Cyberweek Fall 2006 September 25-29

©2006 Oxford University Press All Rights Reserved. Cyberweek and Internetbar.org would like to thank the author and Oxford University Press for allowing us to reproduce materials from this book for our conference.

Chapter 1 - Part 1: Excerpts of pages 21-24

The Eroding Trust, Truth, and Culture of Honesty

The private sector guarantors of trust in the corporate and financial markets have failed to detect and prevent the frauds of the 1990s. Lawyers, accountants, and investment bankers are expected to act as the verifiers of truth. Boards of directors act as internal compliance mechanisms and institutional controllers of abuse of trust. The Enron Corporation debacle was shocking not only because of its magnitude, the involvement of top management, and the lax supervision of its board of directors. It was shocking also because it demonstrated the glaring failure of the lawyers, accountants, analysts, investment and commercial bankers, regulators and even the media to dampen these activities.

Enron Corporation's case demonstrated a "massive failure in the governance system," according to Robert E. Litan of the Brookings Institution. "You can look at the system as a series of concentric circles, from management to directors and the audit committee to regulators and analysts and so forth. This was like a nuclear meltdown where the core melted through all the layers," Litan told the New York Times.98 "The institutions that were created to check such abuses failed. The remnants of a professional ethos in accounting, law and securities analysis gave way to getting the maximum revenue per partner."99

The rating agencies that rate corporate bonds failed to discover fraud. The rating agencies overlooked the serious financial conditions of giants like WorldCom and Parmalat. Standard & Poor's lowered Enron Corporation's rating from "investment" to "speculative" only a few days before the company officially became bankrupt on September 2, 2001. In December 2003, Standard & Poor's lowered the rating of Parmalat by 10 notches from investment (BBB) down to "dump" (CC) only two days before the company went bankrupt. Ten days later, it lowered the rating to D level (default) and refused to continue working with the company. The rating agencies affirm that there was nothing they could do, because the companies deceived them as they deceived all other investors. Globalization of the securities markets requires interaction among the rating agencies and cooperation with those who compile the rating. If the coordination is weak, the rating could be flawed.

Rating agencies are also beset by conflicts of interest. The agencies are paid not by the investing public but by the very same issuers of the securities that the agencies are rating. In addition, rating affects market prices. Therefore, the agencies have "insider information" about their future rating, and those who know could benefit by trading on this information.100

Accountants failed to detect fraud. Some helped their clients to defraud others. A few defrauded clients. The accounting firm Arthur Andersen dissolved after it shredded documents relating to the investigation of Enron Corporation. Before its dissolution, the firm also was involved in a real estate debacle that resulted in payments to the state of Connecticut101 and a $90 million legal settlement to 6,800 investors who were suing the firm for faulty financial advice that cost them millions.102 Richard P. Scalzo, a partner at accounting firm PricewaterhouseCoopers, was barred from practicing before the SEC for his involvement in the accounting practices of Tyco Corporation.103 In a civil fraud lawsuit, the SEC claimed that three former and current PricewaterhouseCoopers accountants had helped to inflate earnings by $59 million, as well as to hide fraud at the Allegheny Health, Education and Research Foundation.104 Large auditing firms that service multinational corporations periodically produce reports that deal with fraud. In these reports, the auditors warned of the rise in frauds.105 But, as Professor John Coffee noted, it seems that they did little about fraud in their role as auditors.106 Among his stories on the recent crash, Roger Lowenstein noted that accounting firms were happy to let the clients choose accounting arrangements that resulted in taking assets (and liabilities) off their balance sheets, as Enron Corporation did [Lowenstein, 65].

The accounting firm KPMG sold tax shelters that were not tested or approved by the Internal Revenue Service (IRS) and involved sham transactions. The firm sheltered itself from scrutiny by other experts and the IRS. It asserted that the shelter was proprietary. Therefore, the buyers of the shelter had to agree not to seek a second opinion of other accountants. In addition, buyers had to agree to hire KPMG to represent them before the IRS. The IRS later disallowed these tax shelters. The clients lost heavily in penalties.107

There were instances of accountants who defrauded their clients. In 1996, Donald Bunsis, a former attorney/accountant/financial advisor, pleaded guilty to stealing more than $1.5 million from his clients.108 In 1995 a verdict was upheld against a lawyer and an accountant who diverted $13.4 million from an estate of a client between 1981 and 1986.109 In 1992 came news of an accountant in Silver Spring, Maryland, Deborah Prince, who pleaded guilty to stealing $326,679 from a Rockville (Maryland) organization that helps autistic people.110 In 1997, Thomas E. Karam was indicted for wire fraud and money laundering. He pleaded guilty to wire fraud and was sentenced to two years in prison. He was also required to pay $775,000 in restitution.111 The Washington Post reported that Victor Oliver pleaded guilty to stealing at least $1.5 million from dozens of clients, many of whom were friends.112

Some lawyers defrauded their own clients by "padding" their bills. In her 1999 study of lawyers of "elite" firms, Lisa Lerman researched cases involving frauds of "padding the bills and expenses." She found almost no prosecution of such cases before 1989, and 36 such cases during the following 10 years. Of course, this increase could indicate either more incidents or more prosecution. The 16 cases that were studied in more detail involved persons who had privileged background, graduated from elite schools, and worked at a number of large law firms. They were accused of stealing over $100,000 over an average of five years. Collectively, they stole about $16 million from clients. These lawyers were at the height of their careers, serving as managing partners, members of the firms' executive committees, or "rainmakers." The researcher noted that in many cases, "it is clear that their partners knew about and/or participated in the billing fraud."113 Two lawyers were found guilty of mail fraud. One was disbarred, and one was suspended for three years for padding clients' bills. Another lawyer was found to have breached his contract and committed fraud. Judgment against him amounted to $3,124,414.114 Put differently, these instances may represent the corruption of private guarantors of trust in the financial sector.

The members of the financial infrastructure, which Americans trusted, have failed to meet the clients' expectations. One example of such failure is the behavior of the investment analysts. Analysts employed by large brokerage firms advised the public to buy securities that these analysts believed to be of little value. Representing themselves as objective professional advisors, they were in fact paid or pressed to sell. Ten Wall Street firms agreed to pay $1.4 billion in fines to settle the charges against them on this score.115

Brokers took advantage of their customers' ignorance about the structure of commissions. Commissions paid on mutual funds shares include volume discounts. The commissions on a purchase of a certain number of shares are lower. Just below that cutoff point, the commissions are higher. Customers who were not aware of these cutoff points were sold a number of shares just below these points and paid higher commissions. When the practice was exposed, the brokers had to make "hefty refunds" to the customers.116 Regulators "accused nearly 450 brokerage firms of overcharging investors for mutual fund purchases," and "10 percent of top mutual fund companies may have been involved in illegal late trading."117

The National Association of Securities Dealers (the self-regulatory organization of broker dealers) and the New York State Insurance Department investigated the sale of variable annuities by Prudential Financial Services. These investigations covered "possible forgeries and other improper handling of sales documents," misrepresenting the performance of annuities, and recommending unsuitable investments for customers. Prudential's history involved other scandals. Prudential employees persuaded customers to exchange insurance policies mainly to produce more commissions for the salespersons (settled in 1997). There were "disputes with customers over investments in limited partnerships" (settled in 1993) and violations in connection with the sales of variable life insurance (cited in 1999, fined in 2001).118

The weight of the information in this chapter can be disputed. Critics could view it as a hodgepodge of items from various sources. They could say: "This chapter includes many stories and studies based on different evaluation systems. The data is not well tested and may be statistically insignificant. It is impressionistic and could lead to erroneous conclusions." Yet this book is not a study of the methods by which information can point to the present state of affairs, let alone prove the causes of a state of affairs. However, there is enough information to raise concern. Chapter 2 continues the inquiry into the implications of this information.

Chapter 8 - Rising Opportunities and Temptations - Excerpts from pages 122 – 125

The Challenge of Economics to Fiduciary Law

Over the past 30 years, a strong movement of lawyers, scholars and some judges advocated changing the law that regulated trusted persons-fiduciaries. The movement pressed hard for fashioning the law of fiduciaries to mimic the law regulating contract parties. Scholars, such as Daniel Fischel, and judges, such as Frank Easterbrook and Richard Posner, viewed the world of fiduciaries and beneficiaries as the market world, and the relationship of fiduciaries and the people who trust them as contract relationships, buying and selling goods and services.11 As I shall show, the change reduces the fiduciaries' duty to repay the profits they made off other people's money. Even more important, the change removes the stigma attached to abuse of trust. A breach of contract does not have the strong odor of dishonesty.

The Test of Fiduciary Law's Efficiency: Inefficient

Rules Can Be Efficient Enforcers of Honesty

The regulation of fiduciaries can be viewed as inefficient. It prevents trusted persons from doing what is legal for others. For example, fiduciaries may not transact any business between their beneficiaries and themselves. The principle in fiduciary law is that a person should not serve two masters. He cannot be loyal to both, especially if he is one of the masters. Therefore, a corporate manager may not buy corporate assets, even at market price, and even if the deal benefits the corporation (it may save on commissions). The manager must get approval for such a sale from parties who are "objective" and not interested. These parties can represent the shareholders and decide whether the shareholders would benefit from the deal and whether the terms of the deal are fair. But if such deals are prohibited, then from the point of view of the managers, and sometimes even from the point of view of the corporation, the prohibition is inefficient. It prevents innocent parties from making profitable transactions, and creating value.

The other side of this coin was ignored. These inefficient rules, limiting the freedom of trusted persons to gain, are efficient in limiting the freedom of trusted persons to gain by abusing their trust. To evaluate the efficiency of these restrictive rules, one must consider the cost to the government and to all trusting people of enforcing the fiduciaries' honesty. If weak enforcement results in the harm that we are discovering since the opening of the twenty-first century, then the restrictions on the fiduciaries and their losses of profits pale in comparison. Inefficient rules may be highly efficient after all.

Besides, fiduciaries who are subject to restrictive rules do not lose all. The restrictions bestow on fiduciaries such as corporate directors and officers a reputation for honesty and help them gain the investors' trust. Even if the value of investors' trust is discounted in the belief that investors care more for profits, it may still be worth something. Over the long term, being trustworthy turns out to be good business, and rules that prevent abuse of trust can turn out to be profitable after all.

The Nature of Fiduciary Law:

A Short Review of Doctrine

Who Is Interested in "Technical Legal Doctrine"?

Why should nonlawyers be interested in legal doctrine, and especially in a long discussion of the topic? One answer is that the changing legal doctrine reflects the evolution of American culture and draws on the developments that have been percolating in America for some time. The more important answer is that this legal doctrine is not in the public domain today but is reserved to the profession. It is time for the public to discover what the latest generation of jurists is thinking. The public ought to understand how these jurists, who affect the law or even make the law, view trusted powerful people on whom the public depends. The public not only ought to know but is entitled to know.

A detailed discussion of contract and fiduciary law is outside the scope of this book.12 It is unnecessary. My purpose here is to show the direction of the law in regulating fiduciaries. One important example of this direction in the past 25 years is the attempts to subsume the law of fiduciaries into the law of contract. Sometimes a transition of the rules is not very clear. For example, transactions may remain within their historical categories, but the rules within the traditional categories can change, by absorbing borrowed rules and principles from other categories [Corbin, 1:111]. In the case of fiduciaries who hold other people's money, however, there was and continues to be a strong movement, bold and open, to change categories-from fiduciary law category to contract law category.

A battle of categories is no idle pastime. Classification determines substance and image. It makes a great difference whether people who hold other people's money are accused of embezzlement or of failing to keep their word. After all, embezzlement can be subsumed in contract. It can be viewed as breaking a promise not to take other people's money and not to use it as your own. But the difference is significant. Embezzlement carries with it a moral stigma. Breaking a promise is far less pernicious. Even stealing is less abhorrent than embezzlement, because embezzlement is easy stealing. And it is stealing what is voluntarily given in trust. When the category of contract absorbs fiduciary relationships, the category colors fiduciary relationships with the moral standards and the rules of a contract exchange, converting the fiduciary into a seller of service, and his embezzlement into a breach of promise.

"Trust" and "Verify" in Contract Relationships

Trust or verification or both are often necessary between buyers and sellers, especially if the parties do not have equal information. But a trusted party to an exchange is not a "trustee" of the money he receives in an exchange. A trusted party in an exchange is not a "fiduciary," who is expected to act for the benefit of the other party. This kind of trusted party has a right to the money he receives and can use the money for his own benefit. After all, that is the deal.

When a trustee receives money in trust, the parties do not intend the money to belong to the trustee. That is not the purpose of the transfer. The purpose of the transfer is to allow the trustee to manage the money for the other party's benefit. The money continues to belong to the person who entrusted the money-the "entrustor." There are gray areas in which the status of the money can be debated. There are gray areas in which the status of controlling other people's money can be debated. But by and large, the models of a contract party and a fiduciary can be clearly distinguished. Money given in a contract exchange belongs to the receiver. Money given in trust continues to belong to the giver.

Many, if not all, the rules that surround the area of contract and fiduciary can be explained in light of this distinction. Shifting a trustee into the category of a buyer or seller confuses the status of property that a trustee receives. It can mislead some trustees into believing that the entrusted property belongs to them when it does not.

Types of Fiduciary and Contract Relationships

The Money Manager and His Client

What are the differences between contract and fiduciary law? Here is an example. When a person hires an advisor to manage his savings, the parties create two types of relationships. One relationship is a contract for hire: an exchange. The advisor offers his services in exchange for fees. The advisor can do with his fees whatever he likes. The fees belong to him.

The second relationship in this transaction is fiduciary.13 The client hands his savings to the advisor so that the advisor will manage the client's money more efficiently. If the client controlled his money, the advisor would have to involve the client in every transaction, and that is costly and inefficient. Therefore, the only purpose for handing the client's money to the advisor is to facilitate the advisory service. The client can then tend to his business and rely on the advisor to invest the money prudently and honestly for the client's benefit. This money that the client hands over to the advisor continues to belong to the client. The advisor must manage the money and use it for the sole benefit of the client, and according to the client's directives.

The Physician and His Patient

A similar and even more powerful example of a fiduciary is the physician. A physician who performs surgery on a patient gains full control over the patient's body and sometimes over the patient's life. Yet the patient's body continues to belong to the patient. For example, in one case, a physician used a patient's unique cells to develop a new medicine. The physician asked the patient to make occasional visits for tests but did not tell him about the research. When the physician patented the medicine, the patient sued for ownership of the patent. The court held that the physician misappropriated the property of the patient in his body. Even though the patient was not harmed, and the physician patented his own innovation, the physician had to share the financial fruits of his research with the patient.14 That is because the physician was a fiduciary, and got control over the patient's body as a fiduciary.

The Teacher and His Students

A teacher is also a fiduciary with respect to some of his powers. I sometimes propose to my students a scheme. I want to auction off the grades at the end of the semester. I will give the highest grades to the highest bidder, and the students can even create a market in the grades. Would not that be attractive? It is attractive to me. After reflection, students note that the grades are designed to show how proficient they are, and not how wealthy they are. Therefore, the idea is not very good. But the main point usually eludes them. It is that my power to award grades is not mine to sell. I hold the power in trust for the university. The university gave me the power for a specific purpose, and for no other. That is the main difference. There was no exchange. I received the power as a fiduciary.

Chapter 9 - The Shift from Professions to Businesses – excerpts pages 136-141 and 146-147

During the past 25 years, the professions, such as physicians and the lawyers, have undergone a shift. They have become less professional and more like businesses. The impact of this change has been felt in the 1990s.

Professionals, Businesspersons, and Fiduciaries

Who are professionals? Historically, are professionals different from businesspersons? How does the distinction relate to trust? Are all professionals viewed as fiduciaries? What are the consequences of the shift of professions to businesses? I deal with each of these questions in the order they are presented.

How do professionals differ from businesspersons? The ideal model of a professional is a person who is public service–oriented. He seeks money secondarily, for he needs to make a living. In contrast, the model of a businessperson is that of a profit oriented person who is exchanging service or goods for the money.

In his article "The Professions in the Society Today," Roscoe Pound, the late dean of Harvard Law School, told the story of an old man who was prosecuted for practicing medicine without a license. The judge called him an amateur. "At this the old man broke-in protesting. He said: åYour Honor is calling me an amateur? Why, I have made more money in my business each of the last five years than all of any three licensed doctors in the country put together.'"1 Dean Pound added:

I have not found it easy to impart the conception of a group of men pursuing a common calling as a learned art and as a public service-nonetheless a public service because it may incidentally be a means of livelihood. From the Middle Ages, the formative era of our social institutions, we had received this idea of a profession, and medicine, the law, the ministry and teaching had grown up in its pattern.2

Pound lists three important ideas that relate to professions: "organization, learning and a spirit of public service. The gaining of a livelihood is not a professional consideration. Indeed, the professional spirit, the spirit of public service, constantly curbs the urge of that instinct. It is no disparagement of honorable trades and callings." Dean Pound notes that while an engineer may claim a patent for innovative ideas, the lawyer may only claim a copyright for his words. The ideas of the lawyer belong to the public and cannot be patented.3

In his book The Lawyer from Antiquity to Modern Times, which followed the article, Dean Pound reiterated the same ideas. The money that a professional earns is but "an incidental purpose, pursuit of which is held down by traditions of a chief purpose," that is, public service. The term profession "refers to a group of men pursuing a learned art as a common calling in the spirit of public service-no less a public service because it may incidentally be a means of livelihood" [Pound, 4–5]. He adds: "It is of the essence of a profession that it is practiced in a spirit of public service. åA trade . . . aims primarily at personal gain; a profession at the exercise of powers beneficial to mankind'" [Pound, 9]. One of the distinctions between professions and trades writes Pound is that "the member of a profession does not regard himself as in competition with his professional brethren. He is not bartering his services as is the artisan nor exchanging the products of his skill and learning as the farmer sells wheat or corn." He does not strike for better wages. "This spirit of public service in which the profession of law is and ought to be exercised is a prerequisite of sound administration of justice according to law" [Pound, 10].

At commencement, Dean Paul M. Siskind of Boston University Law School used to explain the origins of the hood that academics wear with their gowns. The hood has a baggy part on the back of the wearer. It looks like the bag in which infants are carried. Dean Siskind noted that the academics of the past, the monks, taught or gave religious services but did not ask for compensation in exchange. The monks did not hold out their hands to the givers or even face the givers. Payment was not charity. The monks performed services and had to subsist. This was a "nonexchange" giving, preserving the professional image of the monk. Respectfully, people paid by putting food or money or valuables into the back pocket of the hood.4 Reality was probably more pragmatic. The hoods kept the monks warm. Cynthia W. Rossano wrote: "In some areas during the Middle Ages the hood was an alms bag slung around the necks of begging friars; in others, the medieval cowl was worn simply for warmth drawn tightly around the face by the liripipe."5 The practical and symbolic use of the hood can be applied to the professions. Money is important but comes second to public service.6

Both businessperson and professional can be productive, innovative, and brilliant. Their motivations, however, are different, and their emphasis on the monetary rewards is different. The differences are not mutually exclusive. Some businesses, such as the original Ben and Jerry's ice cream enterprise, are oriented toward public interests. Some professions are closer to making money, such as financial managers. When expertise involves making money for others, it is only natural that the experts would use their talents and knowledge to make money for themselves as well. Nonetheless, the origins, basis, and distinction of a profession are its objective of public service.

Even if there are differences between professions and businesses, do these differences concern trust? After all, there are businesspersons who are moral and professionals who are not. However, a professional evokes more trust than the businessperson. If service comes first, the interests of the patient, the client, and the dependent customer come first. The model did not always fit the reality but was the aspiration to which the professions were upheld, sometimes through the media. In the 1938 movie The Citadel, Robert Donat plays the physician caught in a very lucrative service to neurotic upper crust ladies. He finally leaves for a very low-paying service in a mining town where his services are truly needed. The dilemma is old. In the film, the solution highlights the profession's ideal of public service. This aspiration commands trust in those who must rely on professionals and cannot verify their expertise or judge their advice. In contrast, the focus on the payment for the services puts the actor's interests first. His question is: "What and how much is there for me?" The trust of the patient, client, and dependent customer is lower. Doubts about the trusted service are higher.

The image of professions as public service counts. As part of the culture, it builds expectations by those who deal with professionals, and requires professions to honor these expectations. It condemns those who do not comply. The reverse can happen as well. At some point, the image can change, and people reclassify professions as businesses, with different and lower expectations of commitment to service and accompanying reactions.

The models of a professional and a businessperson just described are ideal models. In fact, they are not so separated. There always were fiduciaries who behaved like businesspersons and businesspersons who were trusted and behaved like fiduciaries. A businessman tells me with nostalgia about the times when a deal was closed with a handshake. A manufacturer tells me with the same feeling about the relationships with employees. While his father did not hesitate to help his employees, his son hesitates to give advice, lest he be sued for bad advice. But as models, the morality of professionals was traditionally expected to be higher than that of businesspersons.

Historically, professionals' duties of self-limitation and moral behavior were heavier, in part because of their great expertise. Those who became more expert organized their group to signal their superior knowledge and sometimes asked for a legal distinction, by requiring examinations and registration. The evolution of the nursing profession is one example. Expert practical nurses sought legal licensing to control the membership and to ensure the higher standard.7 In addition, the law provides expert professionals with business. Public corporations must employ certified public accountants to certify their financial statements. Lawyers have the exclusive right to represent others in court. Rating by rating agencies is necessary to gain certain exemptions from the Investment Company Act8 and other securities acts. These privileges come with duties. The experts and their certifications should be trustworthy more than the sellers of services and commodities in the marketplace. he price for the experts' monopolies and privileges is the public service aspect of their activities. For example, the lawyers must participate in the enforcement of the laws that granted them their special status. That is the deal.

Why aren't bankers and insurance providers professionals? They fit the definition of professionals in that they offer a public service and it is hard to monitor, understand, and supervise their activities. One difference between bankers and insurance providers and professionals is historical. Professionals included physicians, lawyers, and teachers. In the Middle Ages, people who dealt with money, especially moneylenders, were not included. Perhaps they could not be deemed professionals because they dealt with money.

Another difference between professionals on the one hand and banks and insurance on the other relates to regulation. Today banks and insurance companies are microregulated by the government, while physicians and lawyers are not. That may be the reason why financial advisers, who are not as micromanaged, are considered professional trusted advisors. And yet, these distinctions are not precise. In sum, professionals include a broad category of trusted people, whose activities are difficult to monitor and judge. They are trusted people who are not subject to close government micromanagement. Therefore, if people are to ask them for help, and if they must be trusted, these professionals are expected to feel constrained to give service, and to control their temptations, even though there are no police around. Sometimes they are expected to give service even if they are not paid in advance or might not be paid at all. A doctor is expected to come forward to the cry: "Is there a doctor here?"

The Recent Transformation of the Professions and its Consequences

In the past three decades, the professions have lost their special status and have been recast as businesses. Professionals have become the producers and sellers of commodities in the markets. Richard Posner compares the legal profession to the seventeenth-century merchant guilds [Posner, 33–70]. The guilds were groups of merchants who organized fairs and maintained the reputation of their members for honesty. Posner predicts: "Something like the evolution of the textile industry from guild production to mass production, and the concomitant decline of artisanality, is occurring today in the market for legal services" [Posner, 47]. It should be noted that the judge compares professional services to the production of textiles. He predicts that lawyers and physicians will render mass-produced services, rather than personal services, like the recent producers as compared to the weavers of the preindustrial era. Perhaps the professionals' advice would be based on an efficient use of statistical data. This economic theory for the industrial age may be unsuitable for today's information age. But then, the professions are not sufficiently efficient. Therefore, it may be that the wealthy will benefit from personal services, while the less wealthy will be put into the mass-production of a standardized service machine. In that case, the controls may have to shift to those who design and operate the machine. Their professional status can be hidden under the facade of businesses that sell their machines.

The Effects of Competition among Professionals

Historically, professionals, such as lawyers and teachers, belonged to fraternities. They did not compete. Their institutions created roles that made them more interdependent. These institutions resulted in greater reciprocity and fairness and more trust among their members [Misztal, 226]. This form of institution makes sense when all members of the fraternities aim at public service. Competition is the antithesis of such fraternities. Competition makes sense when each member serves his own interests and is therefore in conflict with the aims of all other members of the group.

Advertising accompanies competition. Until 1977, lawyers were barred from advertising, and the states approved the prohibition. In Bates v. State Bar of Arizona,9 the Supreme Court ruled that the ban was unconstitutional and permitted lawyers to advertise. First Amendment rights served as the basis for the decisions to allow advertising.10 Advertising and competition could bring benefits. Advertising could offer more information to clients. Competition would reduce the professionals' fees. Market forces could discipline the lawyers' and doctors' transgressions, and empower clients and patients. These expectations did not materialize; the fruits of these changes were not so sweet. In the words of Justice O'Connor: "In one way or another, time will uncover the folly of the approach [of allowing lawyers' direct and targeted solicitation]."11

The expected competition among the professionals did arrive, perhaps with unexpected fierceness, and seemed to bring the morals of the profession down to the level of the marketplace. The prophetic concerns of Dean Pound about the competition among the professions have materialized. Among the four related dangers to the ideal of the professions, Dean Pound noted the "magnified economic exigencies of the individual." Prophetically, he noted the developments of the large law firms: "the creation of partnerships and the reduction of individual responsibility of the lawyers, which make it difficult to resist business methods, which can easily become the methods of competitive acquisitive activity."12

Indeed, as Gregg Bloche noted in discussing trust in the medical field, the contract and market image have changed the medical profession.13 With these changes have come decreased patients' trust and lower respect for the doctors.14 Among the gruesome stories is an example of a doctor who attempted to hurry up the death of his dying mother in order to save blood-clotting cells.15 In the late 1980s, medical professionals were also investigated for a typical marketplace crime: price fixing.16

As lawyers moved to offering revenue-producing advice, lawyers were drawn to search in the gray areas of law and accounting. Discovering or creating loopholes through which clients could crawl would reduce the clients' costs and gain for the clients a competitive advantage, at least until the competitors discovered the same loopholes and used them too.

David Wessel wrote: The decay of professionalism-and codes of ethics that distinguished a profession from a job-intensified in the 1990s, but it didn't begin then. Reflecting on his 23 years in corporate management [treasury secretary Paul O'Neill] recalls a parade of Wall Street professionals who came to his office with plans for "new and exotic" financial maneuvers to reduce his company's tax bill or report debt levels in ways "not clearly prohibited by the tax code or law."

He continues, citing Professor John Coffee: "This disturbing pattern is the biggest reason why the abuses of the 1990s can't easily be dismissed as the fault of a few immoral human beings. åThe professional gatekeepers were greatly compromised by finding they could make tremendous profits by deferring to management.'" 17

Sometimes they did more. Law is not a precise science. Attorneys could justify saying no to almost every new design of a business that had not been tested in court. In the 1980s, they developed a more flexible attitude. A lawyer might decline to approve a prohibited transaction but might help the client design an alternative. The alternative might be less profitable, but still profitable, with the minimal risk of illegality that a new design presents. This trend, which started in the 1960s, reached much wider dimensions in the 1990s.

The search for "creative" transactions, financial assets, and accounting became the order of the day. For example, the large accounting firms KPMG and Ernst & Young have put their energies into marketing "leveraged" tax law and tax shelters.18 The legal effect of these innovative arrangements was not ascertained. In KPMG, money was the main driver. The firm did not comply with the rule that required it to register as the creators of tax shelters. As a partner in the firm wrote in his memorandum: "Penalties [for failure to register] would be no greater than $14,000 per $100,000 in [the firm's fees]"; and: "as the size of the deal increases, our exposure to the penalties decreases as a percentage of [the] fees."19 Breaking the law was factored into the cost of doing business and was indistinguishable from the cost of rent and office supplies. The tax shelters involved paper (sham) transactions, designed to show losses and cover the capital gains of the clients, and were later disallowed by the IRS. The clients, who had paid handsomely for these "shelters," were left with tax bills containing not only the taxes but also interest on the taxes due.20

With the new marketplace environment in the legal profession, clients began to shop around, but not necessarily for lower fees. Sometimes they shopped for better revenueproducing legal opinions and transaction structures. Sometimes they shopped for skewed legal opinions that other lawyers refused to give. It is unclear whether the cost of legal services went down. There are lawyers who demanded part of the clients' revenues from creative advice, and the revenues of large law firms rose dramatically. As already noted, between 1987 and 2003, "revenues at the top 100 firms quintupled to $38 billion, while profits quadrupled to $13.5 billion."21

Weaker Fiduciary Law by Interpretation

The movement from fiduciaries to contract parties, from professions to businesses, was accompanied by changes in the way the law is interpreted. The rules concerning the distribution and sale of securities offer an example. To raise money from public investors ("public offering"), a corporation must file a statement (registration statement) with the SEC. The statement contains information about the corporation and the securities (stock, bonds) that it offers.35 The government officials then review the materials and may require additional information. When they are satisfied, they will declare the registration "effective," and the securities may then be offered and sold to the public. Part of this registration statement becomes the "prospectus," which must be offered to public investors with the stock. But if the investors are sophisticated, the corporation can offer them its securities in a nonpublic distribution, or "private placement." The corporation must then offer these investors adequate information but bypass the registration with the government. Instead, it just sends the government a notice and a copy of the documents that it offers to the investors. How does one decide when a distribution is a "public offering" and when the distribution is a "private placement"?

In a 1953 case of SEC v. Ralston Purina Company, the Supreme Court offered guidelines and a list of factors to define "private placement."36 It emphasized that those who are offered securities in a private placement must be sophisticated and have access to information that would have been included in the registration statement. A later 1977 case, Doran v. Petroleum Management Corporation, provided a more detailed list, including the number of the persons who were offered the stock, their financial situations, their knowledge of the corporation's business, and access to information about the corporation.37

The pressures arose to turn the lists of factors into detailed rules. The SEC published regulation D, which detailed with specificity who are sophisticated investors, and how a private placement is to be made.38 Specific rules seem more efficient, because they are presumably clearer. But experience has shown that specific rules are not necessarily clearer. The more specific they are, the more questions of interpretations they can raise [Cass, 106]. There are now volumes written about regulation D on private placement. Specific rules are assumed to be fairer. After all, people ought to know what is permitted and what is not. The government should tell people precisely what to do and precisely what not to do. Otherwise, people ought to be free to act or not to act as they please.

This approach may be reasonable for tax and criminal laws. In fiduciary law, this approach raises serious problems, precisely because of the precision that it advocates. No rule can list all that is prohibited to fiduciaries, even if the rule filled the Library of Congress. When fiduciaries have broad discretion, such as managing large corporations, and billions of dollars in financial assets, there are always ambiguous and new situations, which abusers of trust can interpret their way. They can construe the law narrowly: What the rules do not specifically say, the rules do not cover. This is a hostile view of the law as an intruder on the trusted persons' freedom to exercise their powers. Another interpretation would inquire into the purpose of the rule, ask how reasonable people would explain it, and impose a broader or narrower interpretation accordingly, depending on the danger of abuse. This is a view of the law as a protector of trust and the public good.

It may be argued that specific rules limit discretion and standards broaden discretion. That may be inaccurate in many areas. As Frederick Schauer points out, specific rules are not as specific as they seem, and standards are not as broad as they seem.39 But for fiduciaries, specific rules can be used to broaden discretion, not narrow it. And standards can be used to limit their discretion.

A strictly literal interpretation of a rule can drain it of its spirit and subvert its goal. The proponents of precise rules strive to free trusted persons from legal constraints as much as possible. Under the banner of the rule of law, they wave the flag of market freedom. This approach allows for easy manipulation. If a law prohibits corporate officers from buying corporate real estate but does not mention leases, then the officers may acquire leases-that is, even though the purpose of the law was to prohibit corporate officers from sitting on both sides of any bargain, as representatives of the corporation and as representatives of their own interests. Or if the prohibition mentions leases but does not mention loans, then corporate officers may borrow from the corporation. If borrowing is prohibited, but no mention is made of using corporate power to obtain business opportunities that should belong to the corporation, then such use would be permitted. And if the rule does not describe with precision and prohibit the manner in which officers of Enron managed seemingly independent entities that in fact held Enron's assets, the actions would be permitted. And if the rule does not prohibit Enron's officers to deal with these seemingly independent entities on behalf of Enron, and draw compensation in the millions from both Enron and the entities, these actions would be permitted.

An example of a literal reading is instructive. The SEC reached a settlement that disqualified a corporate officer from sitting on a board of directors of a "corporation" for five years. Literally, the settlement did not disqualify this person from serving as director on the board of a not-for-profit corporation, or perhaps as trustee on the board of a large trust. It may well be that the settlement was truly limited to corporations, and that the officer was not disqualified from sitting on the boards of other types of entities. But suppose the spirit of the settlement meant full disqualification. In such a case, the interpreters would include in the term "corporation" similar large organizations. After all, the message of this disqualification was that this officer, who was in charge of a large corporation in which accounting frauds had occurred, should not be allowed to manage similarly large organizations. A literal interpretation of the settlement emptied it of its substance. In fact, it could make a mockery of the settlement, as this officer could head a large not-for-profit corporation during the disqualification period.40

Chapter 12 - Toward an Honest Society - Excerpts from pages 204-206

Society is populated by honest and dishonest persons; by selfless compassionate idealists and self-centered ruthless narcissists; by true victims and foolish or fake victims; by productive entrepreneurs and mimics of entrepreneurs who produce nothing. People behave inconsistently, change, and evolve. Moreover, truth, trust, and honesty are indeterminate. The differences among trust, gullibility, and faith are relative. They depend on the sources and cost of verifying the trusted persons' statements and the cost of monitoring the trusted persons' activities. They depend on the abilities of the people who rely on trusted persons to protect themselves against fraud. Protection against dishonesty is tricky. The very protection may undermine the trust we wish to foster in society. And the law, although helpful, is not the whole answer.

Therefore, a competing clear and specific blueprint to the one we have now will be as unreal and as misleading as the legal economics view of the world. An ideal world of truth, trust, and commitment to others as well as to one's own self is just as unrealistic. The closer our competing view will come to reflect the real complex world, the less understood it will become. Humans and their society cannot fit into a square box, or any box, for that matter.

Alternatively, we can continue to search for the simple and specific world that does not exist. A society with a strong sense of survival, like the American society, will swing from one such simple world to another. When a view supports an environment that has become too despotic and corrupt, like the one toward which we are heading, the pendulum could swing drastically in the opposite direction. Historically, America has been switching from one simplistic blueprint to another. As one blueprint has become intolerable, Americans have adopted another, which has become intolerable in turn. America experienced Puritanism with its despotic intrusion into private actions and thoughts, as well as the Wild West, the "roaring" twenties, and the rebellious sixties, with their attitude of "anything goes." Thus, after extreme authoritarian strictness came extreme permissiveness. After confining rules of behavior, dress, and personal moral rules came a revolt against any rule. Perhaps when the compulsion and corruption of the 1990s finally end, the pendulum will swing again, and the country will recede into intrusive regulation and strict authoritarian controls of deception and abuse of trust.

To avoid sharp swings of the pendulum from one simple vision of society to another, we could abandon the search, accept an unstructured world, and suffer the enormous anxiety and confusion that it produces. But such a solution may disintegrate and disorient communities and even individuals. It may also result in uncontrolled power, both governmental and private-a mix of benevolence and despotism, but with no principles and no guidelines.

Let us muddle through in search of a balance. Let America look for a balance. Let self-interest balance with altruism, let taking balance with giving, and commitment to the self balance with commitment to society. Moral self-limiting behavior is not stupid behavior. It offers rewards but does not condemn self-interest. Law is not the enemy of business. It is the enemy of crooked business. Law does not undermine free markets. It protects free markets but leaves them relatively free.

Society and its leaders reflect each other. In this strong democratic American society, followers can lead-that is, if they get involved. If Americans have had enough of what they have seen lately, if they want a society in which relationships are more honest and less cynical, more trusting and less doubting, then Americans can reject a culture dominated exclusively by the self and the market's self-protection. They can tell their leaders and themselves to move toward an honest society. Shareholders can tell management and themselves to move toward an honest corporate behavior. "Making capitalism work well will never be easy. To make it work, shareholders must be seen to play a wise and active role in governance. That would certainly be the best way to restore faith in top business bosses. To excel, good corporate leaders need good owners."43

Just Pick and Follow the Goal of Honesty and Trust

Just aim at honesty and trust. We will disagree on the definition and argue about the details. This does not matter, so long as we care about trust and honesty generally, and so long as most people factor into their decisions the component of honesty and include in their considerations the society at large. The problem, as this book shows, is not that we cannot define honesty and trust with precision. We may argue about the precise definition. But most of us would agree on the basic concepts. The problem is that too many people and too many leaders have abandoned trust and honesty as a goal.

Aiming at honesty and trust could serve to control and mitigate the inhumanity, cruelty, despotism, and rational unreasonableness that any view of the world in vogue is likely to produce. Following this goal, we can maintain the insights of economics yet restrict manipulation, deception, and abuse of trust. The vision can pull us back from the culture of con artists toward which we have been sliding and lift us toward a truthful and more efficient culture.

The cynics may say: "Wake up! Be realistic! You are talking of people, not angels." That is true. But neither are most Americans cruel predators, self-centered beings lacking in empathy, and greedy to embezzle other people's savings by deception. Many Americans would like to see their corporate and financial world in the better light of trustworthiness. They may even be willing to receive lower, but true, returns on their money. The danger and damage of white-collar criminals to society can be abated if a sufficient number of people believe in an honest society, expect everyone to follow, and apply social sanctions on those that do not follow. Then, abusers of trust are likely to remain in the minority, always in the shadows, never emerging to lead in the light.

The critics would say: "This approach eliminates competition. It endangers America's prosperity and way of life." Yet Americans need not cease to compete. The goal of honesty is not to reduce competitive ardor but to channel it in less destructive ways. Honesty encourages competition on the merits and prohibits competition by cheating. Honesty brings better quality of products and services and less shoddy products and fake services. If businesses do not compete on fraud, they can be more successful in gaining and retaining customers. More likely, the ambition toward an honest society will lead America to a better mix of preventive mechanisms, and to the middle of the road rather than to the extremes.

Yes, I am suggesting an unreachable goal. No competitive, dynamic society can be entirely honest. This goal cannot be achieved. Accepting and trying to reach an unreachable ideal is not new to America. American people have relentlessly aspired to the unachievable. And they have produced a free society and an economy that is the envy of the world. The real test for an honest and productive society is not what a society has achieved but what it aims to achieve. A society can put honest people on the pedestal, even if they do not maximize their personal benefits and preferences. A society can discard and shun as models of failure dishonest people who achieve their highest ambitions by fraud and abuse of trust. So what if this approach will not necessarily convert all people into honest people? It is the approach that matters. Like a toddler, we might even take a few steps toward this vision of a society, muddle through, and oscillate on the road to the world we will never reach.

If we substitute the word "honesty" in the statement of Senator Daniel P. Moynihan about crime in America, his words say it all: Honesty is not "revealed truth nor yet a scientifically derived formula. . . . It is simply a pattern that we observe in ourselves. Nor is it rigid." As we have been redefining honesty downward, we are "getting used to a lot of behavior that is not good for us." If the analysis in this book wins acceptance, and if the readers feel a sense of "genuine alarm" at what has been happening to our measure of trust and honesty, "we might surprise ourselves how well we respond to the manifest decline" of the American business morality.44

The one thing on which we need not compromise is the ambition to become an honest society and to have our society reap the rich rewards of honesty. This ambition is an ideal, yet it can shape and become a building block of our culture and our reality. Being an ideal, it is fully within our control-powerful and empowering. We can mold it any way we want. It is Utopia, which we cannot realize. But it can guide our life every day. "A man's reach should exceed his grasp," Robert Browning wrote. A society's reach toward honesty should exceed its grasp as well. It is not reaching that ideal but striving toward it that makes an honest society.