Corporate Fraud and Financial Pyramids – Essay Sample

Corporate Fraud and Financial Pyramids – Essay Sample


Corporate fraud is unfortunately not rare in the business world in Canada. A 2009 multinational survey by Price Waterhouse Cooper “white collar” or economic crime is growing faster in Canada than in other developed countries, with 56 percent of Canadian companies reporting fraudulent activity in 2009. Types of fraudulent schemes include prime bank instruments offering higher than normal returns but which are actually non-existent instruments, Ponzi or pyramid schemes in which initial investors are paid off by the investments of later investors, “pump and dump” scams in which a stock is pumped up using a variety of bogus promotion techniques, allowing the perpetrators to dump the stock when the public heeds the bogus rumors. In all cases, the individuals perpetrating the fraudulent scheme have no real intention of running a legitimate company, but merely use the company as a way to access the wallets of the scheme’s victims. Also, frequently only a few key executives are aware of the fraudulent intentions behind the company; thus, the other stakeholders in the company are often as much victims as those who invest in the schemes.

What all such cases have in common is that stakeholders in the various organizations or investments were harmed by the fraudulent actions of the corporate officials involved. The level of impact on stakeholders can be as little as a few thousand dollars to millions—or billions—of dollars of damages. While current literature has focused on developing models for stakeholder relations with the requisite company, generally speaking, the assumption is that the company and its executives are operating in good faith rather than with fraudulent intentions. In the case of Ponzi scheme or other deliberate fraud, however, such an assumption cannot be made. The characteristics assumed for stakeholder groups assumed by models do not match the characteristics of stakeholder groups who have been (or are being) victimized by corporate executives with malicious intentions. Most research in the field focuses on prevention and accounting policies for detection, rather than on consideration of the issues faced by stakeholders who need to mobilize to recover their lost proceeds.

At issue in these cases is how the stakeholders respond to corporate fraud when it arises. Do they engage as individuals or evolve into a cohesive group? How do such groups of stakeholders arise and what conditions influence their development? What permits stakeholders to mobilize and recruit other stakeholders to participate in actions against the fraudulent executives? These questions have not been broadly addressed in the literature, and are the subject of this paper.

Literature Review

Business exists, within a complex series of relationships between the organization, its employees, owners, clients, suppliers and community in which it operates. All of these actors connected to an organization are known collectively as stakeholders. The term stakeholder finds its genesis in the 18th century English case law, wherein a party would hold a stake in a financial transaction or hold in trust the proceeds of a wager (Johnson-Cramer, 2008). Although stakeholders were not explicitly addressed in managerial literature for most of the 20th century, the idea of managing relationships with those affected by the conduct of business was certainly an undercurrent (Frederick, 1960; Smith, 1937). It was not until Freeman’s pivotal work, Strategic Management: A Stakeholder Approach (1984), where the paradigm of stakeholders began to be more fully articulated and explored.

The literature and evolution of stakeholder theory has followed a number of streams of research and complex models have been developed to describe and predict behaviour. This review follows the genesis of stakeholder theory into the modern streams of stakeholder theory.

Historical Background

R. E. Freeman’s work is still debated by those who study stakeholder theory (Donaldson & Preston, 1995; Dunfee, 2006; Frooman, 1999; Jamali, 2008; Jawahar & Gary, 2001; Phillips, Freeman, & Wicks, 2003). At the most elementary level, Freeman suggested that “a stakeholder in an organization is (by definition) any group or individual who can affect or is affected by the achievement of an organization’s objectives” (1984, p. 46). Freeman offered a visual model wherein the organization was the hub of a wheel with spokes extending out to various stakeholders. Although simplified and at an extremely macro level of analysis, the conceptualization of stakeholder interconnectedness was revolutionary (Freeman, 1984), yet Freeman argued that for subsequent researchers, staying with such a simplified model would be too abstract to fully capture the complexity of relationships. The definition of stakeholders offered at the time by Freeman was too broad; theoretically, it could have encompassed an entire population that could be directly or indirectly be affected by an organization’s operations, so various methods of identification of stakeholder groups and their saliency evolved (Goodstein & Wicks, 2007; Hendry, 2005; Kaler, 2002; Magness, 2008; Mitchell, Agle, & Wood, 1997; Peteraf & Shanley, 1997; Rowley, 1997).
Freeman’s work has been widely cited as a method to identify key stakeholders and manage the politics inherent in those complex firm-stakeholder relationships (Freeman, 1994; Mitchell, et al., 1997). The strategy Freeman offers in this classic work could be used to glean insight on emerging issues which might threaten the firm; furthermore, Freeman was cognizant of the need for a system of corporate governance that harmonized the rational, process and transactional components within a stakeholder framework which would lead to a more ethical organization. Ironically, Freeman argued against the firm identifying stakeholders as separate and differentiated means to strategic ends. Freeman, in later works, argued for a more egalitarian approach where management adopts an approach where all stakeholders are interconnected with the firm. Freeman suggested, in The Politics of Stakeholder Theory: Some Future Directions, that the stakeholders are clearly identified and limited the group of importance to: “employees, financiers, customers, employees and communities” (Freeman, 1994, p. 417) which further reinforces the idea of stakeholders being interconnected with the firm. Freeman’s theory posits that organizations that administer their relationships with stakeholders the most beneficially will endure and thrive, whereas organizations that fail to nurture their relationships are doomed (Freeman, 1984; Frooman, 1999; Rowley & Moldoveanu, 2003). Furthermore, Freeman suggests that organizations manage their relationships and monitor how stakeholder interests change and evolve over time and react accordingly to maintain those relationships. Freeman’s work suggests compartmentalizing stakeholder needs and supporting business functions to fulfil those stakeholder needs.

Debate amongst scholars as to whether a corporation’s duty is to, shareholders or stakeholders, has waged for almost 100 years (Bakan, 2004; Coelho, McClure, & Spry, 2003; Friedman, 1970; Smith, 1937). The stockholder model is heavily supported by property rights of shareholders, legal imperatives for the corporation, legislated governance mandates and public policy (Bakan, 2004; Friedman, 1970); however, in this model there is no allowance for the management of those affected (read: stakeholders) by the externalities created by the operations of the corporate entity (Naylor, 1983). Alternatively, in a stakeholder model, corporations are seen as citizens of their community and must act to increase stakeholder wealth not just shareholder wealth (Andriof & Marsden, 1998; Carroll, 1998; Matten, Crane, & Chapple, 2003; Waddock, 2000). For organizations to survive and increase their profitability, they must manage their reputation with the public, attempt to be good neighbours and become upstanding citizens within their communities.

More recently, scholars are beginning to move away from framing the argument as shareholders versus stakeholders, rather they argue about when and how corporations should respond to demands and increase shareholder value (Campbell, 2007; Hillman & Keim, 2001; Yang & Rivers, 2009). Yang and Rivers (2009) suggest that companies will adapt to the societal norms of their host communities in order to gain legitimacy amongst stakeholder groups. Other scholars suggest that focusing resources on satisfying primary stakeholders (namely: clients, suppliers, human resources and the surrounding community) needs, organizations will create competitive advantage through their largesse and thus increase profitability and build reputation (Hillman & Keim, 2001).

Stakeholder Salience & Engagement.

One would assume that identification of stakeholders would be extraordinarily simple; however, Freeman’s original definition (1984) is exceedingly broad and left management and academics with the difficult task of figuring out who has primacy and authority to have their needs addressed (Carroll, 1991; Husted & Allen, 2006; Mitchell, et al., 1997; Ullmann, 1985). Rather than heed Freeman’s advice (1994) about viewing stakeholder groups as being interconnected with the firm and seen as a whole, the Mitchell, Agle and Wood (MAW) model was composed of a model which divided stakeholders into groups and assessed by three converging dimensions: legitimacy, power and urgency (Mitchell, et al., 1997). The MAW model is dynamic in a number of ways and is intended to be strategically employed by management to better cultivate stakeholder relations. One manager might determine the salience of a stakeholder group differently than another manager and thus give the stakeholder group greater attention than a peer; however, the situation may be so fluid that the salience of a stakeholder group could change in the view of management from moment to moment. By categorizing stakeholders within these 3 dimensions, management can determine which stakeholders are most deserving of attention within a dynamic model. The MAW approach was groundbreaking because it was the first conceptual model that posited and attempted to link the attributes which organizations management needed to assess when determining stakeholders salience. MAW’s model is entirely firm-centric and allows for one-way analysis (i.e. from the firm to the stakeholder) and ignores the inverse, i.e. stakeholder identification of saliency in the firm’s hierarchy to affect change. Challenging MAW’s work, Frooman suggested that stakeholder groups with power would override any other factors for consideration (1999). Parent and Deephouse (2007) further challenged aspects of the MAW model and suggest that the stakeholder attribute types are not balanced in primacy, and that power and legitimacy tend to dominate consideration for management with less emphasis on urgency.
Stakeholder theory has focused on the identification and engagement strategies for the most part (Rowley, 1997); however, there are divergent areas of research exploring activism and stakeholder influence strategies on the firm (Rehbein, Waddock, & Graves, 2004; Rowley & Moldoveanu, 2003). Firm-centric research, wherein the models focus on organizations exercising unilateral control over interconnected and bilateral stakeholder relationships, is pervasive (Burchell & Cook, 2006; Freeman, 1999; Phillips, et al., 2003; Svendsen & Laberge, 2005; Swift, 2001). Addressing stakeholder demands and expectations leads to better relationships with those most affected by an organization’s operations, thus increasing an organization’s reputation and brand cache (Carroll, 1999; Jamali, 2008; Wood & Jones, 1995). The majority of work within stakeholder engagement focuses upon how managers are, and should, be treating their stakeholders (Donaldson & Preston, 1995; Hine & Preuss, 2009; Swift, 2001). Although the majority of stakeholder literature is written from the firm’s vantage point, there are researchers examining influencing strategies from the stakeholder side of the equation (Frooman, 1999; Frooman & Murrell, 2005; Rowley, 1997; Rowley & Moldoveanu, 2003; Zietsma & Winn, 2008).
Frooman’s Model.





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