Edwin Sutherland: The 75th Anniversary of His Coining The Term White-Collar Crime

By William K. Black
(Cross posted at Benzinga.com)


This year is the 75th anniversary of Edwin Sutherland’s presidential address to the annual meeting of the American Sociological Association in 1939.  In the course of beginning to write a book from a white-collar criminological perspective about our modern financial crises I decided to reread Sutherland’s address (which was published as an article in 1940) to see how it stands up in light of modern white-collar criminological research and theory.  It reads exceptionally well today.  It is not even archaic in tone.  Sutherland begins by listing eleven (there were two van Sweringen brothers involved in their scam) examples of the kind of criminals he was referring to.

“The present-day white-collar criminals, who are more suave and deceptive than the ‘robber barons,’ are represented by Krueger, Stavisky, Whitney, Mitchell, Foshay, Insull, the Van Sweringens, Musica-Coster, Fall, Sinclair, and many other merchant princes and captains of finance and industry, and by a host of lesser followers.”

Musica-Coster is hyphenated because he used an alias, as did his brothers, to aid his ability to continue to defraud even after one set of his frauds was discovered.  Each of the eleven people listed ran what we now call a “control fraud” (where the person controlling a seemingly legitimate entity uses it as “weapon” to defraud.  Ten of the individuals controlled private entities.  Secretary of the Interior Albert B. Fall was the corrupt public official leading the Tea Pot Dome scandal.  I am near Minneapolis this semester (go north for the winter, brilliant idea) and in driving into the city tonight I saw Foshay Tower (the tallest building west of Chicago and east of California when it was built).  Wilbur Burton Foshay made Sutherland’s list.

Nine of the eleven fraud schemes involved financial sector frauds.  Harry F. Sinclair, who purchased the sweetheart lease to the Tea Pot Dome from Secretary Fall, was engaged in good old fashioned corruption.  Sutherland recognized that accounting was what we now call the “weapon of choice” in financial sector frauds.

“White-collar criminality in business is expressed most frequently in the form of misrepresentation in financial statements of corporations….

These varied types of white-collar crimes in business and the professions consist principally of violation of delegated or implied trust, and many of them can be reduced to two categories: misrepresentation of asset values [and breaches of trust, e.g., usurpation of corporate opportunity].”

Where I Think We’ve Improved on Sutherland’s Theories

Here’s where we think the book we’re working on can contribute the most to the development of a modern theory of white-collar crime in a manner that differs from Sutherland’s insights.

  • We aim to end the sterile debate about the definition of white-collar crime and the question of whether it the individual or the corporation that matters.  Our answer confirms Edwin Sutherland’s intuition while providing the necessary precision on what makes a subset of elite financial frauds vastly more destructive than all other property crimes (of the streets and suites) – combined.  Sutherland stressed the white-collar criminal’s high status as the key that made it difficult to prosecute him.  We believe that the key is power, not status.  The persons who control a seemingly legitimate entity (private, non-profit, or governmental) can cause unique damage if they engage in fraud because the CEO can direct the corporation and cause it to make the firm’s internal and external environment vastly more criminogenic.  Status is important, but more as a goal.  CEOs (and their spouses) yearn not simply for wealth but also for high social status, and wealth and high position can buy high status.  This quest for status can become pathological when, as is exceptionally common, the CEO is a narcissist.  The CEO’s high social status is a protection against sanction as Sutherland believed, but the CEO’s power is a far greater protection.

The CEO and the organization both matter, but the organization’s interests may not matter.  We will show in our book that the CEO’s interests are frequently contrary to the interests of the corporation.  Accounting control fraud allows the CEO (the “unfaithful agent” of the “principal” – the shareholders) to “loot” the firm and creates what is known in the literature as a “sure thing.”  The CEO will become wealthy and can walk away wealthy even if the bank fails and the shareholders’ interests are wiped out.

Sutherland came tantalizingly close to understanding the CEO’s unique power, the ability to use the power to hire, fire, promote, make wealthy, praise or condemn, and to suborn internal and external controls such as the board of directors and the outside auditor.  The elegant solution for the fraudulent CEO is not to defeat controls but rather to suborn them and pervert them into the most valuable fraud allies.  This explains why sophisticated frauds almost invariably retain top tier auditors to “bless” the financial statements.  The auditor’s positive reputation is a great aid to the ability to commit massive accounting fraud.

The ultimate abuse of the CEO’s power is producing “echo” control fraud epidemics in other fields.  The CEO crafts the compensation to create a “Gresham’s” dynamic in which bad ethics drive good ethics out of the markets and professions.  In a Gresham’s dynamic market forces become so perverse that cheaters prosper and honest individuals, corporations, and professionals are driven out of the markets.  Sutherland stressed that frauds could become endemic and he understood that it something to do with the interaction caused by the introduction of fraud by another firm.

At this juncture, however, Sutherland insisted that “differential association” explained all criminality.  He hypothesized that white-collar criminals are born when ordinary businessmen “get into particular business situations in which criminality is practically a folkway and are inducted into that system of behavior just as into any other folkway.”  He then invoked “social disorganization” and further hypothesized a scenario that comes close to the actual Gresham’s dynamic.  “A business man who wants to obey the law is driven by his competitors to adopt their methods.”  “Groups and individuals are individuated; they are more concerned with their specialized group or individual interests than with the larger welfare.”  Again, this could be reinterpreted to reflect reality.  The second quoted sentence could be reinterpreted to refer to the “unfaithful agent” that maximizes his income at the expense of the firm and its shareholders and creditors.  The first quoted sentence could be reinterpreted as meaning that if your competitors gain a competitive advantage by cheating and you fail to emulate their frauds you and your firm will be driven out of the markets.  But the context demonstrates that this is not what Sutherland actually meant by these sentences.  A Gresham’s dynamic is a far more persuasive explanation for the patterns of behavior Sutherland observed than is differential association (which reverses the direction of causality).

More subtly, notice that Sutherland has slipped into the analytical imprecision Gil Geis charged him with even though Geis published the classic documentation of the dynamic Sutherland suggested in which ordinary businessmen “get into particular business situations in which criminality is practically a folkway and are inducted into that system of behavior just as into any other folkway.”  Geis showed exactly how this was done at GE in the context of the heavy electrical equipment cartel.  But here’s the catch, Sutherland has not explained how the CEOs chose to bring the cartel into being.  Geis showed how the cartel was sustained over many years by socializing not particularly prominent businessmen into being cogs administering an existing cartel.  The CEOs use these “folkways” to train their staff to commit felonies and view the felonies as “normal” business.  The CEOs of the largest manufacturers of heavy electrical equipment began the cartel and bear the primary culpability for it.  As Geis complained, Sutherland too often jumped between the CEO, the corporation (which can only act through self-interested agents), and much lower-level corporate officers.  Modern white-collar criminology has gained powerful insights by rigorously separating these three potential actors and focusing on the unique power that the CEO has.

  • The agency point is critical to understanding a key mistake made by Sutherland and the conservative economists who created the criminogenic environment that produced the accounting control fraud epidemics that drove the financial crisis.  Sutherland argued that elite frauds would target almost exclusively the weak.  Alan Greenspan expressly premised his support for creating a massive regulatory “black hole” for financial derivatives on the similar assumption that because the counterparties to such transactions are financially sophisticated there is no serious risk of fraud.  Elite financial control frauds often target the unsophisticated, and most forms of control fraud add to corporate profitability.

The largest and most destructive financial frauds, however, are accounting control frauds that target what are purportedly the most financially sophisticated firms in the world.  Sutherland’s assumption that elite frauds targeted the weak was often incorrect in his era and three highly criminogenic changes since his time have each pushed in the direction of making his argument even less true in the modern era.  Modern executive compensation allows CEOs to convert enormous amounts of firm assets to their personal wealth based on high short-term reported profits.  In Sutherland’s era partnerships overwhelmingly had “joint and several liability” rather than being “limited liability partnerships” (LLPs).  Joint and several liability meant that the general partners’ personal wealth was on the hook to an unlimited extent to pay all the debts of the partnership.  This created a powerful incentive for partners to monitor each other’s actions to prevent misconduct.  Today, virtually all financial partnerships are LLPs.  Corporate leverage today is often far higher than in Sutherland’s era and investment banking firms, by using special investment vehicles (SIVs), and Fannie and Freddie, because they were treated as “too big to fail,” were able to operate with capital levels that were equivalent to your car operating on fumes.

The unique aspect of accounting control fraud is that it almost always reduces real corporate profits by creating fictional profits and real losses.  The fictional profits make the officers wealthy and allow them to loot the firm through modern executive compensation.  The fraud epidemics that drove this crisis were overwhelmingly accounting control frauds committed against the banks.  This makes sense if one remembers four things.

    • The financially sophisticated have vastly more money than the unsophisticated
    • In the modern era leverage is far larger – that means that corporations are primarily funded by debt, not equity.  That means that the great bulk of the corporate funds that the CEO can potentially loot come from creditors rather than shareholders.  The world’s primary creditors are banks, so if corporations are looted the creditor banks can suffer enormous losses that far exceed those of the shareholders (who are protected by “limited liability.”  The banks’ primary expertise is evaluating credit risk.  They should by ultra-sophisticated.
    • The leverage of banks is far larger than industrial corporations and the leverage of investment banks and Fannie and Freddie were extraordinary.  This means that when financial CEOs loot “their” firms they are overwhelmingly looting their creditors, who are supposedly the most sophisticated financial experts in the world.
    • But all of these financially sophisticated entities can only act through agents – and those agents can maximize their wealth by joining in the looting.  Financial sophistication is no defense against an unfaithful CEO.  To the contrary, it is the fraudulent CEO’s far greater financial expertise and power over the corporation that makes him the most dangerous threat to “his” bank.
  • There are millions of frauds committed without force by less powerful Americans as many criminologists have shown.  Sutherland understood that.  He emphasized repeatedly that he was focusing on a subset of such frauds committed by elites because those crimes caused far greater harm and the criminals were far less likely to be held (meaningfully) accountable.  Sutherland was right that the crimes of a tiny subset of these frauds who run seemingly legitimate corporations produce far larger losses and social crises than all these lesser frauds combined.  That subset is overwhelmingly composed of people who run control frauds.  These control frauds cause greater losses than all other forms of property crime – combined.

Modern white-collar criminology has made important advances, but rereading Sutherland’s work reminded me that those advances were made possible by the strong foundation he provided from the beginning of the new field 75 years ago in his presidential address.

One response to “Edwin Sutherland: The 75th Anniversary of His Coining The Term White-Collar Crime

  1. Sutherland was more right about the perpetrators targeting the weak than you give him credit for.

    What is an “institutional investor” but the collective savings of thousands or millions of account holders? Wikipedia defines the term as an organization which pools large sums of money and invests those sums in securities, real property and other investment assets. Examples are endowment funds, pension funds, mutual funds, hedge funds, sovereign wealth funds and insurance companies. Who are their ultimate beneficiaries? Students (university endowment funds), workers (pension funds)’ policyholders (insurance companies), citizens (sovereign wealth funds). Hedge funds and mutual funds are dominated by other institutional investors. Most IRAs and 401(k)s are invested in mutual funds.

    Sure, the managers of these funds are no doubt sophisticated. After all, they have figured out that in the long run they get a huge share of the gains realized by the funds they manage. But the managers aren’t the ones that lose when the funds lose. Why do you think these institutional investors seem so willing to reach settlements at pennies on the dollar when they are the targets of the control fraud?

    Sutherland was in fact correct when he said that the control frauds you describe target the weak. We just have a system in place now that greatly obfuscates that fact.