How Trust is Abused in Free Markets: Enron’s 'Crooked 'E’'

Abstract

A market can have a lemon's problem when one party to the transaction has far superior information to the other and defects are not obvious. The classic bad car, the "lemon" led to the name for this theory. A lemon's market is inefficient. Both consumers and reputable sellers of high quality goods are harmed by the consumer's inability to distinguish superior goods. Frauds, who sell poor quality goods by misrepresenting quality are the only winners. Markets beset by lemon's problems may be improved by government intervention, which can aid both consumers and honest sellers.

In his article "How Trust is Achieved in Free Markets," Dan Klein, a libertarian, argues that government intervention is not necessary to deal with lemon's problems because the markets do so. A variant of Dan's reasoning lies at the heart of modern corporate governance. Its leading scholars assert that fraud by controlling persons is minimal because legitimate firms successfully distinguish themselves from control frauds. They do so through three primary devices: hiring top-tier outside auditors, insuring that their CEOs own large amounts of the company's stock, and having the company take on large amounts of debt. The S&L debacle and the ongoing financial crises have shown that this confidence in the ability of markets to discern control frauds was misplaced.

White-collar criminologists are less sanguine about the ability of honest firms to distinguish themselves from the control frauds in many contexts absent effective regulation. Fraud always involves the creation and abuse of trust. Fraudulent firms love it when legitimate firms adopt signaling devices that they can mimic. This creates greater trust and allows more lucrative fraud. Moral restraints and legal prohibitions, in a functional, representative government, are generally mutually supportive. They can also support, instead of supplant, voluntary agreement.

Keywords: Corporate law, Financial crisis, Financial regulation, Banking, Banking regulation, Securities, Securities regulation, Control fraud, Fraud

JEL Classification: K14, K22, K23, K42, G18, G28, G38