"The Ethics and Legality of Financial Regulation: What Enron Revealed"

Balancing Regulation: The Prisoner's Dilemma

While stricter punishments may theoretically deter fraud for companies that operate under contractarianism or consequentialism, they create conflicting influences when applied practically to the marketplace. Recall the classic Prisoner's Dilemma: if both players cheat, each player's payoff is lower than if both had cooperated; however, if only one player cheats, the cheater's payoff is the highest of all possible individual outcomes. If this game were expanded to include more players, then, it may follow that the more players there are that don't cheat, the greater the potential reward for an individual that does. Now consider increases in financial regulation: they are intended to prevent firms and individual investors from having unfair advantages in the marketplace. However, if this increased regulation deters (or is perceived to deter) more firms from committing fraud, an egoistic or consequentialist firm may consider the potential rewards of committing fraud to be greater than they were previously.

This example of regulation theoretically promoting fraud can be illustrated with the illegal act of insider trading, a crime of which former Enron CEO Skilling was convicted (Emshwiller, 2006). Insider trading occurs when individuals with material, nonpublic information use their privileged information to make transactions in the economic market. The more insider trading occurs, the more the market suffers: investors without insider information won't want to invest their capital, and even insiders themselves can't make as much money with other insiders acting quickly on profitable opportunities. An agent operating under contractarian or consequentialist principles may weigh the potential gains against the potential ramifications and conclude that it is better to not engage in insider trading. Now, imagine that the penalties for insider trading are increased. For the same firm, the potential negative consequences of insider trading have increased--but with fewer insider traders taking advantage of profitable opportunities, so have the potential gains. If those potential gains outweigh the increased punishments brought about by the new legislation, a firm operating under consequentialism or contractarianism might decide that it is now in its best interest to act illegally. The increase in regulation can theoretically encourage, rather than prevent, illegal activity.

Because continually tightening financial regulation could in fact promote fraudulent activity--and because new regulations are immensely expensive to implement--the development of stricter financial laws may not always be in the best interest of firm stakeholders. Compliance with the SOA has cost corporations millions of dollars in external auditing fees; ironically, these high costs have a much more devastating impact on smaller publicly-traded businesses than they do on the huge corporations (like Enron) whose bankruptcies the SOA seems most concerned with preventing. The more money firms are required to spend in order to comply with current regulation, the less money they are able to reinvest into their own development. This harms not only the shareholders who can't reap the benefits of capital appreciation on a firm's stock but also all market stakeholders who benefit from an expanding economy. In the wake of the 2008 financial recession, the extensive regulation enacted by the Dodd-Frank Act increased regulatory compliance fees even further. But is a continual increase in strict financial regulation the answer to unethical corporate behavior?