Anti-employee Control Fraud

Courtesy of William K. Black at New Economic Perspectives

Apple has released a report on working conditions in its suppliers’ factories. It highlights a form of control fraud that criminology has identified but rarely discussed. I write overwhelmingly about accounting control fraud because it drives our recurrent, intensifying financial crises. The primary intended victims of accounting control frauds are the shareholders and the creditors. Other private sector control frauds target customers (e.g., George Akerlof’s 1970 article on “lemons”), and the public (e.g., the unlawful disposal of toxic waste, illegal logging, and tax fraud).

Anti-employee control frauds most commonly fall in four broad, but not mutually exclusive, categories – illegal work conditions due to violation of safety rules, violation of child labor laws, failure to pay employees’ wages and benefits, and frauds based on goods and loans provided by the employer to the employee that lock the employee into quasi-slavery. Apple has just released a report on its suppliers that shows that anti-employee control fraud is the norm. Remember, fraud is hidden and is often not discovered and Apple did not have an incentive to make an exhaustive investigation. Apple calls its inquiries “audits” and it is apparent that most of its information comes from reviewing written and electronic records at its suppliers. That is exceptionally revealing. The suppliers know that they can defraud their employees with such impunity that they don’t even bother to get rid of records that prove their frauds. Apple has resisted making public its suppliers and the report refused to identify which suppliers committed which violations – often for years despite repeated, false promises to end their anti-employee control frauds. Two other facts are evident (but not reported). First, Apple rarely terminates suppliers for defrauding their employees – even when the frauds endanger the lives and health of the workers and the community – and even where Apple knows that the supplier repeatedly lies to Apple about these fraudulent and lethal practices. Second, it appears unlikely in the extreme that Apple makes criminal referrals on its suppliers even when they commit anti-employee control frauds as a routine practice, even when the frauds endanger the worker’s and the public’s health, and even when the supplier repeatedly lies to Apple about the frauds. Apple’s report, therefore, understates substantially the actual incidence of fraud by the 156 suppliers (accounting for 97% of its payments to suppliers).

“The company said audits revealed that 93 supplier facilities had records indicating that more than half of their workers exceed a 60-hour weekly working limit. Apple said 108 facilities did not pay proper overtime as required by law. In 15 facilities, Apple found foreign contract workers who had paid excessive recruitment fees to labor agencies.

And though Apple said it mandated changes at those suppliers, and some facilities showed improvements, in aggregate, many types of lapses remained at levels that have persisted for years.”

http://www.nytimes.com/2012/01/14/technology/apple-releases-list-of-its-suppliers-for-the-first-time.html?hp

The New York Times, Wall Street Journal, and the Washington Post articles on the Apple report are all lengthy, but none of them has any input from a criminologist and each of the articles misses most of the significance of the report. I have already brought out several of these deficiencies. The most fundamental flaws, however, have to do with why anti-employee control fraud is the norm at Apple’s suppliers and why the suppliers typically don’t even take the inexpensive efforts necessary to avoid holding a paper trail that makes the frauds obvious even to a not terribly vigorous audit that they know is coming.

If there is one single thing that drives us white-collar criminologists around the bend it is the implicit assumption that fraud cannot be common. There is, of course, no logical (or experiential) reason for this belief. Nevertheless, it is a common belief and among economists it is a virtually universal dogma. Economists have a tribal taboo against even using the word “fraud” to describe individual frauds. The surest way to be considered an un-serious economist is to use the “f” word to describe frauds by elite economic actors. Economists’ taboo is particularly bizarre because it is economic theory, developed by a Nobel Laureate that explains why fraud can become endemic. George Akerlof, in his famous article on markets for “lemons” (largely describing anti-customer control fraud), explained the perverse “Gresham’s” dynamic in 1970.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”

Anti-employee control fraud creates real economic profits for the firm and can massively increase the controlling officers’ wealth. Honest firm normally cannot compete with anti-employee control frauds, so bad ethics drives good ethics out of the markets. Companies like Apple and its counterparts create this criminogenic environment by selecting least-cost – criminal – suppliers who offer components at prices that honest firms cannot match. Effectively, they hang out a sign – only the fraudulent need apply to be suppliers. But the sign is, of course, invisible and cannot be introduced in court so Apple and its peers also get deniability. They are shocked, shocked that its suppliers are frauds that cheat their employees and put them and the public’s health at risk in order to make a few extra yuan or dong for the senior officers.

Fraudulent suppliers, therefore, have compelling incentives to locate in nations and regions in which they can commit fraud with impunity. The best way to evaluate the fraudulent CEOs’ view as to the risk of prosecution for their frauds is to observe whether they take cheap means of hiding their frauds. When the CEOs do not even bother to avoid creating a paper trail documenting their frauds one knows that they view the risk of prosecution as trivial. Nations that are corrupt, have weak rule of law, weak or non-existent unions, poor protections for workers, a reserve army of the impoverished, and have few resources devoted to prosecuting elite white-collar crime provide an ideal criminogenic environment for firms engaged in anti-employee control fraud. The ubiquitous nature of anti-employee control fraud (and tax fraud) in many nations explains why U.S. industries have been so eager to “outsource” U.S. jobs to fraud-friendly nations. Companies like Apple also discovered long ago that Americans often made poor senior managers in these nations because they objected to defrauding workers. Not a problem – there are plenty of managers from other nations that have no such ethical restraints. Foreign suppliers run by Asian managers are increasingly dominant.

The endemic nature of anti-employee control fraud also demonstrates an important technical point. The wages reported in the most fraud-friendly nations are substantially overstated because workers work far longer hours without receiving the compensation to which they are entitled. Their hourly rate is much lower than reported, which means that the wage gap between U.S. and the most fraud-friendly nations is significantly greater than reported. U.S. firms that have foreign suppliers in these nations are well aware of this data bias and make their outsourcing decisions based on the real (much larger) wage gap.

The Harm to Employee and Consumer Health is Grave

The NYT article notes that it was bad publicity in the U.S. that finally forced Apple to make greater disclosures about its suppliers’ frauds.

“The calls for Apple to disclose suppliers became particularly acute after a series of deaths and accidents in recent years. In the last two years at firms supplying services to Apple, 137 employees were seriously injured after cleaning iPad screens with n-hexane, a toxic chemical that can cause nerve damage and paralysis; over a dozen workers have committed suicide or fell or jumped from buildings in a manner that suggests a suicide attempt; and in two separate blasts caused by dust from polishing iPad cases, four were killed and 77 injured.”

The Washington Post article noted:

“Apple found that 62 percent of the 229 facilities it inspected were not in compliance with the company’s maximum 60-hour work policy; 13 percent did not have adequate protections for juvenile workers; and 32 percent had problems with the management of hazardous waste.

One supplier was caught dumping wastewater at a nearby farm. Another had a total lack of safety measures, creating “unsafe working conditions,” the report found. Five facilities employed underage workers.

The company in the past had refused to divulge its full supplier list even as it became standard practice for multinational corporations to do so after the public outcry in the 1990s over labor problems at Nike factories in developing countries.

Apple’s change of heart follows a highly publicized string of factory worker suicides in 2010 and deadly explosions in two Chinese factories in 2011.”

The WSJ emphasized this chillingfinding:

“The report also found 24 facilities conducted pregnancy tests and 56 didn't have procedures to prevent discrimination against pregnant workers. Apple said that at its direction, the suppliers have stopped discriminatory screenings for medical conditions or pregnancy.”

The article does not make this point explicitly, but these firms conduct these tests in order to unlawfully coerce their pregnant employees to have undesired abortions in order to obtain and keep their jobs.

Foreign Anti-employee Control Fraud harms U.S. Workers

These frauds take place abroad, but they harm employees in the U.S. Mitt Romney explains that Bain had to slash wages and pensions to save firms located in the U.S. who had to meet competition from foreign anti-employee control frauds. The damage from foreign anti-employee control frauds drives the domestic attack on U.S. manufacturing wages. Bad ethics increasingly drive good ethics out of the markets and manufacturing jobs out of the U.S. and into more fraud-friendly nations.

A final caution is in order because each of the major articles on the Apple report failed to mention it. CEOs who are willing to routinely defraud their workers and expose them to grave threats to their health are exceptionally likely to commit other forms of control fraud.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.