On capital punishment of organizations – Arthur Andersen and Penn State – corporate death versus mild sanctions

Jim Peterson explores the hesitancy our society has to carry out capital punishment on seriously misbehaving organizations.  See his post, Of Crimes and Punishments – And Where Shall Justice Be Found?

He starts by pondering a question from a retired Arthur Andersen partner. The retired CPA wonders if the conviction of a mid-level manager in the Roman Catholic Church who hid abuse by priests will result in the indictment of senior-level executives or the church itself. The painful irony felt by the questioner is that Arthur Andersen was indicted and put out of business because of the bad behavior by one partner and his audit team in following the bad advice of their general counsel.

Essentially, the penalty for Arthur Andersen was capital punishment. Not so for the Catholic Church, Penn State football, or a long string of financial institutions in the news during recent years.

The question is when does our society carry out capital punishment against misbehaving organizations?

Jim Peterson points out there is very serious hesitation on the part of enforcement agencies, whether they are federal prosecutors or the NCAA, to apply the ultimate penalty.

He then points out there are other pressures that come to bear on organizations whose behavior is horrible. Three he mentions are the marketplace sometimes visits failure on bad behavior, civil litigation often brings rough justice, and a damaged reputation has its own high costs. The three paragraphs expanding those ideas are very good – check them out.

Arthur Andersen

As I’ve mentioned before, the federal prosecutors came to the conclusion that the senior leadership of Arthur Andersen considered another round of sanctions as nothing more than the cost of doing business.

After audit failures including Boston Chicken, Arizona Baptist Foundation, Sunbeam, Waste Management, Global Crossing, WorldCom, and then Enron, one can understand that the federal prosecutors decided the pattern wasn’t going to change. In the Waste Management case, the audit partners helped the company unwind the fraud. Shades of Olympus and tobashi.

David Albrecht had this to say in his post, 10 Years Later – Did Andersen Die in Vain?

Andersen deserved its punishment. I shed no tears for it. Its death was not a tragedy. Its forsaking the public trust was the tragedy. There ought to be a special place for those who violate the public trust.

Andersen’s death means only that it was not allowed to continue making the world a worse place. A positive from its death is that there have been no Andersen audit failures since 2002.

The behavior at Arthur Andersen was so severe with so little prospect of a change in performance that the feds pulled the trigger on capital punishment.

Penn State football

In contrast, the NCAA decided capital punishment was not appropriate for the Penn State football program.

We will eventually find out the thought process followed by the private sector regulators who concluded that a long-term, systemic cover-up of child molestation did not warrant capital punishment, but instead deserved some mild sanctions.

From what is visible, Penn State is taking action to make corrections.  The key players in the cover-up are fired and their reputations permanently marred. The leadership of Penn State has accepted the consequences from NCAA without protest. The leadership says, publicly at least, that they will change the culture. From what can be seen, the administration is not just considering this a cost of doing business.

I’m thinking the attitude and apparent intention to change the organization is the difference between Andersen and Penn State.

“Wait a second”, I hear you say. “Mild sanctions? Did you say mild?”

Yes, I did. Mild.

Let’s take a look at the sanctions. I will rely on an article in the Wall Street Journal, NCAA Slams Penn State.

The sanctions are in four areas. Three mentioned in the Wall Street Journal article are:

• $60 million fine
• Football victories for past 14 seasons voided, vacating Joe Paterno’s record for victories by a major-college coach
• New football scholarships awarded annually reduced to 15 from 25 for four years; total football scholarships cut to 65 from 85

An additional penalty is no bowl games for four years.

Let’s walk through those sanctions, looking at them from a different perspective.

All wins voided – While the official records will reflect no wins in the last 14 seasons, I am confident there will be multiple websites that joyfully report the “correct” records. There will be plenty of people who can do the work necessary to report all the scores, win/loss records, and sundry stats that exclude the memory-hole punishment from NCAA. Such sites may already be online. Eventually there will probably be an asterisk on the records of everyone that got bumped up pointing out their place in the record book exists because of the sanctions.

Reduced scholarships – When I first read that the program was going to have to reduce its scholarship count by 20, I thought that would be a fairly serious punishment.

Then I found out the program was allowed 85 scholarships in total and 25 new scholarships a year.

They have to cut from 85 to 65? That’s a fairly small punishment. I guess they won’t be able to give a full ride scholarship to every single person on the team. (A moment of research suggests that means there will be about 35 players instead of 15 who have to pay for schooling.) 

It may reduce their competitiveness. But it’s not exactly a severe penalty. May actually offset some of the dollar penalty by avoiding, oh, about $500k in scholarships to some of the less strong players.

$60 million fine – At first glance that looks like a pretty serious hit. Let’s look at some financial info to put that into perspective.

From the Wall Street Journal article:

The NCAA’s $60 million fine comes at a university that earlier this month approved a $4.26 billion operating budget for the coming fiscal year. Football provides the bulk of revenue for the university’s intercollegiate athletic program. In the university’s 2011-12 operating budget, football generated $50.6 million of the $97.4 million in total revenue for intercollegiate athletics. Total expenses amounted to $84.7 million, $10.4 million of which was on football.

The fine is 1.4% of the university’s annual income.

So here is the income statement for the football program:

• $50.6M – annual income
• $10.4M – costs of the program
• $40.2M  – gross margin from football, not including a large portion of contributions generated by alumni who enjoy the program

So a fine of $60M is equal to about 1.2 years income for the program. Amortize that over the 14 years of success that would have been impaired by reporting the molestation and it is approximately $4.3M per year, or approximately 8.5% of annual income.

So this fine that might appear to be horrendous and unprecedented is essentially a retroactive 8.5% tax on earnings for the last 14 years.

The program will be allowed to pay the penalty over five years (I don’t have an immediate citation for that statement, but if it becomes important I will go find it).  That will avoid creating too serious of a hit in the current year cash flow,

Therefore the cash flow will be payments of $12M a year. That is approximately 24% of annual income for the football program, or approximately 30% of the gross margin.

Let’s look at all intercollegiate programs. Profit from all intercollegiate athletics is about $12.7M ($97.4M – $84.7M).  The annual payments of $12M are then equal to the annual profit from all intercollegiate athletics.

Yes, the financial penalty is substantial. However, it is nowhere near as severe as it seems.

Bowl games – With the damage to the football program because of bad publicity, I’m guessing it would be a few years before the program will recover to the point where they would be going to a bowl game anyway. In any event, that is a loss of about $13 million per year, which would double the penalties I mentioned in the previous section.

So, it’s more than just a slap on the wrist, but let’s not call it a serious penalty.

Why the difference?

That brings us back to Jim Peterson’s article. On one hand, there is capital punishment for Arthur Andersen. On the other hand, there are penalties for Penn State football that are either a reduction in the gross margin of the program or a serious punishment, depending on your perspective.  Why the difference?

I don’t know. That will require more pondering.

Update:  Sanctions on Penn State were dialed way back in September 2014.