In Fraud, Edward Balleisen recounts the evolution of attitudes toward and responses to fraud from the middle of the 1800s to the present day. Needless to say, this is a big subject with many moving parts. But Balleisen, a professor of history and public policy at Duke University, has written a readable—and enjoyable—account of how fraud as variously defined has shaped the very idea of free enterprise in America.

As noted in the jacket blurb: “The United States has always proved an inviting home for boosters, sharp dealers, and outright swindlers. Worship of entrepreneurial freedom has complicated the task of distinguishing aggressive salesmanship from unacceptable deceit, especially on the frontiers of innovation.”

To be clear, the book focuses on frauds perpetrated by businesses on individuals and other businesses. It does not address frauds perpetrated by individuals as individuals. In other words, the book deals with the business of fraud (so to speak). But its real contribution is that it traces the variety of methods by which government, consumers, and business itself have sought to remediate and prevent fraud. Perhaps more intriguing, Balleisen describes how attitudes toward fraud have shifted over time from the days of strict caveat emptor, to the rise of the postal inspectorate after the Civil War, to the advent of the regulatory state beginning around World War I, to the deregulation movement beginning in the 1970s, to the re-regulation we arguably have seen in the recent past.

Fraud or innovation? / Balleisen largely resists the standard knee-jerk response to urge that fraud be treated as a crime and that fraudsters be jailed. To his credit, he does a good job (for a presumed non-lawyer) at explaining why it is so difficult to prove fraud. Indeed, it remains a mystery to me (and others) why the Federal Rules of Civil Procedure (which are also followed in most states) continue to single out fraud for special treatment. Although the rules generally require only a short and plain statement of a claim, Rule 9 requires that in alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake (although malice, intent, knowledge, and other conditions of a person’s mind may be alleged generally).

Balleisen also does a good job explaining how the word “fraud” has been mangled in popular usage to comprehend a range of abuses that often fall far short of true fraud. A business may be described as a “racket” or “scam,” but does that make it a fraud? On the other hand, Balleisen tends to succumb to the idea that for a business to fail suggests foul play of some sort.

For example, he seems to see the failure of the automaker Tucker Corp. and its effort to market the Tucker 48 as not much better than the tactics of the disreputable Holland Furnace Company (of which more presently). As Balleisen notes, Tucker failed because of cost overruns and a lack of capital. In an effort to save the company, Preston Tucker sold dealerships to businesspeople and options to purchase cars themselves to consumers. For this he was charged with mail fraud as well as securities fraud, but he was ultimately acquitted when the judge emphasized to the jury that to convict Tucker of fraud they must find that he had deceived investors and customers with the intent to cheat them. Mere hyperbole was not enough. Moreover, it is not difficult to imagine that the establishment automobile industry was behind the prosecution of Tucker (as should be obvious to anyone who has seen the eponymous 1988 movie). But it is also clear that Tucker is a prime example of an American promoter-hero, perhaps all the more so because he skated close to the edge of the law—as did Richard Sears, who ran afoul of the Post Office for his edgy mail-order business.

It is not at all clear that Tucker Corp. should be seen as sketchy simply because it could not attract adequate capital. In the United States, we have largely eliminated generic capital requirements for business, relegating such regulations to financial businesses that handle other people’s money and thus assume a fiduciary or similar duty (even though there is little agreement as to how much capital is necessary even then). In contrast, the European Union has struggled to retain and rationalize the general requirement of legal capital and has suffered significantly slower recovery and growth. Incidentally, Tucker’s business model is similar in a way to crowdfunding, for which Congress carved out an exception to the securities laws in 2012. Maybe Tucker was just ahead of his time.

Troubling tales / The saga of the Holland Furnace Company, which Balleisen mentions in four separate passages, is another story altogether. Its business model was to offer a free in-home furnace inspection, which required the dismantling of the existing furnace. When the inspector discovered dangerous defects, he would refuse to reassemble the unit, leaving the homeowner with little choice but to buy a new furnace.

Ironically, Holland became the target of a takeover attempt in 1957 by Arnold Maremont, a businessman with a history of corporate takeovers and liquidations. Maremont thought the company’s so-called direct sales method was outmoded and he acquired a substantial block of shares presumably with a view to changing the strategy. The board of directors averted the overture by repurchasing Maremont’s stock at a premium. Stockholders objected that the repurchase depleted company assets for the purpose of entrenching management. But the Delaware Supreme Court ruled that the use of corporate funds to prevent a takeover was permissible because it was for the legitimate business purpose of protecting the business strategy. Never mind that the strategy itself turned out to be illegitimate, as the Federal Trade Commission ultimately found. Nevertheless, the Delaware case Cheff v. Mathes remains good law and is often cited as drawing the line between permissible and impermissible “greenmail”—the strategy of buying stock in an apparent effort to take over a firm, but really to receive a premium repurchase offer from the firm.

The trials of Tucker are reminiscent of the 2002 failure of WorldCom and the fate of its CEO, Bernie Ebbers, who remains in jail today. Although there is no question that WorldCom was guilty of securities fraud by virtue of misreporting its financial situation, one of the accounting rules it violated was subsequently changed by the Financial Accounting Standards Board such that WorldCom would not have been in violation. Yet WorldCom was convicted under the old rule despite the fact that the trial occurred well after the rule change. Moreover, although WorldCom was quite aggressive about classifying cash outflows for fiber capacity as capital expenses giving rise to balance sheet assets rather than ordinary operating expenses that merely reduce earnings, it did not misrepresent the fact of such outflows. Neither the market nor WorldCom knew that so much fiber would remain dark for so long because of the “last mile” problem. But when the market woke up, Ebbers went to jail.

In contrast, around the same time that WorldCom was struggling with its underutilized fiber, Enron was reporting income from transactions that never really occurred. More specifically, buyers retained an option to resell the investments they bought if they declined in value. To be sure, the repurchase might come in the form of Enron stock rather than cash, but the net effect was to treat the issue of stock as income—a gussied up Ponzi scheme. Meanwhile, the management team of Kenneth Lay, Jeffrey Skilling, and Andrew Fastow sold $800 million worth of their own Enron stock while cajoling their employees to invest 100% of their retirement savings in the company.

Someone to blame / It is important to remember that most new businesses fail. And big ideas can fail big. But in the United States we do not subscribe to the so-called precautionary principle requiring assurances that new ventures will do no harm. Indeed, since the late 1980s we have made limited liability ever more available (as Balleisen himself notes with some dismay).

Few would argue today that limited liability is intended to subsidize business by eliminating the downside for entrepreneurs. Rather, its function is to shift the burden to lenders to protect themselves by exacting security or a higher return. Without limited liability, entrepreneurs would be required in effect to risk all of their net worth in starting a business—as in an ordinary partnership. With limited liability, entrepreneurs know what they must risk to do business and can decide whether it is worth the candle. Moreover, creditors can manage risk through diversification. So limited liability arguably maximizes the availability of credit.

Limited liability can be seen as a tax, of sorts, on the creditor class by limiting what they can recover if the borrowing firm fails. If creditors want more return, then they must take more risk. In other words, U.S. law discourages the emergence of a rentier class of lenders. Thomas Piketty would approve. So it is not surprising that business equity, instead of bonds, is the single largest category of wealth for U.S. individuals. According to the Fed, as of year-end 2016, equity constituted 34% of all wealth, while 25% was real estate, 24% was debt instruments, and 11% was cash or near cash.

As for involuntary creditors—the victims of accidents and other torts that are bound to happen—the irony is that plaintiffs almost always would prefer to sue a big corporation with deep pockets anyway. Moreover, if the business is a small one, the chances are that the owner was personally involved in the mishap and thus liable as a participant irrespective of the insulation afforded by limited liability to owners as owners. And once a small business is big enough to hire a few employees, the owner is likely to have most of his wealth tied up in the venture and thus much to lose because the business itself always remains liable for the actions of its agents. So it is likely that the owner will invest significantly in training and monitoring employees who are bound to be less careful and diligent than would be the owner.

As Balleisen emphasizes, the general organizing principle for U.S. commerce in the mid-1800s was one of caveat emptor. And as Balleisen would likely agree, this policy was at least as much a positive choice as it was benign neglect. Consider the following passage from Oliver Wendell Holmes’ The Common Law (Macmillan, 1881):

A man need not, it is true, do this or that act, the term act implies a choice,—but he must act somehow. Furthermore, the public generally profits by individual activity. As action cannot be avoided, and tends to the public good, there is obviously no policy in throwing the hazard of what is at once desirable and inevitable upon the actor. The state might conceivably make itself a mutual insurance company against accidents, and distribute the burden of its citizens’ mishaps among all its members. There might be a pension for paralytics, and state aid for those who suffered in person or estate from tempest or wild beasts. … Or it might throw all loss upon the actor irrespective of fault. The state does none of these things, however, and the prevailing view is that its cumbrous and expensive machinery ought not to be set in motion unless some clear benefit is to be derived from disturbing the status quo. State interference is an evil, where it cannot be shown to be a good. Universal insurance, if desired, can be better and more cheaply accomplished by private enterprise.

To be sure, Holmes was struggling here with the fundamental question of why someone should not be held liable for any chain of events set in motion voluntarily. But the logic applies as much to the law of business organizations as it does to tort law. Indeed, it was only in 1875 that New Jersey made the corporate form generally available (although as Holmes himself notes it had been available for manufacturing companies since the 1820s).

When ventures fail and folks lose money, it is only natural to seek someone to blame. But it is often more interesting and useful to understand how fraud happens. As I have argued elsewhere, the 2008 credit crisis can be traced to an array of factors that would have been difficult to regulate in advance. Perhaps the most peculiar factor was that investment banks (as well as commercial banks) invaded the residential mortgage business, which as recently as the 1980s had been the province of the thrift industry. Think Bailey Building & Loan. Many commentators pointed at the repeal of the venerable Glass–Steagall Act, which separated investment banking from commercial banking. Specifically, the act prohibited commercial banks from dealing in equity securities as a way of insulating the core banking business from the risks associated with stocks following the Crash of 1929. But nothing in that act would have prevented investment banks from going into the residential mortgage debt business as they did.

Many observers focused on credit default swaps (CDSs) as the culprit. To be sure, CDSs led to underestimation of risk and thus probably to overinvestment in mortgage-backed securities. But the idea that we should re-regulate the futures markets by prohibiting off-exchange trading—or even return to the good old days when difference contracts (so-called) could be voided as illegal wagers—ignores the significant social benefit of such derivative instruments. Arguably, U.S. farming is as productive as it is because the futures markets have tamed the supply-demand cycle endemic in agriculture. But that is not enough to tame the moralistic objections of those who see such financial engineering as inherently wasteful because it produces nothing. The real wonder is that the zero-sum game of futures trading does in fact create value from nothing (which is not to mention its heartland pedigree). Here too, Justice Holmes played a significant role by recognizing the property rights of futures exchanges to their data in his 1905 Irwin decision.

In short, it is easy to rail at fraud in the unintended (ab)use of financial products, but it can be difficult to tell the whole story. The one thing that seems quite certain is that our attitude toward fraud is schizophrenic, as Balleisen vividly shows. We despise some fraudsters but admire others. And we adopt regulations to protect consumers while also blaming the victim under the doctrine of caveat emptor. I am reminded of the brief but brilliant TV series Max Headroom, in which every person had the right to unlimited consumer credit, but credit fraud was a crime worse than murder.

Advisers and broker-dealers / Balleisen is at his best discussing the curious concept of self-regulation mostly in the context of the rise and fall of the Better Business Bureau. But he also provides a useful history of the Investment Bankers Association, which became the National Association of Securities Dealers and ultimately the Financial Industry Regulatory Authority (FINRA). As Balleisen shows, a self-regulatory organization (SRO) can be an efficient response in a business where the danger of fraud is acute or conflicts of interest are endemic. After all, it takes one to know one. But SROs can shade into restraint of trade or regulatory capture.

Stockbrokers (like real estate brokers) are paid mostly on commission. And commissions tend to be higher on riskier stocks. The result is that brokers are tempted to churn customer accounts and recommend unsuitable stocks. (As Woody Allen said, a broker is someone who invests your money until it’s gone.) On the other hand, FINRA provides arbitration services for aggrieved investors, the results of which turn out to be much more generous than litigating such claims in federal court. Then again, it could be that industry arbitrators are motivated to punish fellow securities professionals who get caught as a way of eliminating some of the competition. Indeed, when the New York Stock Exchange (NYSE) began to lose listings to NASDAQ because the latter permitted listed companies to have shares with differing voting rights, the NYSE prevailed on the Securities and Exchange Commission to mandate a uniform rule despite the potential competitive benefits of exchanges with differing listing standards.

Incidentally, the recent flap about whether some brokers-dealers should be deemed to be fiduciaries is just the latest installment of a controversy that goes back at least to 1933. A broker-dealer may sometimes be a broker and thus an agent for the client. But a broker-dealer may sometimes act as a dealer in a trade—as a principal thereto—when the security is sold from inventory or added thereto. Think of a real estate broker, who owes a duty at least to the owner of the listed property, as opposed to a car dealer, who has a duty to no one. In the securities markets, both modes of trading are legitimate, whether on an exchange (as broker) or over-the-counter (as dealer). Indeed, there are arguments for the superiority of both. But the point is that the role of the broker-dealer is fluid.

On the other hand, investment advisers (who purport to serve the best interest of their clients) are quite clearly fiduciaries, while a broker-dealer may sometimes act as an investment adviser for a customer. That is why broker–customer disputes often turn on whether there was a relationship of trust and confidence between the two—whether the broker-dealer had assumed a fiduciary duty. The European Union is currently in the process of rationalizing these roles with the promulgation of the second installment of the Markets in Financial Instruments Directive, which will create a bright line between the provision of investment advice for a fee and execution services that may no longer be bundled with supposed free advice. Good luck with that.

Notwithstanding the foregoing defense of the status quo, it is not at all clear that individual investors should ever engage in stock-picking and active-trading. It is well documented that it is impossible to beat the market any more often than is consistent with chance. Indeed, since the market is the aggregate of trading, it is difficult to see how things could be otherwise. But whether or not one believes in the efficient market, investment advice and trading are costly and entail the risk of picking the wrong stocks. So the choice is whether to pay 1–2% annually for active investment management, or to invest in an index fund for as little as three basis points and eliminate all of the risk that goes with individual stocks. To be sure, the latter strategy assumes that others will trade and drive market prices to appropriate levels. But studies indicate that only about 10% of all trading at current levels is necessary to do so. Thus, one could say that the retail securities business is a form of licensed fraud. But it is difficult to argue that individuals should not be permitted to day-trade if they want to do so.

If there is a moral to this story—and Balleisen’s book—it is that fraud will always be with us. There is no cure. There is only management. In the end, regulation will always be one step behind.