of sophomoric activity, and featuring characters who are colorful and greedy to the point of being caricatures. Id. at xi.

(13) A major portion of behavioral decision theory derives from the seminal work of Amos Tversky and Daniel Kahneman. In their experiments and those of their followers, substantial evidence has been produced that most people are prone to using various “heuristics and biases” in their thinking that prevents them from reasoning as economists often presume that rational people would. See generally MAX BAZERMAN, JUDGMENT IN MANAGEERIAL DECISION MAKING (4th ed. 1998)

(14) See, e.g., Robert A. Prentice & Jonathan J. Koehler, A Normality Bias in Legal Decision Making 88 CORNELL L. REV. 583 (2003) (reporting results of an empirical study on biases that affect legal decision making)

(15) Cruver’s book is just one of many that will be written about this scandal

Another exceedingly useful accounting of the Enron fiasco appeared in a five-part series in The Washington Post. See Peter Behr & April Witt, Visionary’s Dream Led to Risky Business, WASH. POST, July 28, 2002, at A1

And, needless to say, the single most important document for those attempting to understand what happened at Enron is the Powers Report, commissioned by Enron’s board and named after the committee’s head, Dean William Powers of the University of Texas School of Law. See WILLIAM C. POWERS, JR. ET AL., REPORT OF INVESTIGATION BY THE SPECIAL INVESTIGATIVE COMMITTEE OF THE BOARD OF DIRECTORS OF ENRON CORP. (Feb. 1, 2002), available at http:// www. chron .com/ content/ news /photos/ 02/ 02/03/enronpowersreport.pdf (the “Powers Report”).

(16) See infra notes 20 to 82 and accompanying text.

(17) See infra notes 83 to 116 and accompanying text.

(18) See infra notes 116 to 131 and accompanying text.

(19) This is not the first article to discuss behavioral decision theory in the pages of this journal. See, e.g., Royce de R. Barondes, Professionalism Consequences of Law Firm Investment in Clients: An Empirical Assessment, 39 AM. BUS. L.J. 379, 440 n. 174 (2002) (making a passing reference to some of the key behavioral decision literature)

Other members of the Academy of Legal Studies in Business have written in a behavioral vein. See, e.g., Hal R. Arkes & Cindy Schipani, Medical Malpractice v. the Business Judgment Rule: Differences in the Hindsight Bias, 73 OR. L. REV. 587 (1994) (analyzing the impact of the hindsight bias on the contrasting rules for judicial review of decisions of doctors and directors).

(20) The birth of the law and economics movement is often traced to the publication of Richard Posner’s seminal work. See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW (1st ed. 1973). Posner’s book was inspired by earlier works, including Ronald Coase, The Problems of Social Cost, 3 J.L. & ECON. 1 (1960) (using economic principles to analyze nuisance law), and Guido Calabresi, Some Thoughts on Risk Distribution and the Law of Torts, 70 YALE L.J. 499 (1961) (analyzing the economic logic of tort law).

(21) See POSNER, supra note 20, at 3. See also Roger G. Noll & James E. Krier, Some Implications of Cognitive Psychology for Risk Regulation, 19 J. LEGAL STUD. 747, 750-51 (1990) (summarizing key assumptions of the standard model)

(22) See, e.g., Stephen Choi, Regulating Investors Not Issuers: A Market-Based Proposal 88 CAL. L. REV. 279 (2000). Choi’s essential notion is that because it is rational for companies and other players in the financial markets to disclose filly and fairly and because sophisticated investors can and do bargain for the amount of risk they are willing to bear regarding fraud and carelessness, the financial markets should be fully deregulated. Id. at 282-83.

(23) See, e.g., Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994) (“[A]ccounting firms–as with all rational economic actors–seek to maximize their profits…. [Therefore,] it seems extremely unlikely that [defendant audit firm] was willing to put its professional reputation on the line by conducting fraudulent auditing work for [its client].”).

(24) See Daniel McFadden, Rationality for Economists?, 19 J. RISK & UNCERTAINTY 73, 76, 83 (1999) (coining the phrase “Chicago Man” to denote the rational actor of the Chicago School law and economics movement as contrasted to “K-T Man,” the severely limited decision maker described by Kahneman and Tversky’s research).

(25) See supra note 13.

(26) See MASSIMO PIATELLI-PALMARINI, INEVITABLE ILLUSIONS: HOW MISTAKES OF REASON RULE OUR MINDS 19 (1994).

(27) Prentice, Irrational Auditor, supra note 14, at 143. The concept of bounded rationality derives from the works of Herbert Simon and James March back in the 1950s. See generally, James G. March, Bounded Rationality, Ambiguity, and the Engineering of Choice, 9 BELL J. ECON. 587, 590 (1978)

(28) Prentice, Irrational Auditor, supra note 14, at 144-45. To “satisfice” is to follow the first satisfactory solution that presents itself, rather than attempt to find the optimal solution. It is a decision making process that is sensible given the constraints humans typically face in making decisions, but would be suboptimal if the constraints were removed, as they are in many economists’ hypothetical worlds. See James G. March, Bounded Rationality, Ambiguity, and the Engineering of Choice, in DECISION MAKING: DESCRIPTIVE, NORMATIVE, AND PRESCRIPTIVE INTERACTIONS 33, 40 (David E. Bell et al. eds., 1988). This concept, an aspect of bounded rationality, also derives from the work of March and Simon. See JAMES G. MARCH & HERBERT A. SIMON, ORGANIZATIONS 171 (2d ed. 1993).

(29) Prentice, Irrational Auditor, supra note 14, at 145-47. Because of the confirmation bias, even trained scientists tend to find articles that agree with their positions to be of higher quality than articles that disagree with their positions. See Jonathan J. Koehler, The Influence of Prior Beliefs on Scientific Judgments of Evidence Quality, 56 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 28, 47 (1993).

(30) Prentice, Irrational Auditor, supra note 14, at 147-49. See also, Jonathan D. Gasper et al., Juror Decision Making Attitudes, and the Hindsight Bias, 13 LAW & HUM. BEHAV. 291, 308 (1989) (noting that jurors generally have difficulty disregarding ultimate outcomes even when instructed to do so).

(31) See John G. Anderson et al., Evaluation of Auditor Decisions: Hindsight Bias Effects and the Expectation Gap, 14 J. ECON. PSYCHOL. 711, 722 (1993).

(32) Donald C. Langevoort, Where Were the Lawyers? A Behavioral Inquiry Into Lawyers’ Responsibility for Clients’ Fraud, 46 VAND. L. REV. 75, 102-03 (1993) [hereinafter Langevoort, Where Were the Lawyers?]. See generally, LEON FESTINGER, A THEORY OF COGNITIVE DISSONANCE (1957)

(33) Prentice, Irrational Auditor, supra note 14, at 151-52. See generally Jonathan B. Holmes et al., The Phenomenology of False Memories: Episodic Content and Confidence, 24 J. EXPERIMENTAL PSYCHOL. 1026, 1027 (1988) (noting that people “often rate their false memories with high degrees of confidence.”).

(34) Prentice, Irrational Auditor, supra note 14, at 152-56.

(35) See Lyle A. Brenner et al., Overconfidence in Probability and Frequency Judgments: A Critical Examination, 65 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 212, 218 (1996).

(36) Prentice, Irrational Auditor, supra note 14, at 156-57.

(37) Karim Jamal et al., Detecting Framing Effects in Financial Statements, 12 CONTEMP. ACCT. RES. 85, 102 (1995) (“Despite their motivation, training, and experience, over half … of the audit partners who participated in this study were deceived by management’s frame.”).

(38) Prentice, Irrational Auditor, supra note 14, at 158-63.

(39) See Richard E. Nisbett et al., Popular Induction: Information Is Not Necessarily Informative, in JUDGMENT UNDER UNCERTAINTY, supra note 13, at 101, 109.

(40) Prentice, Irrational Auditor, supra note 14, at 160-61.

(41) See Mark E. Peecher, The Influence of Auditors’ Justification Processes on Their Derisions: A Cognitive Model and Experimental Evidence, 34 J. ACCT. RES. 125, 137-39 (1996).

(42) Prentice, Irrational Auditor, supra note 14, at 163-66.

(43) See D. Eric Hirst & Lisa Koonce, Audit Analytical Procedures: A Field Investigation, 13 CONTEMP. ACCT. RES. 457, 467 (1996).

(44) Prentice, Irrational Auditor, supra note 14, at 168-70.

(45) See generally Prentice, SEC and MDP, supra note 14, at 1597 (arguing that because of the self-serving bias, we should be leery of allowing audit finns to increase their streams of nonaudit revenue from clients).

(46) Prentice, Irrational Auditor, supra note 14, at 171-76. Honoring sunk cost effects can irrationally lead to escalation of commitment–the pouring of more and more resources into a deteriorating situation. See generally Max H. Bazerman et al., Escalation of Commitment in Individual and Group Decision Making 33 ORGANIZATIONAL BEHAV. & HUM. PERFORMANCE 141, 150 (1984).

(47) Prentice, Irrational Auditor, supra note 14, at 176-79. Time-delay traps arguably have a lot to do with criminal activity in that wrongdoers tend to be unable to appreciate fully the long-term costs of their acts and tend to discount future consequences disproportionately. See generally MARGARET FRY, ARMS OF THE LAW 82-84 (1951).

(48) Prentice, Irrational Auditor, supra note 14, at 179-80.

(49) Id. at 139-81.

(50) Id. at 217-19.

(51) Id. at 181.

(52) Id. at 182-83. See generally Donald C. Langevoort, Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (and Cause Other Social Hams), 146 U. PA. L. REV. 101 (1997).

(53) Prentice, Irrational Auditor, supra note 14, at 184. See generally John C. Coffee, Jr., Beyond the Shut-Eyed Senti: Toward a Theoretical View of Corporate Misconduct and an Effective Legal Response, 63 VA. L. REV. 1099, 1135 (1977) (discussing subgoal pursuit).

(54) It is rational to act honestly because full and fair disclosure does reduce capital costs. See, e.g., Richard Frankel et al., Discretionary Disclosure and External Financing 70 ACCT. REV. 135, 149 (1995) (finding that firms accessing capital markets are more likely to disclose information than firms not doing so)

(55) Top managers are usually forced to resign when accounting irregularities occur. See, e.g., Ehsan H. Feroz et al., The Financial and Market Effects of the SEC’s Accounting and Auditing Enforcement Releases, 29 J. ACCT. RES. 107, 108 (1991) (finding that 72% of the companies targeted for accounting irregularities between 1982 and 1989 fired or received the resignation of top managers). More recently, they have also been doing the “perp walk” on national television. See Beth Piskora, Stocks Back Down, N.Y. POST, Aug. 2, 2002, at 33 (noting the arrest of WorldCom CFO Scott Sullivan).

(56) See George Loewenstein, Behavioral Decision Theory and Business Ethics: Skewed Trade-Offs Between Self and Others, in CODES OF CONDUCT: BEHAVIORAL RESEARCH INTO BUSINESS ETHICS 214, 221 (David M. Messick & Ann E. Tenbrunsel eds., 1996) (“[P]eople tend to conflate what is personally beneficial with what is fair or moral.”).

(57) Prentice, SEC and MDP, supra note 14, at 1603 (citations omitted).

(58) CRUVER, supra note 12, at 80.

(59) Id.

(60) See generally Malcolm Gladwell, The Talent Myth, NEW YORKER, July 22, 2002, at 28 (arguing that Enron’s obsession with hiring the “best and the brightest” and giving them nearly unlimited discretion helped cause its downfall).

(61) CRUVER, supra note 12, at 77.

(62) Prentice, Irrational Auditor, supra note 14, at 182-83.

(63) CRUVER, supra note 12, at 68 (“There was literally no cap on the size of the bonus.”).

(64) Id. at 61-62 (the process’s formal name was the “Peer Review Committee (PRC), but it was widely known within the firm as ‘rank and yank'”).

(65) According to Cruver, he had the following exchange with his anonymous Deep Throat-like source, “Mr. Blue”:

He leaned in: “There was an unwritten rule … a rule of ‘no bad

news.’ If I came to them with bad news, it would only hurt my

career.”

“Bad news about what?”

“About Enron’s deals–how little sense they made, how they would

lose money, how they were run by unqualified egomaniacs.”

Id. at 176.

(66) Id. at 65. Gladwell, supra note 60, at 30 gives another example. A young Enron employee thought that Enron should develop an online gas trading business and set about to do it. “Kitchin’s qualification for running EnronOnline, it should be pointed out, was not that she was good at it. It was that she wanted to do it, and Enron was a place where stars did whatever they wanted.” Id.

(67) CRUVER, supra note 12, at 75.

(68) Bethany McLean, Why Enron Went Bust, FORTUNE, Dec. 24, 2001, at 58 (noting that anyone who challenged Enron was told by its leaders that they “just didn’t get it”).

(69) Of course, these Masters of the Universe have been painted brilliantly by Michael Lewis and Tom Wolfe. See MICHAEL LEWIS, LIAR’S POKER (1989) (factual account)

(70) See Langevoort, Where Were the Lawyers?, supra note 32, at 102-03.

(71) See Prentice, Irrational Auditor, supra note 14, at 150.

(72) CRUVER, supra note 12, at 84.

(73) Id. at 94 (quoting a Business Week interview with Kenneth Lay).

(74) Id. at 125.

(75) See generally Colin F. Camerer, Individual Decision Making, in THE HANDBOOK OF EXPERIMENTAL ECONOMICS 587, 612-13 (John H. Kagel & Alvin E. Roth, eds., 1995) (explaining the phenomenon)

(76) See Prentice, Whither Securities Regulation, supra note 14, at 1462 (discussing the false consensus effect in the context of securities investing).

(77) SEe EVELIN SULLIIVAN, THE CONCISE BOOK OF LYING 206 (2001) (“In scientifically conducted experiments, the success rate of people being asked to sort out lies from truth, say by watching people on videotape either lying or telling the truth, has been shown to be poor.”).

(78) After one of Lay’s pep talks to the Enron employees, a colleague reported to Cruver: “Linda Lay was there, and he introduced her. He’s amazing. He’s just so sincere, and you can really trust that everything is going to be fine. He’s a family man…. We gave him a huge standing ovation.” CRUVER, supra note 12, at 93.

(79) The obvious point that I have made in earlier articles is that it will be difficult even for auditors who are trying to be honest to judge their client’s situation objectively when the auditors have an overwhelmingly strong financial motive to keep the audit client happy. Enron’s auditor, Arthur Andersen, was making more than $50 million a year in fees from Enron (more from consulting than from auditing), and expected soon to be making $100 million annually. One cannot escape the conclusion that Andersen’s collective judgment was affected by the self-serving bias, because several officials inside Andersen realized the legal risks presented by Enron’s aggressive accounting practices. See generally Delroy Alexander et al., Ties to Enron Blinded Andersen, CHI. TRIB., Sept. 3, 2002, at N1 (detailing various problems making it difficult for Andersen to maintain the required auditor’s skepticism).

(80) Like the auditors, many of Enron’s law firms had huge financial ties to Enron that made it difficult for the individual lawyers in those firms to overcome the self-serving bias. For example, Enron was Vinson & Elkins’ single largest client, paying it $36 million in 2001. See Julie Mason, Legal Counsel Scrutinized, HOUSTON CHRON., Mar. 8, 2002, at A22.

(81) Consider that Merrill Lynch was involved with Enron in at least seven different capacities. It underwrote Enron stock and bond deals, raised capital for Enron’s special purpose entities, invested in those entities, partnered with Enron in floating three power plants, loaned Enron money, was a counterparty in various Enron energy derivatives trades, and, notwithstanding all of those ties, purported to provide independent securities analysis of Enron stock to investors. See Paula Dwyer et al., Merrill Lynch: See No Evil?, BUS. WK., Sept. 16, 2002, at 68, 69 (detailing these relationships). One may legitimately question whether Merrill Lynch could provide unbiased analysis of Enron’s stock under such conditions.

(82) To explore just one more example, consider Andy Fastow and Michael Kopper. The clearest evidence of criminal conduct to surface thus far in the Enron probes relates to CFO Fastow and his assistant Kopper who profited enormously by investing in and operating various “special purpose entities” designed to allow Enron to move debt off its books. Fastow apparently took around $40 million at Enron’s expense. Kopper recently pled guilty and agreed to reimburse the government for $12 million that he had pocketed. See Bill Murphy, Go-getter Rose Quickly, Raked in Cash, HOUSTON CHRON., Aug. 22, 2002, at Bus. 1 (detailing Kopper’s plea).

HolmanJenkins recently delved into the psychological literature to suggest that Fastow and Kopper were not conscious criminals, but instead victims of their own poor decision making. HolmanJenkins, How Could They Have Done it?, WALL ST.J., Aug. 28, 2002, at A15. Jenkins noted that behavioralists Max Bazerman and David Messick have pointed out that “[u]nethical business decisions may stem not from the traditionally assumed [rational] tradeoff between ethics and profits … but from psychological tendencies that foster poor decision making.” David M. Messick & Max H. Bazernan, Ethical Leadership and the Psychology of Decision Making, 37 SLOAN MGMT. REV., Winter 1996, at 9, 18.

I believe that it is possible that Fastow and Kopper deluded themselves into thinking that they deserved the extra millions they were salting away. After all, they were being creative

While traditional economic literature assumes that people commit crimes because the expected benefits exceed the expected costs, see RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 242 (5th ed. 1998), “the reality is that people usually slide into crime not as the result ora single rationally-weighed cost-benefit decision, but because ora series of small irrational decisions to experiment with drugs, join a gang, or the like.” Prentice, Irrational Auditor, supra note 14, at 177.

(83) See Charles R.P. Pouncy, The Rational Rogue: Neoclassical Economic Ideology in the Regulation of the Financial Proffessional, 26 VT. L. REV. 263 (2002) [hereinafter Pouncy, Rational Rogue]

(84) Pouncy, Rational Rogue, supra note 83, at 264. Indeed, Pouncy notes that “[t]he decisional structure envisioned by neoclassical economic theory leaves little room for the operation of ethics and morality in its model-building project.” Id. at 281.

(85) Id. at 274. Pouncy also observes that “[w]hen market processes are deemed to yield optimal results, optimality and the efficiency construct upon which it is based become proxies for ethics and morality.” Id. at 276.

(86) Id. at 280. Although I believe that MBAs’ ethical views are largely established before they reach graduate school and that it is difficult to alter them dramatically by business ethics courses, see Prentice, Business Schools, supra note 8, at A21, there is some evidence that business students’ ethics do deteriorate as they go through school. See Etzioni, supra note 10, at B4 (“A recent Aspen Institute study of about 2,000 graduates of the top 13 business schools found that B-school education not only fails to improve the moral character of students, it actually weakens it.”).

(87) CRUVER, supra note 12, at 23.

(88) Id. at 3 (emphasis added).

(89) Id. at 68.

(90) Id. at 69.

(91) Among the individuals who sold Enron stock just during the class action period of the initial shareholder suit filed against Enron, Lay sold $184 million, Robert Belfer $111 million, Rebecca Mark $82 million, Lou Pai $270 million, Jeff Skilling $70 million, Andy Fastow $33 million, Ken Harrison $75 million, etc., etc. Id. at 131-32.

(92) Id. at 40.

(93) William J. Bennett, Capitalism and a Moral Education, CHI. TRIB., July 28, 2002, at C9.

(94) Ott has pointed out the distinction in many organizations between espoused values and values-in-use. J. STEVEN OTT, THE ORGANIZATIONAL CULTURE PERSPECTIVE 44-45 (1989). In Enron, there was a stark distinction between the two.

(95) Pouncy, Rational Rogue, supra note 83, at 364 (“The teaching of this and similar studies is that ethical intervention by means of codes or training is only effective when the organization actively enforces its ethical proscriptions, and leaders of the organization model appropriate ethical behavior.”), citing inter alia Anusorn Singhapakdi & Scott J. Vitell, Analyzing the Ethical Decision Making of Sales Professionals, J. PERS. SELLING & SALES MGMT., Fall 1999, at 1.

(96) Pouncy, Rational Rogue, supra note 83, at 292.

(97) Id. at 322.

(98) See ROBERT B. CIALDINI, INFLUENCE: SCIENCE AND PRACTICE 114-66 (Rev. ed. 1993) (explaining and illustrating the social proof concept)

(99) John Mariotti, Understanding Influence and Persuasion, THE INDUSTRY STANDARD, Apr. 5, 1999, at 126.

(100) Id. (noting that the Jonestown mass suicide can be linked to social proof). Empirical studies have also linked social proof to suicide. See, e.g., Ann F. Garland & Edward Zigler, Adolescence Suicide Prevention: Current Research and Social Policy Implications, (Special Issue) 48 AM. PSYCHOLOGIST 169, 174 (1993) (noting a social imitation effect that increases suicide likelihood when others have modeled the behavior and thereby lowered taboo against suicide)

(101) See BIBB LATANE & JOHN M. DARLEY, THE UNRESPONSIVE BYSTANDER: WHY DOESN’T HE HELP? 125 (1968) (making this point about the famous Kitty Genovese case in which dozens of people witnessed or heard a series of attacks on a young woman in New York City, yet no one intervened).

(102) G. Richard Shell, Fair Play, Consent and Securities Arbitration: A Comment on Speidel 62 BROOK. L. REV. 1371 (1996) (“To the extent customers think about [clauses in form contracts] at all, my guess is that they say to themselves: ‘There are a lot of people like me … and they all signed this contract, too. Some of them must have given it some thought even if I am too busy to do so. It must be OK.'”).

(103) Harvey A. Hornstein et al., Influence of a Model’s Feeling about His Behavior and His Relevance as a Comparison Other on Observers’ Helping Behavior, 10 J. PERSONALITY & SOC. PSYCHOL. 222, 225 (1968) (finding that people are more likely to return an apparently lost wallet intact when they have a model of someone similar to them doing so).

(104) Bram P. Buunk & Arnold B. Bakker, Extradyadic Sex: The Role of Descriptive and Injunctive Norms, 32 J. SEX RES. 313, 317 (1995) (finding in two studies that the perceived conduct of others had an important impact on whether individuals chose to engage in extramarital sexual relations)

(105) See LARRY M. BARTELS, PRESIDENTIAL PRIMARIES AND THE DYNAMICS OF PUBLIC CHOICE 110 (1988) (finding that favorable poll results cause people to evaluate a candidate more positively)

(106) Hayagreeva Rao et al., Fool’s Gold: Social Proof in the Initiation and Abandonment of Coverage by Wall Street Analysts, 46 ADMIN. SCI. Q. 502, 521 (2001) (reporting the results ora study indicating that “research departments of investment banks and brokerage firms were more likely to adopt a focal firm for coverage when peers had recently adopted it.”). Similarly television networks take cues from each other in programming, introducing shows aimed at taking advantage of the success of competitors even though conventional industrial organization theory implies that firms should differentiate their products instead. See Sushil Bikhchandani et al., A Theory of Fads, Fashion, Custom, and Cultural Change as Information Cascades, 100 J. POL. ECON. 992, 1010 (1992), citing Robert E. Kennedy, Strategy Fads and Strategic Positioning: An Empirical Test for Herd Behavior in Prime-Time Television Programming (Harvard Business School, Division of Research Working Paper, 1997).

(107) Asch’s classic studies demonstrate how overpoweringly persuasive social proof can be. Subjects asked whether line A is the same length as line B, line C, or line D often give an obviously incorrect response when confederates of the experimenter have previously given the same obviously wrong answer. See Solomon E. Asch, Opinions and Social Pressure, SCI. AM., Nov. 1955, at 31, 31-35. See also Richard A. Crutchfield, Conformity and Character, 10 AM. PSYCHOLOGIST 191, 196 (1955) (replicating Asch’s study with female subjects–Asch had studied only males)

(108) Two other obvious recent examples include WorldCom and Tyco. WorldCom was brought low by the excessive financial frauds of its CFO, the same frauds that had made it seem a success in the first place. See generally Jonathan Moules, WorldCom Trial Net Cast Wider, FIN. TIMES, Sept. 5, 2002, at 24 (noting that WorldCom’s former CFO Scott Sullivan had pled “not guilty” in federal court to charges of securities fraud). Tyco, another high-flying firm, was apparently looted by its insiders. See generally, Kevin McCoy & Gary Strauss, Kozlowski, Others Accused of Using Tyco as ‘Piggy Bank,’ USA TODAY, Sept. 13, 2002, at 1B (noting that former CEO Kozlowski and others had been charged with stealing at least $600 million from the company).

(109) CRUVER, supra note 12, at 80.

(110) Id. at 73.

(111) Id. at 196-97.

(112) Id. at 248, 256-58.

(113) Id. at 252.

(114) Id. at 297-98.

(115) Id. at 298-99.

(116) e-Bay later pulled Cruver’s listing, apparently after threats of litigation from Enron. Id. at 300.

(117) Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 746-810 (2002)(codified as amended in 15 U.S.C. [subsection] 7201-7266 and scattered sections of 18 U.S.C.). Sarbanes-Oxley’s text is available on the Internet at various sites. See, e.g., http://news.findlaw.com/ hdocs/docs/gwbush/sarbanesoxley072302.pdf.

(118) See SAMUELA. DIPIAZZA JR. & ROBERT G. ECCLES, BUILDING PUBLIC TRUST: THE FUTURE OF CORPORATE REPORTING 48 (2002).

(119) 15 U.S.C. [section] 7241 (2002) (civil provision) and 18 U.S.C. [subsection] 1341, 1343 (2002) (criminal provision).

(120) 15 U.S.C. [section] 7244.

(121) Id. [section] 7242.

(122) Id. [section] 78p.

(123) Id. [section] 7264.

(124) Id. [section] 7265.

(125) Pub. L. No. 107-204, Title III, [section] 301 (2002).

(126) See Stampede to Sign Up for New Oath Law, LLOYD’S LIST, Aug. 15, 2002, at 1 (noting that Sarbanes-Oxley will likely expose audit committee members to greater personal liability than they faced before).

(127) 15 U.S.C. [subsection] 7211-7219.

(128) Id. [section] 7231.

(129) Id. [section] 7245.

(130) Id. [subsection] 78o-6, 78u-2.

(131) Id.

(132) Knowingly or recklessly making false representations or omissions in connection with the sale of securities was already punishable under the 1934 Securities Exchange Act, for example. Section 10(b) of the 1934 Act prohibits such conduct in violation of SEC rules. 15 U.S.C. [section] 78j(b) (2002). Rule 10b-5 implements that provision. 17 C.F.R. [section] 240. 10b-5 (2001). Section 32 of the Act provides that ally intentional violation of any 1934 Act provision or rule issued thereunder is a criminal offense. 15 U.S.C. [section] 78ff (2002). The maximum penalty for individuals was already 10 years in jail and/or a fine of $1 million. Id.

(133) Through a different mechanism, Sarbanes-Oxley also helps issuers’ employees to do the right thing by providing protection for whistleblowers. 18 U.S.C. [section] 1514A (2002).

(134) Section 807 of Sarbanes-Oxley punishes fraud in connection with any security of a public company, largely duplicating [section] 10(b) of the 1934 Act.

(135) Section 1106 of Sarbanes-Oxley increases the criminal penalties for violating provisions of the 1934 Securities Exchange Act from an already stiff maximum punishment of a fine of $1,000,000 and/or 10 years in jail for an individual to a fine of $5,000,000 and/or 20 years in jail.

(136) See generally PLOUS, supra note 5, at 125-27 (discussing the vividness effect).

(137) See generally ROBYN M. DAWES, EVERYDAY IRRATIONALITY 99-107 (2001) (discussing studies of the availability bias).

(138) See generally Shelley E. Taylor, The Availability Bias in Social Perception and Interaction, in JUDGMENT UNDER UNCERTAINTY, supra note 13, at 190, 192 (defining the saliency bias).

(139) See Christine Jolls et al., A Behavioral Approach to Law and Economics, in BEHAVIORAL LAW AND ECONOMICS 13, 37-38 (Cass R. Sunstein ed., 2000) (discussing how the public’s perception of risk is heavily influenced by vivid, available anecdotes). See also Harry S. Gerla, The “Reasonableness” Standard in the Law of Negligence: Can Abstract Values Receive Their Due?, 15 U. DAYTON L. REV. 199, 200-11 (1990) (discussing how these three biases can affect jury decision making).

(140) Yummies for the CEO ST. LOUIS POST-DISPATCH, Sept. 10, 2002, at B6 (“The sight of executives being walked in handcuffs in front of TV cameras also has a deterrent effect. More ‘perp walks’ and people may decide that crime doesn’t pay.”).

(141) See THOMAS DONALDSON & THOMAS W. DUNFEE, TIES THAT BIND: A SOCIAL CONTRACTS APPROACH TO BUSINESS ETHICS 95-96 (1999):

Outside sources may influence the development of norms. Law,

particularly when it is perceived as legitimate by members of a

community, may have a major impact on what is considered to be

correct behavior. Thus, the U.S. Corporate Sentencing Guidelines may

be expected to influence perceptions of appropriate structures and

policies for assigning managerial responsibility pertaining to

corporate social responsibility. Conventional wisdom holds that U.S.

law has influenced changes in ethical norms pertaining to racial or

gender-based discrimination and also as to the legitimacy of insider

trading.

See also Mark Kelman, Consumption Theory, Production Theory, and Ideology in the Coase Theorem, 52 S. CAL. L. REV. 669, 695 (1979) (observing that “perhaps society learns what to value in part through the legal system’s descriptions of our protected spheres”)

Robert Prentice, Ed and Molly Smith Centennial Professor of Business Law, University of Texas at Austin.