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«Who Was Swimming Naked When the Tide Went Out? Introducing Criminology to the Finance Curriculum Jacqueline M. Drew and Michael E. Drew Griffith ...»

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Journal of Business Ethics Education 9 Special Issue: 63-76.

© 2012 NeilsonJournals Publishing.

Who Was Swimming Naked When the

Tide Went Out? Introducing Criminology

to the Finance Curriculum

Jacqueline M. Drew and Michael E. Drew

Griffith University, Australia

Abstract. Finance programs around the world have been revising their curricula following the

Global Financial Crisis (GFC). While much of the debate has centred on the dominance of scientific

and quantitative pedagogical approaches to finance education in business schools, one of the most egregious aspects uncovered during the deleveraging of the financial system was the scale and scope of finance crime and financial fraud (including the Madoff scandal, described as the largest Ponzi scheme in history). This paper argues that those “on the inside”, the professionals within the finance industry, have a central role to play in safeguarding the ethics and integrity of financial markets. It is our conjecture that prevention and earlier detection of finance crime and financial fraud may be addressed, in part, by better educating finance professionals about these issues. We posit that the enormity of illegal activity uncovered in the wake of the GFC demands, as a matter of priority, the integration of criminological and criminal justice theory into the finance curriculum.

Keywords: finance curriculum, criminology and criminal justice across the curriculum, financial crime and fraud, pedagogy.

1. Introduction Mr Warren Buffett famously stated, “after all, you only find out who is swimming naked when the tide goes out” (Chairman’s Letter Berkshire Hathaway 2002).

This quote has been cited often following the Global Financial Crisis (GFC) as it eloquently captures the liquidity crisis that engulfed the global economy. The deteriorating economic outlook, heightened systemic risk, the collapse of financial markets and an erosion of confidence sparked a run on fund withdrawals, as institutional and individual investors moved swiftly to liquefy their holdings (Benson 2009, Drew and Drew 2010). Given the radical fall in liquidity, the GFC was a primary catalyst in the exposition of the single largest episode of finance crime and financial fraud in generations.

The dislocation of economies and markets during the GFC, in concert with the egregious nature of the finance crime and fraud committed, has seen significant and important questions raised about the role and impact of business education.

Emotive arguments have been proffered concluding that middle and senior finance professionals are products of business schools. In turn, it has been concluded that business schools are largely to blame for the unethical behaviour, A licence has been granted to the author(s) to make printed copies of the paper for personal use only. Apart from these licenced copies, none of the material protected by the copyright notice can be reproduced or used in any form either electronic or mechanical, including photocopying, recording or by any other information recording or retrieval system, without prior written permission from the owner(s) of the copyright. © NeilsonJournals Publishing 2012.

64 Who Was Swimming Naked When the Tide Went Out? Introducing Criminology to the Finance Curriculum manifested as unabashed self-interest, profit-maximisation and greed, uncovered post-GFC (Giacalone and Wargo 2009). In the wake of the financial crisis,

popular media have questioned those who have “created” these business leaders:

“Business schools: a failing grade on ethics” (Gentile 2009) “Who taught them greed is good? To what extent are business schools’ MBA courses responsible for the global financial crash?” (Walker 2009) Interest in business ethics inevitably ebbs and flows as events in the financial marketplace draw attention to its flaws. Similar reflection took place following the dot.com crash and accounting scandals occurring in the beginning of the previous decade (namely, Enron and WorldCom) (Friedrichs 2010, Giacalone and Wargo 2009). So with the advent of the GFC, practitioners and academics alike have again taken a renewed focus on the ethical conduct of business leaders.

The enormity of the events, involving well-known and respected investment houses, the high profile individuals involved and magnitude of financial losses across a wide spectrum of the consumer population has put business education and specifically, ethics, under the microscope (Balotsky and Steingard 2006).

A review of the academic literature that has addressed business ethics indicates that recent discussions are generally placed against the backdrop of a body of research that stretches back more than 25 years (Balotsky and Steingard 2006). To date, this body of work has produced promising findings. Most would conclude that ethics education is valuable and can make a difference, however a clear and consistent answer to how business schools most successfully impact on business ethics remains open (Balotsky and Steingard 2006). How ethics should be taught, the content of business ethics courses and what outcomes can be achieved are topics that continue to be examined (Nguyen, Basuray, Smith, Kopka, and McCulloh 2008). The paper builds on this previous body of work, contributing to the debate through an examination of the financial crime and fraud identified by the GFC and prosecutes the case for formal inclusion of criminological and criminal justice content within the finance curriculum.

As stated earlier, the liquidity crunch associated with the GFC was instrumental in exposing significant criminal and fraudulent practices in global financial markets. This paper considers the role and emphasis given to finance crime and in particular, the prevention and detection of financial fraud in finance curricula. It is proposed that a positive outcome that could be drawn from the scandals uncovered by the GFC is a recognition that the finance curriculum should and must draw on the work of criminologists and criminal justice scholars to enhance the robustness of the program. The paper argues that the role of “insiders”, those that work within the finance industry as finance professionals, are central to the ethical conduct and professional practice within the financial markets. We need to take significant and meaningful steps towards better educating these “finance insiders”. The next generation of graduates must grasp Journal of Business Ethics Education 9 Special Issue 65 the prevalence of financial crime and fraud and the devastating impact it can have on the confidence of consumers and, ultimately, the integrity of the global financial system.

2. Finance Crime and Financial Fraud Uncovered Post-GFC In order to provide a view on what criminology and criminal justice content is required within the finance curriculum it is essential to consider the type of finance crime and financial fraud that was uncovered in the wake of the GFC.

This analysis is instructive as it provides a basis on which to determine the specific criminological content that would be most useful in ensuring that finance professionals are an essential resource in the prevention, detection and reporting of illegal activities within markets.

2.1. The Financial Boom, Growing Numbers of Participators and Complex Financial Products and Services It has been argued that the enormity of financial frauds that were uncovered following the GFC were able to be perpetrated more easily as they were camouflaged by the euphoria of the market during the financial boom (Tomasic 2011). Recent reports of the key enforcement actions taken by the US Securities and Exchange Commission (SEC) (through to August 2011) provide some indication of the types of misconduct which led or arose from the financial crisis (SEC 2011). The SEC has taken action against numerous entities that were found to have, “... concealed from investors risk, terms, and improper pricing in collateralised debt obligations (CDOs) and other complex structured products, made misleading disclosures to investors about mortgage-related risks and exposure and concealed the extent of risky mortgage-related and other investments in mutual funds and other financial products” (SEC 2011).

Further, Hudson and Maioli (2010) concluded that a major contributor to the crisis was the burgeoning complexity of both products and participators in the financial system. The financial system expanded to include a large number of new and complex financial products, most notably derivatives that required sophisticated and advanced knowledge of risk management and financial engineering. A raft of new players also entered the market, such as those in shadow banking activities (including hedge funds, a segment we will return to later in the paper), structured investment vehicles (SIVs) and private equity funds.

It is alleged that the misconduct was able to be enacted given that regulation and transparency of these market participators was relatively weak (Hudson and Maioli 2010).

66 Who Was Swimming Naked When the Tide Went Out? Introducing Criminology to the Finance Curriculum In late 2009, the US Department of Justice announced the establishment of the interagency Financial Fraud Enforcement Taskforce. Attorney General Eric Holder stated that “... this task force’s mission is not just to hold accountable those who helped bring about the last financial meltdown, but to prevent another meltdown from happening” (US Dept. of Justice 2009). The Financial Fraud Enforcement Taskforce by the end of 2010 reported that Operation Broken Trust which involved a massive investment fraud sweep across the United States (between 16 August and 1 December 2010), resulted in the identification of 211 cases of investment fraud involving over 120,000 victims and more than US$8 billion (Federal Bureau of Investigation (FBI), 2010). Whilst the majority of cases were Ponzi schemes, other frauds identified included market manipulation (“pump and dump”), affinity fraud, real estate investment fraud, commodities fraud, business opportunity fraud and foreign exchange fraud (FBI 2010). From the beginning of 2009 through to the end of 2010, over 200 Ponzi scheme cases were opened, involving more than US$20 million (FBI 2010).

Classification of cases of misconduct (such as those highlighted) as instances of finance crime and financial fraud provide a useful foundation on which to argue for the integration of criminology into the finance curriculum. Finance crime captures activities of “large-scale illegality that occurs in the world of finance and financial institutions” (Friedrichs 2010, p. 168). Financial fraud is used to refer to entities or individuals that “carry out a swindle while appearing to be engaged in a legitimate enterprise” (Friedrichs 2010, p. 200). We consider each of these issues in the following sections.

2.2. Finance Crime

Finance crime can take a myriad of forms and, as history has taught us all too frequently, is dynamic in its scope, nature and modus operandi. In recent years, the burgeoning shadow banking sector, in particular the rise of hedge funds, has illustrated the different ways unethical practice can adversely impact investors in these funds and materially heighten systemic risk. To provide some context, the global hedge fund industry now stands at around US$2 trillion and, while a relatively small part of the global financial markets, is a key element of the shadow banking system (Hedge Fund Research (HFR) cited by Herbst-Bayliss 2011). Unethical practice in the hedge fund arena can include: misrepresentation (for example, misreporting the performance of a hedge fund); and, omission (investment risk—exposure to, say, subprime mortgages; liquidity risk—the level of redemption requests; and, operational risks—people, technology, proprietary models and data/information); and, most audaciously, fabrication (Bollen and Pool 2009).

In an effort to identify fraudulent activity before massive losses are incurred, institutional investors perform due diligence and regulators examine hedge funds, Journal of Business Ethics Education 9 Special Issue 67 often after receiving complaints from investors (Bollen and Pool 2009, 2010).

The due diligence challenge facing investors globally relating to the risks of misrepresentation, omission and fabrication in hedge funds cannot be underestimated. Recent research by Brown, Goetzmann, Liang and Schwarz (2012) found that one in five hedge fund managers misrepresents their fund or its performance to investors during formal due diligence investigations. Using confidential data taken from 444 due diligence reports commissioned by investors between 2003 and 2008, Brown et al. (2012) analysed the extent to which hedge fund managers’ representations about their funds differed from reality. Managers most frequently misrepresented the size of funds under management in the hedge fund, the performance (or track record) of the fund and their regulatory and legal histories (Brown et al. 2012). The research also identified “noted verification problems”—characterised as “misrepresentations or inconsistencies”—in 42 per cent of due diligence reports (Brown et al. 2012).

The severity of these findings from the hedge fund sector underscores the myriad of risks facing investors. It also highlights that while the Madoff and Bayou scandals focus debate on issues of fabrication (discussed below), the frequent occurrence of misrepresentation and omission in financial transactions demands that such risks are identified and actively mitigated.

2.3. Financial Fraud

Francis (1988) used the term “contrepreneurs” (derived from “con artist” and “entrepreneur”) to describe individuals who “carry out a swindle while appearing to be engaged in a legitimate enterprise” (Friedrichs 2010, p. 200). Fraud, and of particular relevance to this discussion, financial fraud is a contrepreneurial crime.

The most obvious example of a contrepreneurial crime uncovered in the wake of the GFC was the Madoff Ponzi scheme. Madoff’s scheme is used as but one illustrative example of the fabrication-type of financial fraud that were subsequently uncovered following the GFC.

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