Lecture 2 The Briber‘s Dilemma

1. Anticorruption and the Design of Institutions 2010/11 Lecture 2 The Briber‘s Dilemma Prof. Dr. Johann Graf Lambsdorff

2. Literature • Lambsdorff, J. Graf (2007), The Institutional Economics of Corruption and Reform: 164-189. Further Reading: • Brunner, K. and W.H. Meckling (1977), ”The Perception of Man and the Conception of Government," Journal of Money, Credit and Banking, IX (1), 70-85. • Friedman, M. (1970) ”The Social Responsibility of Business Is to Increase Its Profits,” New York Times Magazine, September 13. Reprinted in L.P. Hartmann, Business Ethics, (Chicago: Irwin/McGraw-Hill), 246-51. • Shearman & Sterling (2009), FCPA digest. Cases and Review Releases Relating to Bribes to Foreign Officials under the Foreign Corrupt Practices Act of 1977, ed. by N. Waites and A. Walker, Shearman & Sterling LLP, online retrievable at http://www.shearman.com/files/upload/fcpa_digest.pdf .

3. 1. The Prisoner‘s Dilemma • Bribing always involves two sides, a briber and a bribee. In a seminal contribution Friedman [1970] claims innocence for businesspeople, as their sole responsibility is to increase profits. • Brunner and Meckling [1977: 82-4] consider it defendable for business people to disregard morality and pay bribes, when this is part of a maximizing strategy. • Industrial bodies of exporting countries often point to high levels of corruption in less developed countries when defending their strategy to condone bribery. Some even claim a cultural acceptance of these practices abroad. • By contrast, people from less developed countries point to the difficulty of establishing an honest administration and a transparent political environment when low-paid public servants are constantly offered side payments by business people from industrial countries.

4. 1. The Prisoner‘s Dilemma

5. 1. The Prisoner‘s Dilemma • A crucial question regards the interaction between competition and morality: Can a high standard of ethics survive? Is it the bottom line or the moral code that wins out? • Assume that two equally qualified firms compete in a public tender, yielding a profit of 100. The tender board consists of 7 members. Each firm has the possibility to pay a bribe worth 10 to one of them in exchange for a favorable vote. The resulting probability of winning can be depicted from following matrix.

6. 1. The Prisoner‘s Dilemma • Considering the probability of obtaining the profit (100) and the costs of bribing (10), the following matrix determines the expected profit. • The matrix reveals that bribing emerges as the dominant strategy.

7. 1. The Prisoner‘s Dilemma • Also in reality bribing may sometimes be the individually dominant strategy. One obtains an edge over competitors who do not pay, and looses by rejecting a payment when all others bribe. • But jointly the firms are worse off, because the costs of bribing lower their overall profit. • The overall decrease in profit arises because each firm disregards the damage that its bribing strategy imposes on the competitor. • There are two solutions to the problem. • Corporate liability: the payoff to the matrix is changed by penalties imposed on the firms. • Collective action: Firms unite in their efforts to fight corruption.

8. 1. The Prisoner‘s Dilemma • Imagine the calculus of a firm’s employee who is given a bonus payment if he secures the contract for the firm. • Such a payment would act as an inducement to engage in bribery. • In an NBER paper (http://www.nber.org/papers/w12274) Bertrand, Djankov, Hanna and Mullainathan (2007) investigate the effect of bonus payments on the behavior of Indian applicants who wanted to obtain a driver’s license. One group was given free driving lessons, another a bonus payment for obtaining the license within 32 days. • Those who were given a bonus were less qualified in driving, less often participated in the official test and more often engaged local agents to arrange things.

9. 1. The Prisoner‘s Dilemma

10. 1. The Prisoner‘s Dilemma • Codes of conduct are at risk of “window dressing”: While they present the official policy, unofficially firms sometimes communicate that acquisition of a contract is all what counts. • The promise of a bonus supersedes moral considerations. • This unofficial culture of bribery can only be changed by imposing corporate liability. • Once the risk of detection and fines exceeds 5, bribing ceases to be the dominant strategy.

11. 1. The Prisoner‘s Dilemma • Once firms have an incentive to allow bribery, penalties must concentrate on penalizing firms, not only individuals. • While quite often blacklisting of firms and threats of contract cancellation are mentioned in this context, in the lecture “The Economics of Corruption” it was argued that monetary fines are superior. Hints for Reform

12. 2. Collective Action International multilateral approach • Unilateral approach: Foreign Corrupt Practices Act imposed in 1977, the USA: End tax deductibility and impose legal sanctions. • Most trading partners did not follow the US lead, because imposing stricter national regulation was seen to hurt their export industry. • This well resembles the problem of a prisoner's dilemma: while all export nations may profit from transparent procurement and good codes of conduct it is profitable to be the only one deviating from such behavior.

13. 2. Collective Action • A CIA report claimed that between 1994 and 1995 the US lost $ 36 billion worth of business deals due to bribery and corruption by its competitors, inducing public complaints. • About that time talks at the OECD started for a multilateral approach. • In May 1997, an agreement was signed by ministers of the 29 members of the organization (and further non-member countries) to enact laws by April 1998 making bribery a punishable offence. • All major countries have meanwhile ended the tax deductibility of bribes and made bribing of foreign officials a legal offence.

14. 3. Unilateral Approaches The Economist (Ungreasing the wheels; 19.11.2009): Governments around the world are making life difficult for corrupt firms. If ever a clash was inevitable between one country’s commercial law and another’s business culture, it would be between America’s Foreign Corrupt Practices Act (FCPA), which seeks to punish firms that bribe government officials, and China, where many businesses are owned by the government and bribery is endemic. A recent spate of prosecutions under the act of firms operating in China and other notoriously crooked places has stoked fear in the heart of many executives. Nor is the crackdown limited to America. On November 18th the British government became the latest to promise tough new anti-corruption legislation, during the annual Queen’s Speech to Parliament. In 2005 DPC Tianjin, the Chinese subsidiary of a Californian company that makes medical equipment, admitted paying bribes to doctors and laboratory personnel. American prosecutors said this fell under the scope of the FCPA because health care in China is government-run. Yet the Chinese government is involved in much of business life. Last year, for example, Lucent paid a multimillion-dollar fine for “training” trips it had arranged for executives from state-owned telecommunications firms that involved visits to Las Vegas and Orlando, rather than factories. This year Control Components, a manufacturer of valves for power plants, and several of its employees entered guilty pleas related to bribes allegedly paid to employees at some of China’s biggest companies. These included PetroChina, China National Offshore Oil Corporation, Jiangsu Nuclear Power Corporation, Guohua Energy Investment Company, China Petroleum Materials and Equipment Company and Dongfang Electric Corporation. Two recent cases have further widened the scope of the FCPA. In February ITT Corp settled charges related to payments made by a subsidiary to various Chinese “design institutes”, which are linked to the government but do not make big purchases of foreign goods. They do, however, set local product standards and thus can have a huge influence over foreign firms’ sales in China. Last year AGA Medical Corporation of Minnesota pleaded guilty to bribing doctors to push medical devices, and officials in China’s Intellectual Property Office to push patent approvals. Even though the payments were made by a distributor, the courts still held the manufacturer responsible—a worrying precedent for firms that use agents of different kinds.

15. 3. Unilateral Approaches The two American agencies responsible for enforcing the FCPA, the Department of Justice (DoJ) and the Securities and Exchange Commission, have both made clear their intention to be even fiercer under the new administration than they were under the previous one. “We will be intensely focused on rooting out foreign bribery in your industry. That will mean investigation and, if warranted, prosecution of corporations to be sure, but also investigation and prosecution of senior executives,” thundered Lanny Breuer, the new head of the DoJ’s criminal division at a gathering of pharmaceutical bosses earlier this month. America recently prosecuted one of its own public officials under the FCPA. However, although William Jefferson, a former congressman, was sentenced to 13 years for bribery, he was acquitted on the FCPA charge because the $90,000 in cash found in his freezer, allegedly intended to pay off a Nigerian politician, was never handed over… The fines imposed on firms are also getting bigger. In February American courts fined KBR, a construction firm, and Halliburton, its former parent, $579m over bribes paid to obtain contracts in Nigeria. Last year they hit Siemens, a German conglomerate, with an $800m fine—the biggest to date. The German authorities also fined Siemens a similar amount. That case has helped spur more zealous pursuit of corporate bribery in Europe, says Richard Dean of Baker & McKenzie, another law firm. In September British prosecutors secured their first big conviction, of Mabey & Johnson, a bridge-building company, over bribery of foreign government officials. But prosecutors are still weighing politically charged allegations of bribery involving BAE Systems, a defence contractor, and foreign officials. The British government says its proposed new law will close several loopholes and make prosecutions easier. American prosecutors have made it clear that they will be more lenient with firms that confess possible lapses, rather than waiting to be caught. This month a defence contractor, DynCorp International, did just that. But that means investing in internal monitoring, which can be expensive. Scanning e-mail alone can cost $200-400 an hour if done by a law firm, and $50-90 an hour even if a legal outsourcing firm such as the Clutch Group is used. American lawyers worry that local prosecutors will remain tougher than their counterparts in other rich countries, putting American firms at a competitive disadvantage and deterring foreign firms from listing their shares on American stockmarkets. As one lawyer puts it, “They are catching up, but not that fast.” That may be true. But the more striking trend is that it is getting harder for firms all over the rich world to get away with bribery, which must be a good thing.

16. 2. Collective Action Will these laws be effective? • Will firms start to understand the new rules? • Will prosecutors start investigations in case of malfeasance? • Will firms invent new methods for making payments which are accepted under the existing legal standard, or which cannot be prosecuted and appropriately penalized? • Will firms just delegate the bribery to local agents or middlemen and claim ignorance when this is uncovered? • Will firms arrange deals via subsidiaries and off-shore companies to keep them off their books?

17. 2. Collective Action Transparency International’s Integrity Pact (IP) • The IPs are developed for individual government (or subdivision) contracts and should enable the bidders to abstain from bribing. • All officials involved commit to abstain from requesting or accepting bribes or to unduly favor one bidder over another. This commitment is assisted by disclosure of all relevant information and potential conflicts of interest. • The bidders commit to not offer or hand out bribes or other favors and to not accept any inappropriate advantage.

18. 2. Collective Action • Sanctions (to be negotiated) may include disciplinary or criminal sanctions against officials, cancellation of contract, forfeiture of the bid and blacklisting of bidder for future government contracts. • But: Sanctions and regulations exist anyways • An IP will only be effective if further sanctions can be tailored to a certain project. • Further actors (CEOs, Civil Society) can be involved. • Trust among participants can be created. • Assessments of effectiveness of IPs are biased because its implementation already suggests a political will to contain corruption.

19. 3. Unilateral Approaches • Sometimes paying bribes is not the dominant strategy. Various reasons suggest that paying bribes is a costly approach: • A firm engaging in bribery might be exposed to denunciation and extortion. It fears legal sanctions or a bad reputation and may be forced to pay hush-money. • Corrupt agreements cannot usually be legally enforced. A potential risk is that public servants may fail to deliver after receiving a bribe. Some firms may be more reluctant than others to run such a risk. • Bribes requested may rise with the propensity of a firm to pay.

20. 3. Unilateral Approaches • The Wall Street Journal, Jan 31 2007, cites from the prosecutorial investigation of M. Kutschenreuter, an executive manager at the German Siemens: A former Saudi-Arabian local representative, whose contract had been cancelled by Siemens, is supposed to have blackmailed the firm. He requested more than 900 mio. US$ as hush-money and threatened to pass on documents about corruption in telecommunications contracts to the SEC otherwise. In negotiations both sides agreed on a payment of 50 mio. US$.

21. 3. Unilateral Approaches • A Hong Kong employee of the German Mannesmann was in charge of paying bribes to Chinese officials in exchange for contracts. It was later detected that he embezzled parts of the money. But the firm did not bring the case to court, because the employee threatened to expose the names of Chinese officials. Being confronted with the death penalty in China, this would have brought operation of Mannesmann in China to a standstill. • A staff member of the Christian Democratic party in Hesse, Germany, was alleged to have embezzled 1 Mio. DM of party funds. But he was given impunity due to fears he may denounce the party's illegal hidden accounts. The party even paid for his gambling debts.

22. 3. Unilateral Approaches • In a recent study about truck drivers in Indonesia, Bolken and Barron (2007: 9-10) www.nber.org/papers/w13145, find that truck drivers do not truthfully report to their companies about the bribes they have to pay at checkpoints: “By exaggerating bribe payments, drivers may be able to extract more money from their bosses to pay bribes than they actually need, and pocket the difference. In fact, we compared the amount of bribes we observed on 40 trips between January 25th, 2006 and February 20th, 2006 with twelve interviews we conducted around the same time with drivers who had just completed their trips, and found that on average the bribes drivers reported in interviews were more than double the amount of the bribes we recorded by direct observation.”

23. 3. Unilateral Approaches I have not taken any bribe and I swear I’m not hiding any money from you. Those are false allegations usually made during elections to discredit our party! Laxman, Times of India, Nov. 13 2003

24. 3. Unilateral Approaches • Slush funds can be misappropriated by firm staff. • The secrecy surrounding corrupt side-deals can be used by firm staff to take their share. Employees are thus seduced to betrayal, for example, by requesting a share of the bribes to be sent to their own offshore bank accounts. • Internal auditors can hardly distinguish between bribing in favor of the firm and employee fraud. The red flags of the two misdoings are similar:

25. 3. Unilateral Approaches

26. 3. Unilateral Approaches Benford’s Law

27. 3. Unilateral Approaches Source: International Business Attitudes to Corruption – Survey 2006, Control Risks Group

28. 3. Unilateral Approaches Source: International Business Attitudes to Corruption – Survey 2006, Control Risks Group

29. From news.com.au, April 11, 2001: For Jakub Bierzynski, the wake-up call was of a personal nature. Head of the Warsaw-based media planning company OMD-Poland, a US-Polish joint venture, Bierzynski was confronted by corruption last year when two big international clients separately demanded bribes of "hundreds of thousands" for two advertising contracts. "It was like a very cold shower. I asked myself if I could do business in a corrupt environment," says Bierzynski, who had incorrectly assumed his firm's US mother company afforded him a degree of protection from kick-backs. The answer was no. "This is what scared me the most (that despite OMD and the clients all being international companies), they would dare to ask for a bribe," he says. "Leaving aside the moral connotations of (giving bribes), I have no skills in giving bribes. I have never done it before, I don't know how much, I don't know to whom and I don't know in what situations I'm supposed to give bribes, so I am losing in that competitive field and I am sentenced to death in the business world.” Instead, the 34-year-old channeled his outrage into a proposal to launch an anti-corruption business association unprecedented in central and Eastern Europe, in which members would pledge not to offer or receive bribes.“ 3. Unilateral Approaches

30. Appendix Discussions1) Explain how competition between firms that may engage in bribery can lead to a socially undesirable outcome.2) Which are the two strategies for overcoming the prisoner’s dilemma?3) Do “good ethics” survive in reality? Why?4) Discuss the subsequent case study! Why didn’t H. Davidson discuss the dilemma with his superiors?

31. 3. Unilateral Approaches The Wall Street Journal Europe, Career Journal (03.12.2002): “In 1994, Howard Davidson faced his crucible. At the time, he was an investment banker, working in an Asian country. He was on the verge of pulling off a prestigious $500 million (502.8 million euro) stock offering for an Asian utility. "We invested $11 million in the deal and pre-sold the issue," recalls Mr. Davidson, now a financing consultant for the Institute, a management-consulting firm in Redwood City, California. "At the last minute, I was approached by a government official." The official's message: Give him a kickback or forget the deal. "To him, it was as logical as day follows night," Mr. Davidson says. It would have been simple to comply. He felt he couldn't even share the decision with superiors at the bank. What if they ordered him to pay up and push on with the offering? And with other people involved, how could he be sure the whole sordid mess wouldn't leak to the press? […] In the end, he declined and the deal was pulled, resulting in a lot of heat for his company from an unknowing public. Press critics wondered aloud if the company knew how to pull off a deal of that magnitude in a foreign land. The decision turned out well for Mr. Davidson, who finally confided in his superiors afterwards. The company's senior executives felt he'd made the right call, and he wound up with a promotion after his division went on to a "great year" anyway, he recalls. But it could have been a disaster. In another, less-ethical, get-the-job-done-at-any-cost culture, he could have been pushed aside, ignored or outright vilified by co-workers and his career could have come to a dead halt. […] In a highly competitive world, there's considerable pressure to adopt that point of view. When bosses talk about doing "whatever it takes" to make a sale, the salespeople see that as an easily decipherable code. Translation: "Do whatever you have to, as long as it doesn't come back on me." There's also social pressure to "go along with the gang." People who don't are ostracized. […]”