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       Hrishikesh D. Vinod

9.1 WHAT ARE FRAUD                              9.5 DATA MINING FOR DETECTION OF
    AND CORRUPTION? HISTORICAL                      FRAUD AND CORRUPTION                       126
                                                9.6 CORPORATE GOVERNANCE,
    BUSINESS, AND COMMUNITY       123               AND CLIENTS                                127
    MANAGING FRAUD                                  SOLUTIONS PREVENTING FRAUD
    AND CORRUPTION                  125             AND CORRUPTION                             130
9.4 BEST PRACTICE GUIDELINES FOR                   REFERENCES                                  131
    REFERENCES                   126

The topic discussed in this chapter is rather vast in its scope and impossible to
cover within the confines of a single chapter. For brevity, I will focus on topics
with which I am most familiar as evidenced by my own publications and refer
the reader to those sources for additional information, detailed references, and
background discussion. The chapter is divided into seven sections with descriptive
self-explanatory titles.

Fraud and corruption have many facets, including cultural, legal, socioeconomic,
and ethical aspects. Fraud is defined as deliberate deception designed for gain by
hurting another person’s interests. Corruption is defined as abuse of a position
of trust for dishonest gain, such as taking a bribe. An economist’s or business
manager’s materialistic definitions of fraud and corruption refer to all unethical
behavior, which can be illustrated by business deception and bribery. Ethics may
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122 Ch. 9 Fraud and Corruption

appear to belong to the realm of morality and theology, but actually does have
considerable role in our context. Analytical methods used by economists do heed
ethical considerations, often under the headings of income distribution, economic
justice, and regulation.
       Ancient humans instinctively thought of fraud and corruption as immoral
and therefore inconsistent with material and spiritual well-being of citizens. Aris-
totle asked in Chapter 4 of Politics: “What sort of wealth-getting activity is
necessary and honorable for humans to undertake?” He was perhaps the first
to study the practical question of human relationships in the context of material
environment. He also said in Chapter 8: “The amount of property which is needed
for a good life is not unlimited.”
       Ancient philosophers often blamed crass materialism for fraud and cor-
ruption and therefore took an antiwealth stance to discourage cheating and a
tendency to achieve material wealth by hook or by crook. For example, spiritual
well-being was emphasized by Stoic philosophers like Marcus Aurelius, who
appealed to achieving true happiness by submission to destiny, not by deception.
Similarly, Arab-Islamic scholars were not antiwealth, but did believe in the role
of fate or kismet. The Biblical story that it is easier for a camel to pass through
the eye of a needle than for a rich man to get into heaven is quite explicit. An
open disdain for wealth may be read in some Jewish, Hindu, and Chinese phi-
losophy. Major religions preach against fraud and corruption by pointing to the
will of God and to natural law, and rarely through rational arguments.
       During the Italian renaissance, Thomas Aquinas asked a number of practical
questions in the world of commerce and morality. He wondered whether it is
ethical and legal to sell an item for more than it is worth, and explicitly considers
moral obligations of sellers and buyers. It is possible to read his work Summa
Theologica as a guidebook for commercial behavior. He considered failing to
reveal information about an item’s defect as cheating. In his time most people
lived in a subsistence economy; when markets were not well established, there
was no practical way to determine the fair worth of anything except by tradition.
Hence it was perhaps appropriate for Aquinas to insist on buying and selling
at the true intrinsic worth of items. He was concerned with living the good life
and being a good citizen. His philosophy contains the rudiments of the following
purely rational argument against fraud and corruption: If a great many citizens
deceive each other and if government officials are corrupt, a good life through
commerce is impossible.
       Clearly, honestly earned wealth must be distinguished from ill-gotten riches,
and a government is needed to punish the cheaters and bribe takers. Aristotle was
the first to make this distinction explicit. As capitalism developed, honestly earned
wealth began to be admired. Besides Aquinas, John Calvin was responsible for
the development of the Protestant ethic, which thought of wealth acquisition as
virtuous, not sinful; encouraged prudent use of wealth; and indirectly laid the
foundation for capital accumulation made possible by the industrial revolution.
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            9.2 Consequences of Fraud and Corruption for an Individual, Business, and Community 123

        Thomas Munn was an East India Company officer. His essay “England’s
Treasure by Foreign Trade” argued that wealth accumulation, which made busi-
nesspeople rich, also contributed to the economic and political strength of england.
His was an influential articulation of the Protestant ethic. Munn also supported
colonialism and expected the British government to support the commercial activ-
ities of the likes of the East India Company. He was also a mercantilist supporting
globalization of his era, and was concerned with trade balances, exchange rates,
and capital movements. Mercantilists were focused on enriching the king and
strengthening national power, rather than raising the living standards of the com-
mon folk. Mercantilists thought of trade as a zero-sum game in which one country
gained what the other lost. Their gains and losses were measured by gold and
power, while morality was unimportant.
        Adam Smith’s celebrated work The Wealth of Nations attacked mercantil-
ism and was preceded by The Theory of Moral Sentiments. It is interesting that
Smith emphasized division of labor and human capital, not gold. Smith strongly
criticized greed and callousness of capitalists and argued for the importance of
ethics for a prosperous society.
        Jeremy Bentham focused on self-interest as the main motivation and did not
want to wait for Smith’s “invisible hand” to right the existing social inequalities.
He proposed legislation changing the Poor Law and advocated education for the
working class. John Stuart Mill argued that human motivation includes sympathy
and benevolence. Mill took a more nuanced modern approach to morality and
laissez-faire economics. He understood the so-called problem of the commons, or
the unique nature of public goods, which are best provided by the government.
        There are two views of human nature in a business context. In the liberal
camp we have Aristotle, John Locke, Adam Smith, Jeremy Bentham, and John
Stuart Mill, among others, who saw humans as good and rational. This view
supports limited government and limited interference with individual choices.
By contrast, classical conservatives included Augustine, Aquinas, Hobbes, and
Machiavelli, who saw humans as greedy, irrational, even bestial, and supported a
strong central governing authority. Since excess regulation can kill entrepreneurial
spirit, public opinion and policy generally swing between these two views with
distinct practical implications for control of fraud and corruption.

The consequences of fraud and corruption for an individual perpetrator obviously
depend on whether he or she is caught, which in turn depends on the level of
enforcement of antideception and antibribery laws, and on the role of the media
in exposing and shaming the miscreants. The consequences for a small busi-
ness perpetrator are mostly similar. By contrast, fraud and corruption in larger
businesses have important consequences for the following stakeholders: share-
holders, customers, suppliers, employees, managers, and local governments. This
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124 Ch. 9 Fraud and Corruption

section argues that due to these undesirable consequences, fraud and corruption
need to be minimized with eternal vigilance, even if they cannot be eliminated
       Vinod (1999) is one of the first empirical papers to study the consequences
of corruption on the domestic economies of various countries using data on
16 socioeconomic and political variables. In this cross-sectional study Vinod
shows the relevance of red tape and efficiency of judiciary to explain the cor-
ruption perception index (CPI) of a country. Transparency International regularly
publishes the CPI, using a carefully designed survey of businesspeople, profes-
sional risk analysts, and the public. Vinod relies on subset regression methods
using Mallows’ Cp and Akaike information criteria (AIC) and finds that bet-
ter schooling and reduced income inequality can help reduce corruption. He
also shows that corruption is similar to an uncertain tax and estimates that a
dollar’s worth of corruption imposes $1.67 worth of a burden on the domestic
       The consequences of corruption on the international economy are also
severe, as explained in Vinod (2003) and illustrated by the 1997 Asian contagion
and banking distress, popularly blamed on crony capitalism in those countries.
The consequences are worse in countries where the financial sector is inefficient.
A well-developed financial derivatives market is helpful in managing different
risks, including credit risk, default risk, risk of fraud, and so on. Thin or ineffi-
cient derivatives markets in the absence of scale economies can exacerbate any
contagion when international investors rebalance their portfolios across countries.
Financial institutions themselves are hurt by contagion in several ways, including
loss of physical assets, loss of goodwill, and loss of stock value due to manip-
ulation and fraud. Moreover, corruption erodes the trust in the local financial
institutions. Sometimes rating agencies cause the proliferation of herd behavior
or self-fulfilling prophecies.
       International trade is known to be subject to a refusal of investors to diver-
sify their portfolios across countries, or home bias. When developing countries
are included in the picture, instead of home bias one observes flight of capi-
tal away from poor and corrupt countries. Hence policy makers impose capital
controls to prevent the much-needed domestic capital from leaving the coun-
try. However, capital controls themselves often further promote monopolies and
corruption. Using the International Monetary Fund (IMF) annual report, Vinod
(2003) creates an “index of capital controls” and shows that capital flight con-
trols themselves might discourage foreign direct investment (FDI). Data show
that investors more heavily weight potential costs of corruption, especially if
they use value at risk (VaR) analytical methods, popular for choosing among
portfolios. This is not surprising, since VaR means a study of worst-case
       Vinod (2003) verifies that corruption does increase the cost of capital,
by using data from PricewaterhouseCoopers, which reports percentage penalty
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       9.3 Principal-Agent Problem with Practices and Procedures for Managing Fraud and Corruption 125

in terms of capital due to lack of transparency and corruption in 34 countries.
Vinod (2003) reports that following correlation coefficients are statistically sig-
nificant: (1) between the corruption perception index (CPI) and the FDI/GDP
ratio (showing that FDI goes to countries with less corruption); (2) between CPI
and the trade/GDP ratio (showing that with trade comes more foreign compe-
tition and less corruption); (3) between CPI and the capital flow control index
(suggesting that controls themselves encourage corruption); and (4) between CPI
and the cost of capital percentage penalty. Data show that corrupt countries pay a
penalty when they borrow in international financial markets and that the penalty
decreases as the corruption in the country decreases.
       In short, the cost of investing in a corruption-ridden country is very high,
thus leading to a reduction in FDI. The greater uncertainty caused by corruption
means a larger risk premium. In conclusion, in both open and closed economies,
corruption can have several strong detrimental effects.

The principal-agent problem is a name given by economists to a common prob-
lem in almost all employer-employee relationships, where the employer has
incomplete information about the motives and activities of the employee. See
Sappington (1991) and Prendergast (1999) for surveys of the literature. The
employees of governmental bodies or businesses are often tempted to achieve
personal gains at the cost of the employer, such as by taking bribes, especially
if they can get away with it and all records can be erased. It is very difficult to
police such corruption, since the private gain may include nonmeasurable things
such as sexual favors or donations to favorite charities or political parties, and
the private gains might be granted to third parties.
       Most tools commonly used for aligning the interests of the employee (or
agent) with those of the employer (or principal) have the following themes:
   •   Make employee compensation directly proportional to the employer’s gain.
       This includes efficiency or piece wages, commissions, and profit sharing.
       A relatively recent example is the granting of stock options or other
       deferred compensation such that it is positive only of the stock price goes
       up. Of course we must guard against fraud (backdating) and misuse of these
       schemes (manipulation of quarterly earnings reports by hiding losses in off-
       shore and/or off-balance-sheet entities). All these compensation schemes
       can fail if employer’s profits depend on employee team effort rather than
       individual hard work.
   •   Threaten the employee with sanctions such as the loss of the job, a deposit,
       a bond, a cut in compensation in the form of a significant fine, or public
   •   Use special rewards and prizes (e.g., employee of the month).
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126 Ch. 9 Fraud and Corruption

    •   Use surveillance cameras, anonymous reports by independent observers,
        private investigators, and whistle-blowers to expose miscreants and reward
        team players.
    •   Since it might take a thief to catch a thief, peer reviews can be useful.
    •   Use profiling of employees and make intensity of monitoring proportional
        to past transgressions, however minor. This can include providing net-
        working opportunities for employees who benefit the employer.
       We conclude this section by noting that the fight against fraud and corrup-
tion is not hopeless.

Honest and moral behavior can often be traced to upbringing at home. Background
checks on individuals are often valuable tools for ensuring that convicted per-
petrators are not inadvertently hired in sensitive positions. The managers should
treat these checking activities with the seriousness they deserve and bring modern
science to bear on these tasks. Evidence of a past criminal record or drug use
often flags problematic employees who should not do sensitive jobs. Of course,
the employer has to be aware of scams and be sure to check the background
checkers themselves. The reference names given by employees should be inde-
pendent, and a lack of good references can be indicative of potential problems.
Mental health, marital relations, genetics, credit reports, Internet searches, and
travel histories can also be relevant. Specialized forensic accountants are some-
times used for preventing fraud and corruption. Great care is needed in using
these investigative tools and while handling personal data, since it is immoral
(and generally illegal) to invade the privacy of employees.

A large corporation routinely collects a great many measurements, which in-
evitably interact with employee activities. There are data on all kinds of expenses,
telephone usage, visitors, energy use, travel, and the like. Most examples of fraud
and corruption can manifest themselves in these routine measurements in subtle
ways. Fraudsters often have measured values that do not fit a common pattern,
trend, known evolution, or known long-memory stochastic process. In traditional
statistics these measurements are called outliers and their detection was originally
intended for the purpose of cleaning of data. Statistical outlier detection methods
were developed long ago in the context of quality assurance using the fact that
normal distribution varies within three standard deviations of the mean, but have
been extended to far more general nonnormal, nonlinear models with the advent
of computers.
        A fancier name for outlier detection is computer-intensive knowledge dis-
covery and data mining (KDD). It has become a field of study widely used in health
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           9.6   Corporate Governance, Compliance Issues, and Knowing Your Employees and Clients        127

care, retail, credit card services, telecommunications (phone card fraud), and so
on. The basic idea is to use historical data to build behavior models for detecting
unusual activities flagging potential fraud and corruption. Here are some examples.
   •   The insurance industry uses KDD to detect those who stage automobile
       accidents to collect insurance, and to catch professional patients and dis-
       honest doctors.
   •   The U.S. Treasury’s Financial Crimes Enforcement Network uses KDD to
       detect money laundering.
   •   British Telecom uses KDD for studying the destination, duration, and tim-
       ing of phone calls to apprehend fraudulent callers.
   •   KDD helps the retail sector reduce large losses due to employee theft and
       other abuses.
       All KDD involves a form of machine learning of human behavior, which
in turn requires careful data selection, cleaning, reduction, and transformation to
reduce its dimensionality. Various multivariate statistical tools, including cluster
analysis, principal component, canonical correlation, discriminant analysis (Vinod
and Ullah1981, ch. 12), are used in data mining to evaluate joint multivariate pat-
terns with a view to finding outlier patterns for further investigation. Decision
trees and neural networks mentioned in Vinod and Reagle (2005, sec. 6.3) are
also useful. There are no magic KDD tools, just painstaking application of usual
tools that generalize, summarize, classify, predict, and contrast data characteris-
tics. Vinod (1969) provides the mathematical programming model for clustering,
where the basic aim is to minimize within group sum of squares (WGSS) and
maximize between group sum of squares (BGSS), which is more general than
hierarchical clustering models. These multivariate methods have become more
practical with the availability of powerful computers.
       Data mining for detection of fraud and corruption has obvious applications
in detecting terrorist cells, and therefore some of the research in this area is likely
to be classified. There are a number of public domains (e.g.,
and other software products for accomplishing what is suggested here, and the
possibilities keep expanding as experience is gained.

Corporate governance mostly refers to government regulation controlling self-
governance of corporations as business entities. In this section, let us focus on
organizational structures preventing ethical lapses before they occur. Although
the interest of shareholders (owners) must remain supreme in a capitalist system,
the long-term interest of those owners and society lies in fair treatment of all
stakeholders: owners, managers, employees, clients, governmental entities, and
the general public. A successful business is impossible in the long run without
trust among the stakeholders built on a foundation of fair play.
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128 Ch. 9 Fraud and Corruption

        Efficient corporate governance requires appropriate record keeping, clear
assignment of responsibility, and suitable public disclosure (perhaps on the Inter-
net) of past actions and future plans. Although any business will have some
secrets it would like to keep from its competitors, a good corporate governance
regime must strike a proper balance between secrecy and transparency. Similarly,
a balance is needed between delegation and concentration of authority, along with
proper checks and balances on almost all exercises of discretion and power.
        The following anecdote illustrates the necessity of government regulation
and the difficulty of enforcing morality. A city boy, Kenny, moved to the country
and bought a donkey from an old farmer for $100. The farmer agreed to deliver the
donkey the next day. However, the next day the farmer drove up and announced,
“Sorry, son, but I have some bad news! The donkey died.” Kenny replied, “Well
then, just give me my money back.” The farmer said, “Can’t do that, since I’ve
already spent it all.” Kenny answered, “Okay then, at least give me the donkey.”
The farmer asked, “What’re you gonna do with him?” Kenny said, “I’m going
to raffle him off.” The farmer exclaimed, “You can’t raffle off a dead donkey!”
Kenny said, “Sure I can. Watch me. I just won’t tell anybody he is dead.”
A month later the farmer met up with Kenny and asked, “What happened with
that dead donkey?” Kenny answered, “I raffled him off. I sold 500 tickets at two
dollars a piece and made a profit of $898.” The farmer asked, “Didn’t anyone
complain?” Kenny replied, “Just the guy who won. So I gave him his two dollars
back.” The anecdote suggests fraudsters can come up with new schemes and it
can be difficult for regulators to anticipate and stay ahead of them.
        Prevention of fraud and corruption in all corporations is greatly helped by
efficient governance of financial institutions. Many of the corporate scandals in
recent years have resulted in large fines (exceeding a billion dollars) being paid
by financial institutions, because they were complicit in the fraud. After all, banks
do know a great deal about the corporate borrowers. We should blame the 1999
Gramm-Leach-Bliley Act, which sanctioned financial conglomerates, while doing
little to curb newly created conflicts of interest. A banker is also a bond trader,
a foreign exchange dealer, an investment broker, an insurance agent . . .; the list
keeps growing as the boundaries blur and conflicts of interest proliferate.
        Money center banks and large brokerage houses are often lenders to busi-
nesses in their role as investment bankers. They are also advisers to individual
savers who want to lend. This means they are representing the interests of buyers
and sellers of investment funds. Vinod (2004) argues that, just like the same law
firm cannot honestly represent both the prosecution and the defense in a lawsuit,
it is impossible for this fundamental conflict of interest to disappear by any arti-
ficial tools, such as the so-called Chinese wall forbidding communication. With
the availability of fast money transfers, the need for vigilant supervision of banks
is great. There are glaring examples of bank failures due to failure of super-
vision. In 1995 a 233-year-old bank called Barings Bank collapsed when one
trader (Nicholas W. Leeson) notched up losses of $1.40 billion in his derivatives
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           9.6   Corporate Governance, Compliance Issues, and Knowing Your Employees and Clients        129

trading. A study by the IMF put the taxpayers’ total bill for resolving banking
crises in emerging countries since 1980 at $250 billion. America’s savings and
loan troubles cost around 2 percent of GDP. The reason for a specific focus on
the banking sector is that there is a paradox when private bank failure leads to
public rescue with taxpayer funds.
       The Enron example illustrates several failures of corporate governance
discussed in Vinod (2002), who also called for expensing of stock options to
prevent managerial abuses. The Financial Accounting Standards Board (FASB)
has recently adopted such expensing, which was opposed by the same companies
that are found accused of fraudulent backdating (Wall Street Journal , August 14,
2006, C1). However, the Sarbanes-Oxley Act (SOX) of 2002 is a good example
of a thoughtful response, which deserves to be copied in other countries. Tarantino
(2006) discusses SOX in great detail. The United States has the same excesses
as any corrupt country, but also has the alphabet soup (SEC, Federal Reserve,
FAA, FDA, FBI, EPA, IRS, INS, etc.) of vigilant agencies run by mostly uncor-
rupt bureaucrats who consistently expose, punish, regulate, and ultimately reform
those excesses. America’s moral authority to lead the capitalist world derives
from the efficiency of these U.S. government agencies and bureaucrats.
       Unfortunately, the implementation of SOX did not include sufficient prac-
tical compliance guidelines for small businesses. In fact, these uncorrupt bureau-
crats should have allowed posting on the Internet of answers to simple compliance
questions. Clearly, SOX is evolving and simple procedures should be forthcom-
ing so that a well-governed small corporation can obtain a compliance certificate
without much cost. Instead, the accounting profession has abused SOX to charge
large fees, burdening the small and medium-sized businesses. It is interesting
that closely held companies are embracing SOX’s internal controls due to pres-
sure from customers, lenders, directors, and owners wishing to take the company
public in the future (Wall Street Journal , August 14, 2006, B3).
       A rather comical list of the effects of executive self-dealing is instructive
(Paul Krugman, New York Times, June 21 2002). Imagine that you manage an
unprofitable ice cream parlor. How can you get rich? Here are strategies for
executive self-dealing.
   •   Enron strategy. Sign contracts to provide customers with an ice cream
       cone a day for the next 30 years. Deliberately underestimate the cost, and
       book all the projected profits on future ice cream sales as this year’s bottom
       line. Your business appears highly profitable and the stock price goes up!
   •   Dynegy strategy. Convince investors that you will be profitable in the
       future. Enter into a quiet agreement with another ice cream parlor in which
       each will pretend to buy hundreds of cones daily in order to appear to be
       a big player in a coming business, and sell shares at inflated prices.
   •   Adelphia strategy. Sign contracts with customers, and get investors to
       focus on the volume of contracts rather than their profitability. Instead
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130 Ch. 9 Fraud and Corruption

        of imaginary trades, invent imaginary customers. Stock analysts give you
        high marks, and you can sell shares at inflated prices.
    •   WorldCom strategy. Make real costs disappear by pretending that operat-
        ing expenses—cream, sugar, chocolate syrup—are part of the purchase
        price of a new refrigerator, so you appear to borrow only for new equip-
        ment. You can then sell shares at inflated prices.
    •   Fictitious asset sale (Enron, Harken Energy) strategy. Sell your ice cream
        delivery van to XYZ Inc. for an outlandish price to claim capital gain as
        profit. Actually you own XYZ secretly anyway. In all this, top managers
        benefit through stock options, Adelphia-style personal loans, and other
      We conclude the section on corporate governance in the United States by
urging a ban on self-dealing and stricter control of numerous other abuses by top
executives. We need healthy skepticism, as well as sharp eyes, ears, and nose by
the board of directors, supported by independent no-nonsense auditors (inspectors
general) well versed in criminology in addition to law and accounting.

Prevention of fraud and corruption is far better than enforcement through pun-
ishment. Hence we now discuss some tools for preventing corrupt behavior by
using standard administrative and regulatory mechanisms to discourage persons
with discretionary power from misusing that power for personal gain. First, dis-
closure of personal assets and liabilities of public officials and their close relatives
means that they cannot hide any significant bribes received without being noticed.
In some cases local officials are too beholden to the locally powerful individu-
als and entities. Then, an international monitoring authority might be needed to
enforce transparency of public sector contracts.
       For example, a group of countries can sign long-term integrity pacts, with
suitable sharing of information and coordination of investigations into fraudulent
dealings. Another preventive tool is to simplify procurements by reducing pro-
cedural complexities and discretion. Corruption can be in the form of concealed
payments and illegal transfers of valuable public assets to “sweethearts” of offi-
cials. It is important to remove potential incentives for exchanging favors and all
quid pro quo payments. We have to prohibit corrupt officials from taking public
or third-party time and resources hostage.
       Market solutions to prevent fraud and corruption include liberalization,
expanded foreign trade, privatization, and more generally providing customers
with wider choices and fuller information. Liberalization means creating a com-
petitive, transparent, and level playing field for all competitors. Market reforms
can be genuine only if government refrains from directly owning commercial
enterprises and managing markets. Moreover, the reforms need to be coupled with
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         9.7 Enforcement, Incentive Schemes, and Market Solutions Preventing Fraud and Corruption 131

sound rules of the game, administered by impartial regulators in an environment
free of outside (political) interference.
       As a practical matter, public servants should know their rights (presumption
of innocence, due process, etc.) and obligations in the context of such wrongdo-
ing. The officials need clear guidelines regarding their normal interactions with
their friends, relatives, general public, businesspeople, and political leaders. It is
important that management policies, procedures, and practices promote ethical
conduct and that there are good role models. When unethical conduct is uncov-
ered, the person responsible should be held accountable for the lapse, while the
punishment process should be transparent and open to scrutiny. Prompt and appro-
priately transparent sanctions should be imposed, and current procedures should
be improved whenever possible to discourage similar misconduct in the future.
       This chapter began with a historical philosophical review of the role of
ethics in business transactions. We defined fraud and corruption and indicated its
consequences in both domestic and international arenas. Despite unavoidability
of the principal-agent problem, we argued that the situation is not hopeless by
listing best practice guidelines, use of data mining statistical tools, and corpo-
rate governance regimes. We also discussed prevention and enforcement tools,
including some involving market incentives.


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