Corruption. Said slowly, even the word seems to subvert and ensnare. Corruption permeates business, government, and the global economy. It saps the strength of people and institutions, especially in developing countries. Everyone’s against corruption, or so they claim. But virtually all countries are involved in facilitating an enormous global flow of corrupt, criminal, and tax-evading money. It’s a problem that is “capitalism’s Achilles heel,” declares Raymond Baker (MBA ’60), executive director of the Washington, D.C.–based organization Global Financial Integrity (GFI). This month at the G20 conference in Canada, Baker will present the assembled leaders with an online, worldwide GFI petition that calls for greater transparency in the global financial system and stronger enforcement of international money-monitoring laws and regulations.

For Baker, this is the latest salvo in a long campaign that began in Nigeria, where, as a recent HBS graduate, he started his business career, investing in and acquiring companies. The corruption he found in Africa, and later in Asia and Latin America, convinced him that the issue needed to be better understood. As a scholar, researcher, speaker, and writer, with stints at the Brookings Institution, the Center for International Policy, and now GFI, Baker has become a leading expert on the world’s shadow financial structure and illicit money supply. He also understands corruption’s human toll. Burned into his memory is the Nigerian lady who helped care for his children, begging him from her knees to take her own child to America because corruption had destroyed her hopes for her country and her son’s future. “People in poor countries are not resigned to corruption, they actively despise it,” Baker says. “It is rooted in the weak rule of law, not poverty. Good legislation and effective judiciaries that curtail corruption can be found in poor countries; bad legislation and ineffective judiciaries in rich nations can enable it.”

Defined by the watchdog group Trans-parency International (TI) as “the abuse of entrusted power for private gain,” corruption includes a range of crimes beyond bribery, such as embezzlement, fraud, price-fixing, and influence peddling. But bribery is corruption’s most recognizable face, with some $40 billion annually doled out to corrupt government officials, TI says. Half of the executives in a 2009 TI global survey said that bribery and corruption raised project costs up to 10 percent; one in five say they lost business to competitors who bribed.

Low-level, low-cost bribery is frequently not illegal, nor are other, high-cost activities that may appear corrupting (e.g., money in politics); some people even defend small-scale bribery as a way to spread money around inequitable societies. But bribery and corruption do more than divert wealth from legitimate commerce or investment in long-term growth: They help cement the power of corrupt regimes, institutionalize injustice, frustrate entrepreneurship, and undermine a society’s full potential.

A Shadow Structure
How should companies behave in such an environment? Clearly, refusing to pay or receive bribes and acting according to high ethical standards is the best course of action. But operating in the real world is a complicated matter, says HBS professor Rawi Abdelal. “When we talk about corruption, the interesting and important issues are shades of gray,” observes Abdelal, who has authored several case studies on corruption and is writing a book on the subject with HBS professor Rafael Di Tella.

Very broadly speaking, Abdelal explains, there are two modes of bribery: extortion and capture. “Extortion is when government officials force you to pay them to do their job, such as issue permits or sign documents — although, it should be noted, bribes are sometimes offered proactively, before any ‘extortion’ by the official.” Capture, which usually involves lucrative inducements at a high level, “is when you actually tilt the playing field by influencing the policymaking or contracting process; this is illegal and unfair.” Abdelal says that for many executives, the challenge is managing a business culture in which it is sometimes necessary to make low-level “facilitating payments” (which are often legal and unavoidable), while maintaining a strong anti-corruption and anti-capture stance.

HBS professor Lou Wells, with many years of experience working on mining agreements and as a negotiator in Africa and Indonesia, has witnessed a variety of corrupt practices. Without excusing it, he too emphasizes that making facilitating payments for essential documents and services is a routine fact of life in many countries, so much so that facilitating payments are not barred by the 1977 U.S. Foreign Corrupt Practices Act, which is widely viewed as the toughest, most effective foreign-corruption legislation extant. High-level bribery is part of the fabric of many societies, Wells says, because in a number of developing countries, the scarcity of well-paying jobs, among other reasons, encourages officials to make money while their party is in power.

While Baker tracks bribery closely, he sees it as part of a bigger problem: the global financial system’s shadow structure. According to GFI research, the proceeds of bribery represent only 3 percent of the $2 trillion annual cross-border flow of illicit money — illicit meaning “illegally earned, transferred, or utilized.” The organized crime component is about 30 to 35 percent. A whopping 60 to 65 percent is due to the private sector’s illegal and intentional manipulation of taxes and commercial transactions. How can this be? Because the global system lacks transparency, Baker explains, it becomes a vast enabler not only of corruption and criminality but also of commercial illegality. This shadow structure facilitates the hiding of money, be it from a murderous “godfather,” a corrupt official, or a tax-evading, transaction-manipulating executive; the system’s mechanisms are available to and exploited by all three actors. “The richest countries are the biggest promoters of lawlessness in international trade and finance,” Baker writes in his 2005 book, Capitalism’s Achilles Heel. “In a process that parades as agreeable enterprise…illegal money streams through mechanisms designed by western countries to bring hundreds of billions annually into western coffers.”

Recently, due to its opacity and ease of incorporation (of dummy as well as legitimate companies), Britain’s independent Tax Justice Network placed the state of Delaware at the top of its Financial Secrecy Index, Time magazine reported in February. The magazine added that “the U.S. just might be the world’s biggest washing machine for dirty money.” Baker concurs, noting that the U.S. Treasury Department asserts that virtually 100 percent of dirty money presented for deposit in the United States is accepted into secure accounts. (In March, Wachovia Bank made a $160 million settlement with the Justice Department, agreeing it had been lax about accepting drug money from Mexico.) While U.S. law is tough on drug trafficking, terrorist financing, bank fraud, and theft by foreign government officials, Baker notes, “It does not bar proceeds generated abroad from activities such as handling stolen property, counterfeiting, contraband, environmental crimes, and foreign tax evasion.”

The broader problem, asserts Baker, lies in the manipulation of normal commercial procedures: falsified invoices, sham transactions, and tax-evading deposits in secrecy jurisdictions. To be sure, money derived from trafficking and violence-based enterprise is bloodier than ill-gotten, white-collar gains. But the global financial system’s shadow architecture provides the same haven for all illegal money, however derived, with blood money inevitably hiding alongside money from mainstream business malpractice.

One common technique for moving large sums of illict money, Baker asserts, is falsified pricing in international trade. Invoices can be written to reflect one price, while still another sum is agreed to, often verbally, with the difference deposited in someone’s offshore account. Even bigger sums are involved in abusive transfer pricing, the otherwise legal practice — common among multinationals — of trading within an organization. As much as 60 percent of global trade’s annual $35 trillion is trade within multinationals, with countries losing several hundred billion dollars every year in tax revenues due to abusive transfer pricing (see sidebar, above). Says Baker, “Most multinationals deliberately intend to evade some of their taxes on some of their transactions, using transfer pricing to move that tax-evading money between parent, subsidiaries, and affiliates. Transfer pricing is legal, but when it becomes abusive — serving no legitimate business purpose and with tax evasion as its only intent — then you are breaking the law.”

Opinions differ, however, over what constitutes fair transfer pricing. It was the subject of the largest tax dispute in IRS history, settled in 2006 when GlaxoSmithKline paid the agency some $3.4 billion, a case that the IRS said sent “a strong message of our resolve” in dealing with transfer pricing. Says Wells, “The manipulation of transfer prices to evade taxes is a big issue. It’s a difficult area, and there’s no question that multinationals play at the edge of what is appropriate, and that should be corrected. But I would hesitate to have those kinds of financial dealings thought of as equivalent to the problems of drug money, or terrorist financing, or secreted money from blatant bribes.”

For his part, Baker believes multinationals are engaged in increasingly risky behavior. He notes that two major European multinationals with SEC requirements in the United States were recently fined for corruption activity that had no U.S. content. And he cites a 2005 Supreme Court ruling, Pasquantino v. U.S., that suggests that American companies may be punishable under U.S. law if they break another country’s tax laws. “The implications of Pasquantino,” Baker says, “have not sunk into the corporate community. The business of manipulating prices to evade taxes, including the taxes of another country, could very well be a felony offense under U.S. law. Yet this is something that goes on in the majority of U.S. corporations all the time. Think what this says to the thousands of people involved in these kinds of decisions every day.”

Crossing the Line
There are two main deterrents to bribery and corrupt practices: government laws and regulations, and companies’ own compliance systems. Both are effective only if they are consistent and enforced. For example, countries work at cross purposes when they legislate against corruption while simultaneously funding export credit agencies (ECAs). ECAs offer financial guarantees to multinationals that in effect may reimburse firms for bribes paid or for contracts canceled by host countries because the multinationals paid bribes. As for companies’ internal guidelines, Transparency International reports that while almost 90 percent of the top 200 businesses worldwide have adopted business codes, fewer than half indicate that they monitor compliance. And gray areas will persist. Notes Wells: “It’s not clear that subsidiary managers always want clarity from their superiors. Some managers will want precise prohibitions so they can say, ‘I’m not allowed to bribe.’ Others prefer ambiguous instructions so they can do what they have to do to get the business and keep up with the competition.” But managing in such a culture where signals are mixed can be a tricky business. As Abdelal observes, “One problem for firms is that if they get comfortable giving in to extortion in various countries, that can lead to crossing the line into capture.” Companies’ reputations can affect the degree of corrupting pressures to which they are subjected. But even when firms strive to create a corruption-free culture, extraordinary defensive measures, such as acquiring one’s own generators to circumvent bribe-seeking electricity authorities, may not be enough, as Ikea recently found out in Russia. (The company has admitted kickbacks were paid to acquire the generators.)

If a company wants to strengthen its anti-corruption posture, it should avoid any semblance of tax evasion or illicit activity, says Baker. He points to the goals of GFI’s Task Force on Financial Integrity & Economic Development (TFFIED), a global coalition of civil society organizations and some 55 governments. The task force has five priorities: curtailment of mispricing in trade imports and exports; country-by-country accounting of sales, profits, and taxes paid by multinational corporations; confirmation of beneficial ownership (i.e., naming the real owners, not frontmen) in all banking and securities accounts; automatic exchange of tax information between countries; and across all countries cooperating in anti– money laundering efforts, harmonization of predicate offenses (i.e., agreement as to what crimes’ proceeds shall fall under anti–money laundering laws). “Having the beneficial parties to a transaction sign, under penalty, that these terms have been met would substantially curtail illicit financial flows,” says Baker. “I believe in the power of the signature.”

For its part, the World Bank cites five elements as key to reducing corruption: increasing political accountability; strengthening civil society participation; creating a competitive private sector; establishing institutional restraints on power; and improving public-sector management. Organizations such as TI, TFFIED, and its member groups are also making a difference. Notes Wells, “Governments don’t like to be rated poorly. Transparency International is putting pressure on countries, as is the World Bank’s Ease of Doing Business index. External pressure does help.”

Abdelal cites another strong anti-corruption motivator: national pride. “In the 1990s,” he observes, “Russia was basically captured by its oligarchs, who essentially owned the political process. The country looked more like a developing country than the world power it fancied itself to be. Putin decided the best way to weaken the oligarchs was to strengthen the state and its institutions, and he succeeded. It was a huge achievement to get rid of capture, but the pendulum seems to have swung too far the other way. Extortion has returned, and now that must be addressed.” Indeed, Russia says it convicted 3,512 officials of corruption in 2009. “Russia recognizes that it won’t be a modern, successful capitalist economy unless it can resolve this,” Abdelal adds.

Just as corruption can threaten the economy of an individual state, it can also threaten the stability of the global economy. “Over the last fifty years in the West,” declares Baker, “we’ve created a global shadow financial system of secrecy jurisdictions, entities, and mechanisms that has as its core purpose the shift of money from poor to rich. One trillion dollars of illicitly generated money leaves developing countries annually through this system: Ten corrupt dollars go out for every one dollar of development assistance that goes in. The resulting poverty, inequality, and political insecurity are creating a very dangerous situation for the world. We can — and we must — correct it.”

When Corruption Beckons: What Would You Do?

Professor Lou Wells has written a number of “caselets” depicting actual bribery and corruption situations. Here are summaries of three of them.

• For the release of the manager of your Latin American subsidiary, his leftist kidnappers have demanded that you run a newspaper ad detailing the group’s criticisms of the government; provide $100,000 worth of food to be distributed to the poor; and pay a $1 million ransom, which would be illegal under the country’s laws. What would you do?
• In Indonesia, you are negotiating with the state-owned electricity company to build and own a power plant. It is suggested that you take on a grown son of the country’s president as a partner. The son is a partner in other important companies in the country but apparently has no significant business skills. He wants 15 percent of the equity and would take out a loan from your parent company to buy his shares, the loan to be repaid with dividends from those shares. Would you make him a partner?
• On a cold winter day in Boston, your car battery is dead. A neighbor gives you a jump, and you drive to a big-box auto-parts store to buy a new battery. The salesperson offers you a new battery with a receipt for $55, or the same battery with no receipt for $25. Which do you take?

The Old Shell Game: How Do They Do That?

When unaffiliated companies trade with each other, their transaction’s price, shaped by market factors, is usually accepted for tax purposes. Transfer pricing happens when affiliated companies — say, a parent and a subsidiary, or two subsidiaries — can set their own artificial (non-market) transaction price. The following scenario, from a December New York Review of Books article by Raymond Baker, is an example of what he deems abusive, illegal transfer pricing:

“A company in country A makes photocopy machines that have a production cost of $1,000. The company establishes a dummy corporation in a tax haven that buys the copiers at cost for $1,000 apiece. Since the company has not made any profit on the sale, no taxes are owed. The dummy corporation in the tax haven then sells the copiers to another subsidiary in country C, at a price of $2,000 each. Now the company in country A is making a profit of $1,000 on each machine sold, but since the sales are through the offshore dummy corporation, the company pays only those marginal taxes that are charged in the tax haven. The subsidiary in country C may in turn sell the copiers on the open market for $1,500 each, allowing it to claim, for tax purposes, a $500 loss on the $2,000 purchase price. But since the company in country A owns all of the parties involved in the transaction, it is actually making a $500 profit on each sale.”

Sources of statistics cited in this article

Page 31

“…$40 billion annually” (Transparency International press release Sept. 23, 2009)
“….as much as 10 percent’ (TI press release 9/23/10)
“…one in five said…” (TI Press release 9/23/10)

Page 32

“….Delaware at the top…” (Time magazine, Feb. 2, 2010)
“…biggest washing machine” (Time, Feb. 2, 2010)
“..Wachovia Bank…” (Wall Street Journal, March 18, 2010)

Page 33

“…60 percent of global trade…” (Raymond Baker; Tax Justice Network)
“…$35 trillion…” (Raymond Baker; World Trade Organization)
“…several hundred billion dollars annually..” (Tax Justice Network; citing GFI)
“..largest tax dispute…” (IRS press release Sept. 11, 2006)
“..a strong message of our resolve” (IRS press release 9/11/06)

Page 34

“ ..almost 90 percent…” (TI press release 9/23/09)
“…Ikea…” (New York Times, Feb. 16, 2010)

Page 35

“…3,512 officials..” (Bloomberg News, March 1, 2010)

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