CH-10 Ethical Decision-Making: Corporate Governance, Accounting, and Finance – Business Ethics: Decision Making for Personal Integrity and Social Responsibility : Chapter Notes

Chapter 10: Ethical Decision-Making: Corporate Governance, Accounting, and Finance Chapter Objectives After reading this chapter, you will be able to: 1. Explain the role of accountants and other professionals as “gatekeepers.” 2. Describe how conflicts of interest can arise for business professionals. 3. Outline the requirements of the Sarbanes-Oxley Act. 4. Describe the COSO framework. 5. Define the “control environment” and the means by which ethics and culture can impact that environment. 6. Discuss the legal obligations of a member of a board of directors. 7. Explain the ethical obligations of a member of a board of directors. 8. Highlight conflicts of interest in financial markets and discuss the ways in which they may be alleviated. 9. Describe conflicts of interest in governance, created by excessive executive compensation. 10. Define insider trading and evaluate its potential for unethical behavior. Opening Decision Point Global Banking On June 27, 2012, as part of a U.S. Department of Justice investigation, Barclays Bank admitted to manipulating and reporting fraudulent interest rates used in international financial markets. Barclays, a multinational financial services and banking firm headquartered in London, was fined more than $450 million (US) by regulators in both the United Kingdom and the United States. Within a week, Marcus Agius, the chairman of the board, Bob Diamond, chief executive officer, and Jerry del Missier, chief operating officer, all resigned. Evidence showed that Barclays had regularly manipulated the LIBOR (London Inter-Bank Offered Rate) interested rate, since at least 2005, in order to both profit from large trades and to falsely portray the bank as financially stronger than it was. The LIBOR is the rate at which major London banks report that they are able to borrow. This rate then serves as the benchmark at which interest rates are set for countless other loans, ranging from credit cards to mortgages and inter-bank loans. It also acts as a measure of market confidence in the bank; if a bank must pay a higher rate than others to borrow, then markets must have less confidence in the institution’s financial strength. The LIBOR is established in a surprisingly simple manner. Each morning at 11 A.M. London time, members of the British Bankers Association (BBA) report to the financial reporting firm of Thomson Reuters, the rates that they would expect to pay for loans from other banks. Discarding the highest and lowest quartiles, Thomson Reuters then calculates a daily average, which becomes the daily LIBOR benchmark. Within an hour, Thomson Reuters publicizes this average worldwide, along with all of the individual rates reported to them. This benchmark is then used to settle short-term interest rates as well as futures and options contracts. By one estimate, the LIBOR is used to set interest rates for global financial transactions worth more than $500 trillion. The individual rates also provide an indirect measure of the financial health of each reporting institution: the lower their rates, the stronger their financial position. Evidence shows that as early as 2007, before the major financial collapse of Lehman Brothers and the economic meltdown that followed, regulators in both the United States and the United Kingdom were aware of allegations that Barclays was underreporting its rates. In the early days of the 2008 financial collapse, The Wall Street Journal published a series of articles that questioned the integrity of LIBOR reporting and suggested that banks were intentionally misreporting rates to strengthen public perception of their financial health. Timothy Geithner, U.S. Secretary of Treasury under President Obama, acknowledge that in 2008 when he was chairman of the New York Federal Reserve Bank, he recommended that British regulators change the process for setting the LIBOR. In testimony to the U.S. Congress in July 2012, Geithner said “We were aware [in 2008] of the risks that the way this was designed created, not just the incentive to underreport, but also the opportunity to underreport.” Internal documents and e-mails, acknowledged by Barclays during the investigation, showed that traders, compliance officers, and senior management were aware of and approved the underreporting. An e-mail sent from a Barclays employee to his supervisor in 2007 said: “My worry is that we are being seen to be contributing patently false rates. We are therefore being dishonest by definition and are at risk of damaging our reputation in the market and with the regulators. Can we discuss urgently please?” Evidence also showed that Barclays’ employees were in regular communication with traders who would explicitly ask that Barclays report specific higher or lower rates in order to benefit their trades. Derivative traders, who would stand to gain or lose millions of dollars, depending on the rate, would communicate directly with their Barclays banking contacts and request certain rates be reported. The tone of their communication demonstrates the familiarity that existed between these parties: “Dude. I owe you big time!...I’m opening a bottle of Bollinger,” wrote one trader to his Barclays contact. “Pls set 3m libor as high as possible today,” wrote another. Yet another, “duuuude…what’s up with ur guys 3.5 3m fix…tell him to get it up!” (Source: http://www.bbc.co.uk/news/business-18671255) Students should consider the following questions when assessing this scenario: • What are the ethical issues involved in this case? • Who are the stakeholders in this case? Who was hurt by rate fixing? • What responsibilities did senior executives at Barclays have to prevent fraud in circumstances that, in Timothy Geithner’s words, created both the incentive and opportunity for fraud? • What sort of internal controls might he Barclays’ Board of Directors have instituted to prevent such fraud? I. Introduction a. The first edition of this textbook was written in 2006, soon after a wave of major corporate scandals had shaken the financial world. i. Recall those companies involved in the ethical scandals during the early years of this century: Enron, WorldCom, Tyco, Adelphia, Cendant, Rite Aid, Sunbeam, Waste Management, Health-South, Global Crossing, Arthur Andersen, Ernst &Young, ImClone, KPMG, J.P.Morgan, Merrill Lynch, Morgan Stanley, Citigroup Salomon Smith Barney, Marsh & McLennan, Credit Suisse First Boston, and even the New York Stock Exchange itself. ii. At the center of these scandals were fundamental questions of corporate governance and responsibility. iii. Significant cases of financial fraud, mismanagement, criminality, and deceit were not only tolerated, but in some cases were endorsed by those people in the highest levels of corporate governance who should have been standing guard against such unethical and illegal behavior. b. Sadly, the very same issues are as much alive today as they were several years ago. i. Consider the rash of problems associated with the financial meltdown in 2007-08 and the problems faced by such companies as AIG, Countrywide, Lehman Brothers, Merrill-Lynch, Bear Stearns and of the financier Bernard Madoff. ii. Once again, we have witnessed financial and ethical malfeasance of historic proportions and the inability of internal and external governance structures to prevent it. c. At the heart of the biggest ethical and business failures of the past decade were aspects of financial and accountings misconduct: i. Misconduct ranged from manipulating special purpose entities to defraud lenders, to cooking the books, to instituting questionable tax dodges, to allowing investment decisions to warp the objectivity of investment research and advice, to Ponzi schemes, to insider trading, to excessive pay for executives, to dicey investments in sub-prime mortgages and hedge funds, to risky credit default swaps. ii. Ethics in the governance and financial arenas has been perhaps the most visible issue in business ethics during the first years of the new millennium. iii. Accounting and investment firms that were once looked upon as the guardians of integrity in financial dealings have now been exposed corrupt violators of the fiduciary responsibilities entrusted to them by their stakeholders. d. Many analysts contend that this corruption is evidence of a complete failure in corporate governance structures. i. As we reflect on the ethical corruption and financial failures of the past decade, some fundamental questions should be asked: 1. What happened to the internal governance structures within these firms that should have prevented these disasters? 2. In particular, why did Boards, auditors, accountants, lawyers, and other professionals fail to fulfill their professional, legal, and ethical duties? 3. Could better governance and oversight have prevented these ethical disgraces? 4. Going forward, can we rely on internal governance controls to provide effective oversight, or are more effective external controls and government regulation needed? ** Teaching Note: To link governance to the discussion of ethics throughout the text, consider asking students how ethics plays a role in governance. How does ethics play a role in these governance arenas? • Shareholder rights • Executive compensation • Mergers and acquisitions • Composition and structure of the board of directors • Auditing and control • Risk management • CEO selection and executive succession plans II. Professional Duties and Conflicts of Interest a. Ethical Responsibilities: i. The watershed event that brought the ethics of finance to prominence at the beginning of the twenty-first century was the collapse of Enron Corporation and its accounting firm Arthur Andersen. ii. The Enron case “has wreaked more havoc on the accounting industry than any other cases in U.S. history,” including the demise of Arthur Andersen. ** Teaching Note: The trailers from the Enron movie never cease to amaze students, even years later: http://www.youtube.com/watch?v=0zMakN-EMLg, yet many instructors still prefer “greed is good” from “Wall Street”: http://www.americanrhetoric.com/MovieSpeeches/moviespeechwallstreet.html. iii. Ethical responsibilities of accountants were not unheard of prior to Enron, but the events that led to Enron’s demise brought into focus the necessity of the independence of auditors and the responsibilities of accountants like never before. b. Accounting is one of several professions that serve very important functions within the economic system itself. i. Even a staunch defender of free market economics such as Milton Friedman believes that markets can function effectively and efficiently only when certain rule-based conditions are met. 1. It is universally recognized that markets must function within the law and they must be free from fraud and deception. 2. The LIBOR rate scandal described in the Opening Decision Point is a case of how fraud can undermine the integrity of an entire financial system. 3. Some argue that only government regulation can ensure that these rules will be followed. 4. Others argue that enforcement of these rules is the responsibility of important internal controls that exist within market-based economic systems. 5. Business and economic markets require business professionals to operate with integrity and fairness. *Chapter Objective 1 Addressed Below* ii. Professions like attorneys, auditors, accountants, and financial analysts can be thought of as “gatekeepers” “or “watchdogs” in the marketplace. 1. Their role is to insure that those who enter into the marketplace are playing by the rules and conforming to the very conditions that ensure the market functions as it is supposed to function. 2. These roles provide a source for rules from which we can determine how professionals ought to act. 3. In entering into a profession, we accept responsibilities based on our roles. iii. These professions can also be understood as intermediaries, acting between the various parties in the market, and they are bound to ethical duties in this role as well. iv. All the participants in the market, especially investors, boards, management, and bankers, rely on these gatekeepers: 1. Auditors verify a company’s financial statements so that investors’ decisions are free from fraud and deception. 2. Analysts evaluate a company’s financial prospects or creditworthiness, so that banks and investors can make informed decisions. 3. Attorneys ensure that decisions and transactions conform to the law. Indeed, even boards of directors can be understood in this way. 4. Boards function as intermediaries between a company’s stockholders and its executives and should guarantee that executives act on behalf of the stockholders’ interests. *Chapter Objective 2 Addressed Below* c. Conflicts of Interest: The most basic ethical issue facing professional gatekeepers and intermediaries in business contexts involves conflicts of interests. i. A conflict of interest exists where a person holds a position of trust that requires that she or he exercises judgment on behalf of others, but where her or his personal interests and/or obligations conflict with those others. 1. Example: A friend knows that you are heading to a flea market and asks if you would keep your eyes open for any beautiful quilts you might see. She asks you to purchase one for her if you see a “great buy.” You are going to the flea market for the purpose of buying your mother a birthday present. You happen to see a beautiful quilt at a fabulous price, the only one at the market. In fact, your mother would adore the quilt. You find yourself in a conflict of interest – your friend trusted you to search the flea market on her behalf. Your personal interests are now in conflict with the duty you agreed to accept on behalf of your friend. ii. Conflicts of interest can also arise when a person’s ethical obligations in her or his professional duties clash with personal interests. 1. Example: A financial planner who accepts kickbacks from a brokerage firm to steer clients into certain investments fails in her or his professional responsibility by putting personal financial interests ahead of client interest. 2. Such professionals are said to have fiduciary duties—a professional and ethical obligation—to their clients, duties that override their own personal interests. Decision Point How to Solve the “Agency Problem” This Decision Point explores what many observers call “a deep problem” at the heart of modern capitalist economies. Modern economies rely on some individuals, called “agents,” who work for the best interests of others, the “principals.” For the system to work, agents must be loyal representatives of their principal’s interests, even in those situations when their own personal interest is at stake. For example, a member of a board of directors acts as an agent for the stockholders, executives act as agents of boards, and attorneys and accountants act as agents for their clients. This agent-principal model assumes that individuals can put their own interests on hold, and be sufficiently motivated to act on behalf of another. But, this would seem to run counter to a view of human nature that is assumed by much of modern economic theory: individuals are self-interested. Thus, the “agency problem.” How can we trust self-interested individuals to act for the well-being of others in cases where their own self-interest must be sacrificed? Many of the ethical failures described in this chapter can be seen as examples of the agency problem. These are precisely those situations where boards have failed to protect the interests of stockholders, executives have failed to serve their boards, accountants, lawyers, and financial analysts have failed to act on behalf of their clients. Economics and management theorists have offered several solutions to the agency problem. Some argue that the best solution is to create incentives that connect the agent’s self-interest with the self-interest of the principal. Linking executive compensation to performance by making bonuses contingent on stock price means that an executive gains only when stockholders gain. Another approach is to create structures and institutions that restrict an agent’s actions. Strict legal constraints would be the most obvious version of this approach. Agents have specific legal duties of loyalty, confidentiality, and obedience and face criminal punishments if they fail to uphold those duties. Professional or corporate codes of conduct and other forms of self-regulation are also versions of this approach. These two most common answers share a fundamental feature; the agency problem can be solved by connecting motivation to act on the principal’s behalf back to the agent’s own self-interest. In the first case, motivation is in the form of the “carrot” and the agent benefits by serving the principal; in the second case, motivation is in the form of the “stick,” and the agent suffers if she fails to serve her principal. A third answer to the agency problem denies that there truly is a problem by denying that self-interest dominates human motivation. This third approach points out that, in fact, humans regularly act from loyalty, trust, and altruism. Human relationships are built on trust and reliability; and these motivations are just as basic, just as common, as self-interest. Thus, this approach would encourage corporations to look to moral character and develop policies and practices that reinforce, shape, and condition people to want to do the right thing. Students should consider the following questions when assessing this scenario: • Can you think of examples in your own experience where someone is required to work as an agent for another, or when you were involved as an agent? How is the agent motivated in this particular case? • If you were asked to design a policy that would provide a solution to the agency problem in the company that you work, where would you begin? • Review the section on virtue ethics in Chapter Three and explain how the agency problem would be viewed from that perspective. • Under what circumstances, or for what kinds of tasks, do you think agency problems are most likely to be a challenge? iii. Many of these professional intermediaries are paid by the businesses over which they keep watch, and perhaps are also employed by yet another business. 1. For example, David Duncan was the principal accounting professional employed by Arthur Andersen, though he was hired by and assigned to work at Enron. 2. As the Arthur Andersen case so clearly demonstrated, this situation can create real conflicts between a professional’s responsibility and his or her financial interests. iv. Certified public accountants (CPAs) have a professional responsibility to the public. But their clients’ financial interests are not always served by full, accurate, and independent disclosure of financial information. 1. CPAs work daily with and are hired by a management team that itself might have interests that conflict with the interests of the firm represented by the board of directors. 2. Real and complex conflicts can exist between professional duties and a professional’s self-interest. *Reference: Figure 10.1 – Conflicts of Interest in Public CPA Activity* v. In one sense, the ethical issues regarding such professional responsibilities are clear. 1. Because professional gatekeeper duties are necessary conditions for economic legitimacy, they should trump other responsibilities an employee might have. 2. Example: David Duncan’s responsibilities as an auditor should have overridden his role as an Andersen employee, in large part because he was hired as an auditor. 3. But, knowing ones duties and fulfilling those duties are two separate issues. Decision Point When Does Financial Support Become a Kickback? This Decision Point asks students to consider the case of what is referred to as “soft money” within the securities industry. According to critics, a common practice in the securities industry amounts to little more than institutionalized kickbacks. “Soft money” payments occur when financial advisors receive payments from a brokerage firm to pay for research and analyst recommendations that, in theory, should be used to benefit the clients of those advisors. Such payments can benefit clients if the advisor uses them to improve the advice offered to the client. Conflicts of interest can arise when the money is used instead or also for the personal benefit of the advisor. In 1998, the Securities and Exchange Commission released a report that showed extensive abuse of soft money, using the payments for office rent, equipment, personal travel and vacations, among other personal expenses. If you learned that your financial advisor received such benefits from a brokerage, could you continue to trust the financial advisor’s integrity or professional judgment? Students should consider the following questions when assessing this scenario: • What facts do you need to know to better judge this situation? • Who are the stakeholders involved and what values are at stake in this situation? Who is harmed when a financial advisor accepts payments from a brokerage? What are the consequences? • For whom does a financial advisor work? To whom does she have a professional duty? What are the sources of these obligations? • Does accepting these soft money payments violate any individual’s rights? What would be the consequence if this practice were allowed and became commonplace? • Can you think of any public policies that might prevent such situations? Is this a matter for legal solutions and punishments Compare this situation with the practice, as described in Chapter 8, of pharmaceutical companies to supply physicians with small gifts and promotional items. In what ways are they similar? Dissimilar? Are physicians gatekeepers? The pharmaceutical industry voluntarily banned such gifts, should the brokerage industry do the same? d. Ethical Implications: Agency responsibilities generate many ethical implications. i. If we recognize that the gatekeeper function is necessary for the very functioning of economic markets, and if we also recognize that self-interest can make it difficult for individuals to fulfill their gatekeeper duties, then society has a responsibility to create institutions and structures that will minimize these conflicts. 1. For example: As long as auditors are paid by the clients on whom they are supposed to report, there will always be an apparent conflict of interest between their duties as auditors and their personal financial interests. ii. This conflict is a good reason to make structural changes in how public accounting operates. 1. Perhaps boards rather than management ought to hire and work with auditors because auditors are more likely reporting on the management activities rather than those of the board. 2. Perhaps public accounting somehow ought to be paid by public fees. 3. Perhaps legal protection or sanctions ought to be created to shield professionals from conflicts of interests. iii. These changes would remove both the apparent as well as the actual conflicts of interest created by the multiple roles—and therefore multiple responsibilities—of these professionals. iv. From the perspective of social ethics, certain structural changes would be an appropriate response to the accounting scandals of recent years. e. Broken Trust: Perhaps the most devastating aspect of the banking industry meltdown of the first decade of this century was the resulting deterioration of trust that the public has in the market and in corporate America. i. Decision-makers in large investment banks and other financial institutions ignored their fiduciary duties to shareholders, employees, and the public in favor of personal gain. 1. This was a direct conflict of interest leading not only to extraordinary personal ruin but also to the demise of some of the largest investment banks in the world. 2. The fact is that major federal legislation enacted after Enron to provide regulatory checks on such behavior failed to prevent it from happening. ii. Despite these government rules, the watchdogs still have little ability to prevent harm. iii. Changes within the accounting industry stemming from the consolidation of major firms and avid “cross-selling” of services such as consulting and auditing within single firms have virtually institutionalized conflicts of interests. f. Answers to these inherent challenges are not easy to identify. i. Imagine an executive is paid based on how much he or she impacts the share price and will be ousted if that impact is not significantly positive. 1. A large boost in share price, even for the short term, serves as an effective defense to hostile takeovers and boosts a firm’s equity leverage for external expansion. 2. In addition, with stock options as a major component of executive compensation structures, a higher share price is an extremely compelling quest to those in leadership roles. ii. That same executive, however, has a fiduciary duty to do what is best for the stakeholders in the long term, an obligation that is often at odds with that executive’s personal interests. iii. These conflicts create a very challenging environment for executive decision-making. Consider the options available in the Decision Point, “But Is Regulation the Answer?” Decision Point But Is Regulation the Answer? This Decision Point asks students to consider Sarbanes-Oxley compliance. The jury is still out on the costs to corporations of Sarbanes-Oxley compliance; but t is a safe guess that the prices is already in the billions of dollars and millions of person-hours. It is arguable that no one doing Sarbanes-Oxley work adds value to any company. They design nothing, make nothing, and sell nothing. They make no improvements to management, marketing, or morale. They meet no demands, satisfy no necessities, and create no opportunities. They simply report. If Sarbanes-Oxley has these challenges, are there alternatives to address wrongdoing in corporate governance? Is Sarbanes-Oxley the best alternative? What other suggestions might you offer? Students should consider the following questions when assessing this scenario: • What else might you need to know to determine how to prevent mismanagement of this type? • What ethical issues are involved? • Who are the stakeholders in financial mismanagement? • Whose rights are protected by Sarbanes-Oxley’s implementation? What are the consequences of Sarbanes-Oxley’s implementation? Is it the fairest option? Is it regulating companies to act in the way a virtuous company would act? • What alternatives have you compiled? • How do the alternatives compare; how do the alternatives affect the stakeholders? III. The Sarbanes-Oxley Act of 2002 a. Government Intervention: The string of corporate scandals since the beginning of the millennium has taken its toll on investor confidence. The more it is clear that deceit, evasiveness and cutting corners go on in the markets and in the corporate environment, the less trustworthy those engaged in financial services become. i. Because reliance on corporate boards to police themselves was not working, Congress passed the Public Accounting Reform and Investor Protection Act of 2002, commonly known as the Sarbanes-Oxley Act, which is enforced by the Securities and Exchange Commission (SEC). 1. The act applies to over 15,000 publicly held companies in the United States and some foreign issuers. 2. In addition, a number of states have enacted legislation similar to Sarbanes-Oxley that apply to private firms and some private for-profits and nonprofits have begun to hold themselves to Sarbanes-Oxley standards even though they are not necessarily subject to its requirements. *Chapter Objective 3 Discussed Below* b. Regulation and Protection: Sarbanes-Oxley strived to respond to the scandals by regulating safeguards against unethical behavior. i. Because one cannot necessarily predict each and every lapse of judgment, no regulatory “fix” is perfect. However, the act is intended to provide protection where oversight did not previously exist. ii. Sarbanes-Oxley seeks to provide oversight in terms of direct lines of accountability and responsibility. iii. The following provisions have the most significant impact on corporate governance and boards: 1. Section 201: Services outside the scope of auditors (prohibits various forms of professional services that are determined to be consulting rather than auditing). 2. Section 301: Public company audit committees (requires independence), mandating majority of independents on any board (and all on audit committee) and total absence of current or prior business relationships. 3. Section 307: Rules of professional responsibility for attorneys (requires lawyers to report concerns of wrongdoing if not addressed). 4. Section 404: Management assessment of internal controls (requires that management file an internal control report with its annual report each year to delineate how management has established and maintained effective internal controls over financial reporting). 5. Section 406: Codes of ethics for senior financial officers (required). 6. Section 407: Disclosure of audit committee financial expert (requires that they actually have an expert). iv. Sarbanes-Oxley includes requirements for certification of the documents by officers. v. When a firm’s executives and auditors are required to literally sign off on these statements, certifying their veracity, fairness, and completeness, they are more likely to personally ensure their truth. c. One of the most significant criticisms of the act is that it imposes extraordinary financial costs on the firms. And the costs are even higher than anticipated. i. A 2005 survey of firms with average revenues of $4 billion conducted by Financial Executives International reports that section 404 compliance averaged $4.36 million, which is 39 percent more than those firms thought it would cost in 2004. ii. The survey also reported that more than half the firms believed that section 404 gives investors and other stakeholders more confidence in their financial reports, making it a valuable asset. iii. The challenge is in the balance of costs and benefits: 1. Some say that section 404 is well intentioned, but the implementation effort can be overkill. 2. In response, one year after its implementation, in May 2005, the Public Company Accounting Oversight Board (PCAOB) released a statement publicly acknowledging the high costs and issuing guidance for implementation “in a manner that captures the benefits of the process without unnecessary and unsustainable costs.” 3. The PCAOB now advocates a more risk-based approach where the focus of internal audit assessments is better aligned with high-risk areas than those with less potential for a material impact. 4. For a comparison of the application of Sarbanes-Oxley in the European Union, see the Reality Check, “Global Consistencies: The European Union 8th Directive.” *Reference: “Reality Check – Global Consistencies: The European Union 8th Directive”* IV. The Internal Control Environment *Chapter Objective 4 Addressed Below* a. Sarbanes-Oxley and the European Union’s 8th Directive are external mechanisms that seek to insure ethical corporate governance, but there are internal mechanisms as well. i. One way to ensure appropriate controls within the organization is to utilize a framework advocated by the Committee of Sponsoring Organizations (COSO). ii. COSO is a voluntary collaboration designed to improve financial reporting through a combination of controls and governance standards called the Internal Control-Integrated Framework. 1. Established in 1985 by five of the major professional accounting and finance associations, originally to study fraudulent financial reporting and later to develop standards for publicly held companies. iii. The elements that comprise the control structure include: 1. Control environment—the tone or culture of a firm: “the control environment sets the tone of an organization, influencing the control consciousness of its people.” 2. Risk assessment—risks that may hinder the achievement of corporate objectives. 3. Control activities—policies and procedures that support the control environment. 4. Information and communications—directed at supporting the control environment through fair and truthful transmission of information. 5. Ongoing monitoring—to provide assessment capabilities and to uncover vulnerabilities. *Chapter Objective 5 Addressed Below* b. Control Environment: Refers to cultural issues such as integrity, ethical values, competence, philosophy, and operating style. Many of these terms were addressed in Chapter 4’s discussion of corporate culture. i. COSO is one of the first efforts to address corporate culture in a quasi-regulatory framework in recognition of its significant impact on the satisfaction of organizational objectives. ii. Control environment can also refer to more concrete elements (that can better be addressed in an audit) such as the division of authority, reporting structures, roles and responsibilities, the presence of a code of conduct, and a reporting structure. c. Shift to Organizational Environment: The COSO standards for internal controls moved audit, compliance, and governance from a numbers orientation to concern for the organizational environment (see Table 10.1 – COSO Definition of Internal Control). i. The discussion of corporate culture in chapter 4 reminds us that both internal factors such as the COSO controls and external factors, such as the Sarbanes-Oxley requirements, must be supported by a culture of accountability. ii. These shifts impact not only executives and boards; internal audit and compliance professionals also are becoming more accountable for financial stewardship, resulting in greater transparency, greater accountability, and a greater emphasis on effort to prevent misconduct. iii. In fact, all the controls one could implement have little value if there is no unified corporate culture to support it or mission to guide it. *Reference: Table 10.1 – COSO Definition of Internal Control* d. Enterprise Risk Management: COSO developed the Enterprise Risk Management - Integrated Framework to serve as a framework for management to evaluate and improve their firms’ prevention, detection, and management of risk. i. This system expands on the prior framework in that it intentionally includes “objective setting” as one of its interrelated components, recognizing that both the culture and the propensity toward risk are determined by the firm’s overarching mission and objectives. ii. Enterprise risk management assists an organization or its governing body in resolving ethical dilemmas based on the firm’s mission, its culture, and its appetite and tolerance for risk. V. Going Beyond the Law: Being an Ethical Board Member a. Accountability: The corporate failures of recent years would seem to suggest a failure on the part of corporate boards, as well as a failure of government to impose high expectations of accountability on boards of directors. i. It is the board’s fiduciary duty to guard the best interests of the firm itself. ii. However, in many cases, boards and executives operated well within the law. 1. For instance: It is legal for boards to vote to permit an exception to a firm’s conflicts of interest policy, as happened in the Enron case. The actions may not necessarily be ethical or in the best interests of stakeholders; but they were legal nonetheless. iii. The law offers some guidance on minimum standards for board member behavior, but is the law enough? *Chapter Objective 6 Addressed Below* b. Legal Duties of Board Members: The law imposes three clear duties on board members, the duties of care, good faith, and loyalty. i. The duty of care involves the exercise of reasonable care by a board member to ensure that the corporate executives with whom she or he works carry out their management responsibilities and comply with the law in the best interests of the corporation. 1. Directors are permitted to rely on information and opinions only if they are prepared or presented by corporate officers, employees, a board committee, or other professionals the director believes to be reliable and competent in the matters presented. 2. Board members are also directed to use their “business judgment as prudent caretakers.” 3. The director is expected to be disinterested and reasonably informed, and to rationally believe that the decisions made are in the firm’s best interest. 4. The bottom line is, the director does not need to be an expert or actually run the company. ii. The duty of good faith is one of obedience, which requires board members to be faithful to the organization’s mission. 1. Board members are not permitted to act in a way that is inconsistent with the central goals of the organization. 2. Their decisions must always be in line with organizational purposes and direction, strive towards corporate objectives, and avoid taking the organization in any other direction. iii. The duty of loyalty requires faithfulness; a board member must give undivided allegiance when making decisions affecting the organization. 1. Conflicts of interest are always to be resolved in favor of the corporation. 2. A board member may never use information obtained through her or his position as a board member for personal gain, but instead must act in the best interests of the organization. c. Board Member Conflicts of Interest: Board member conflicts of interest present issues of significant challenges because of the alignment of their personal interests with those of the corporation. i. Board members usually have some financial interest in the future of the firm, even if it is only through their position and reputation as a board member. 1. If a board member owns stock, then her or his interests may be closely aligned with other stockholders, removing a possible conflict there. 2. However, if the board member does not hold stock, perhaps he or she is best positioned to consider the long-term interests of the firm in lieu of a sometimes enormous windfall that could occur as the result of a board decision. ii. In the end, a healthy board balance is usually sought. d. Ethics and Compliance: i. The Federal Sentencing Guidelines (FSG), promulgated by the U.S. Sentencing Commission and (since a 2005 Supreme Court decision) discretionary in nature, do offer boards some specifics regarding ways to mitigate eventual fines and sentences in carrying out these duties by paying attention to ethics and compliance. ii. The board must work with executives to analyze the incentives for ethical behavior. iii. The board must also be truly knowledgeable about the content and operation of the ethics program. Being “knowledgeable” involves having a clear understanding of the process by which the program evolved, its objectives, its process, and next steps. iv. The FSG also suggest that the board should exercise “reasonable oversight” with respect to the implementation and effectiveness of the ethics/compliance program by ensuring that the program has adequate resources, appropriate level of authority and direct access to the board. v. In order to ensure satisfaction of the FSG and the objectives of the ethics and compliance program, the FSG discuss periodic assessment of risk of criminal conduct and of the program’s effectiveness. vi. In order to assess their success boards should evaluate: 1. Their training and development materials. 2. Their governance structure and position descriptions. 3. Their individual evaluation processes. 4. Their methods for bringing individuals onto the board or removing them 5. All board policies, procedures and processes, including a code of conduct and conflicts policies. *Chapter Objective 7 Discussed Below* e. Beyond the Law, There is Ethics: The law answers only a few questions with regard to boards of directors. i. Certainly Sarbanes-Oxley has strived to answer several more, but a number of issues remain open to board discretionary decision-making. ii. One question we would expect the law to answer, but that instead remains somewhat unclear, is whom the board represents. 1. Who are its primary stakeholders? 2. By law, the board of course has a fiduciary duty to the owners of the corporation—the stockholders. 3. However, many scholars, jurists, and commentators are not comfortable with this limited approach to board responsibility and instead contend that the board is the guardian of the firm’s social responsibility as well. 4. For one perspective on a board’s additional, ethical responsibilities, see the Reality Check, “The Basics.” *Reference: “Reality Check – The Basics”* iii. Some executives may ask whether the board even has the legal right to question the ethics of its executives and others. 1. If a board is aware of a practice that it deems to be unethical but that is completely within the realm of the law, on what basis can the board require the executive to cease the practice? 2. The board can prohibit actions to protect the long-term sustainability of the firm. 3. Unethical acts can negatively impact stakeholders such as consumers or employees, who can, in turn, negatively impact the firm, which could eventually lead to a firm’s demise. 4. It is in fact the board’s fiduciary duty to protect the firm and, by prohibiting unethical acts, it is doing just that. *Reference: “Reality Check – The Concerns of Corporate Directors” iv. Malcom Salter warned that perhaps one of the most important lessons from Enron was that “corporate executives can be convicted in a court of law for a pattern of deception that may or may not be illegal.” 1. Salter also says, “at the end of the day, we are a principles-based society, rather than a rules-based society, even though rules and referees are important.” v. Though our rules and processes offer guidance in terms of corporate decision making from a teleological, utilitarian perspective, if corporate executives breach common principles of decency and respect for human dignity, society will exact a punishment, nonetheless. 1. A board has an obligation to hold its executives to this higher standard of ethics rather than simply following the legal rules. vi. Fortune journalists Ram Charan and Julie Schlosser suggest that board members have additional responsibilities beyond the law to explore and to investigate the organizations that they represent. 1. They suggest that an open conversation is the best method for understanding, not just what board members know, but also what they do not know. 2. They suggest that board members often ignore even the most basic questions such as how the firm actually makes its money and whether customers and clients truly do pay for products and services. 3. Board members should also be critical in their inquiries about corporate vulnerabilities—what could drag the firm down and what could competitors do to help it along that path? Ensuring that information about vulnerabilities is constantly and consistently transmitted to the executives and the board creates effective prevention. 4. Board members need to understand where the company is heading and whether it is realistic that it will get there. vii. It is the board members’ ultimate duty to provide oversight, which is impossible to do without knowing the answers to the preceding questions. **Teaching Note: The U.S. is considered the “bad boy” of governance since Enron, but is Europe any better? Italy has a reputation for poor corporate governance combined with the shameless exploitation of minority shareholders, but much the same can be said of other European countries, including France, the Netherlands and Switzerland. Most European countries have mere codes of practice for corporate governance, rather than legal statutes, and progress towards meeting the standards of the codes has been patchy at best. In Germany, a government-appointed commission published recommendations for the reform of corporate governance in February 2002 (Germany's first governance code ever) but majority is voluntary (though firms that do not comply have to explain to shareholders why). The biggest difference in governance practices among EU members lies in the role of the employee and the strength of shareholders' influence. VI. Conflicts of Interest in Accounting and the Financial Markets *Chapter Objective 8 Addressed Below* a. Conflicts of interest, while common in many situations among both directors and officers also extend beyond the board room and executive suite throughout the financial arena. In fact, trust is an integral issue for all involved in the finance industry. i. What more can an auditor, an accountant, or an analyst offer than her or his integrity and trustworthiness? There is no real, tangible product to sell, nor is there the ability to "try before you buy." 1. Treating clients fairly and building a reputation for fair dealing may be a finance professional's greatest assets. 2. Conflicts—real or perceived—can erode trust, and often exist as a result of varying interests of stakeholders. ii. Public accountants are accountable to their stakeholders and therefore should always serve in the role of independent contractor to the firms they audit. 1. Companies would love to be able to direct what that outside accountant says because people believe the "independent" nature of the audit. 2. However, if accountants were merely rubber stamps for the word of the corporation, they would no longer be believed or considered "independent." iii. Accounting offers us a system of rules and principles that govern the format and content of financial statements. 1. By its very nature, it is a system of principles applied to present the financial position of a business and the results of its operations and cash flows. 2. It is hoped that adherence to these principles will result in fair and accurate reporting of this information. 3. Does an accountant stand guard or instead seek out problematic reporting? The answer to this question may depend on whether the accountant is employed internally by a firm or works as outside counsel. iv. Linking public accounting activities to those conducted by investment banks and securities analysts creates tremendous conflicts between one component’s duty to audit and certify information with the other’s responsibility to provide guidance on future prospects of an investment. 1. Ten of the top investment firms in the country had to pay fines in 2005 for actions that involved conflicts of interest between research and investment banking. 2. Companies that engaged in investment banking pressured their research analysts to give high ratings to companies whose stocks they were issuing, whether those ratings were deserved or not. b. The ethical issues and potential for conflicts surrounding accounting practices go far beyond merely combining services. i. They may include underreporting income, falsifying documents, allowing or taking questionable deductions, illegally evading income taxes, and engaging in fraud. ii. In order to prevent accountants from being put in these types of conflicts, the American Institute of CPAs publishes professional rules. iii. In addition, accounting practices are governed by generally accepted accounting principles (GAAP), established by the Financial Accounting Standards Board that stipulate the methods by which accountants gather and report information. iv. The International Accounting Standards Committee, working with the U.S. SEC, is in the process of creating “convergence” between the International Financial Reporting Standards and the GAAP, with compliance required by 2009. 1. Beyond the prospect of standards simply being translated appropriately and effectively, the standards themselves can be complex, modifying the standards becomes infinitely more complicated, small global firms may realize a greater burden than larger multinationals, and differences in knowledge bases between countries may pose strong barriers. v. Accountants are also governed by the American Institute of Certified Public Accountants’ (AICPA) Code of Professional Conduct. The code relies on the judgment of accounting professionals in carrying out their duties rather than stipulating specific rules. c. Can standards keep pace with readily changing accounting and financing activities in newly emerging firms? In complex cases, it can take regulators, legislature, and courts years to catch up with the changing practices in business. d. Would Regulatory Standards Be Enough? Scholar Kevin Bahr identifies a number of causes for conflicts in the financial markets that may or may not be resolved through simple rule-making: 1. The financial relationship between public accounting firms and their audit clients. 2. Conflicts between services offered by public accounting firms. 3. The lack of independence and expertise of audit committee. 4. Self-regulation of the accounting profession. 5. Lack of shareholder activism. 6. Short-term executive greed versus long-term shareholder wealth. 7. Executive compensation schemes. 8. Compensation schemes for security analyst. e. A Case for Regulation: Scholar Eugene White contends that, in part based on the preceding challenges, markets are relatively ineffective and the only possible answer is additional regulation. i. Bahr argues that there may be means by which to resolve conflicts, such as due notice and separation of research and auditing activities. ii. White maintains that conflicts cannot be eliminated. “Financial firms may hide relevant information and disclosure may reveal too much proprietary information.” iii. There remains no perfect solution; instead the investment community has no choice but to rely in part on the ethical decision making of the agent who acts within the market, constrained to some extent by regulation. iv. Moreover, there is not simply just one solution. 1. Consider how the financial community needed to reply on the honesty of individuals reporting their lending rates for the LIBOR benchmark. 2. It is difficult to imagine an adequate response to this scandal that does not include everything from individual integrity to government regulation, both nationally and internationally. VII. Executive Compensation a. Excessive Compensation: Few areas of corporate governance and finance have received as much public scrutiny in recent years as executive compensation. i. In 1960, the after-tax average pay for corporate chief executive officers (CEO) was 12 times the average pay earned by factory workers. By 1974, that factor had risen to 35 times the average. By 2000, it had risen to a high of 525 times the average pay received by factory workers! In 2005, it had reached an estimated ratio of 411 times a worker’s average pay. 1. These numbers only address the average pay; the differences would be more dramatic if we compared the top salary for CEOs and minimum-wage workers. 2. In 2005, total direct compensation for CEOs rose by 16 percent to reach a median figure of $6.05 million, not including pensions, deferred compensation, and other perks. *Reference: “Reality Check – Average CEO to Average Worker Compensation Ratio” ii. Forbes reported that the CEOs of 800 major corporations received an average 23 percent pay raise in 1997 while the average U.S. worker received around 3 percent. 1. The median total compensation for these 800 CEOs was reported as $2.3 million. 2. Half of this amount was in salary and bonuses, and 10 percent came from such things as life insurance premiums, pension plans and individual retirement accounts, country club memberships, and automobile allowances. Slightly less than half came from stock options. **Teaching Note: Have students conduct research on current executive compensation data and compare to the current average worker’s salary. Discuss some of the reasons for and against executives making so much money. iii. It is relevant to note in Figure 10.2 – “Cumulative Percent Change in Economic Indicators, from 1990 (in 2005 Dollars)” that CEO pay and the S&P 500 Index seem to follow similar trajectories. One might expect something along these lines since “pay for performance” is often based on stock price as one element of measurable performance. iv. Notice that actual corporate profits, not to mention worker pay, have not increased at the same rate as CEO pay. 1. Though CEOs have seen an increase, the corporations themselves—and the workers who contribute to their successes—have not reaped equivalent benefits. 2. This lack of balance in the distribution of value has led to the perception of unfairness with regard to executive compensation, as we will discuss below. v. Example: Compensation packages paid to the top executives of Exxon-Mobil drew harsh public criticism in 2005, amid rising gas prices and soaring profits. *Reference: “Reality Check – AIG’s Bonuses”* b. Ethics of Excessive Executive Compensation Packages: Skyrocketing executive compensation packages raise numerous ethical questions. i. Greed and avarice are the most apt descriptive terms for the moral character of such people from a virtue ethics perspective. ii. Fundamental questions of distributive justice and fairness arise when these salaries are compared to the pay of average workers or to the billions of human beings who live in abject poverty on a global level. Consider Tyco’s Dennis Kozlowski’s justification of his salary in the Reality Check, “How Do Salaries Motivate?” *Reference: “Reality Check – How Do Salaries Motivate?”* *Chapter Objective 9Addressed Below* iii. Serious ethical challenges are raised against these practices even from within the business perspective. 1. Both Fortune and Forbes magazines have been vocal critics of excessive compensation while remaining staunch defenders of corporate interests and the free market. 2. Beyond issues of personal morality and economic fairness, however, excessive executive compensation practices also speak to significant ethical issue of corporate governance and finance. c. In theory, lofty compensation packages are thought to serve corporate interests in two ways. i. They provide an incentive for executive performance (a consequentialist justification), and they serve as rewards for accomplishments (a rights-based justification). ii. In terms of ethical theory, they have a utilitarian function when they act as incentives for executives to produce greater overall results, and they are a matter of ethical principle when they compensate individuals on the basis of what they have earned and deserve. iii. In practice, reasonable doubts exist about both of these rationales. 1. First, there is much less correlation between pay and performance than one would expect. At least in terms of stock performance, executives seem to reap large rewards regardless of business success. 2. It might be argued that in difficult financial times, an executive faces greater challenges and therefore perhaps deserves his salary more than in good times. iv. There are several reasons why excessive compensation may evidence a failure of corporate boards to fulfill their fiduciary duties. 1. First, is the fact that in many cases there is no correlation between executive compensation and corporate performance. 2. Second, there is also little evidence that the types of compensation packages described above are actually needed as incentives for performance. v. The fiduciary duty of boards ought to involve approving high enough salaries to provide adequate incentive, but not more than what is needed. 1. Surely there is a diminishing rate of return on incentives beyond a certain level. 2. Does a $40 million annual salary provide twice the incentive of $20 million, four times the incentive of $10 million, and 40 times the return of a $1 million salary? d. Use of Stocks in Executive Compensation: Another crucial governance issue is the disincentives that compensation packages, and in particular the heavy reliance on stock options, provide. i. When executive compensation is tied to stock price, executives have a strong incentive to focus on short-term stock value rather than long-term corporate interests. ii. One of the fastest ways to increase stock price is through layoffs of employees. 1. This may not always be in the best interests of the firms, and there is something perverse about basing the salary of an executive on how successful they can be in putting people out of work. iii. A good case can be made that stock options have also been partially to blame for the corruption involving managed earnings. 1. Two academic studies concluded that there is a strong link between high levels of executive compensation and the likelihood of misstating or falsely reporting financial results. 2. When huge amounts of compensation depend on quarterly earnings reports, there is a strong incentive to manipulate those reports in order to achieve the money. e. Excessive executive compensation can also involve a variety of conflicts of interest and cronyism. i. The board’s duties should include ensuring that executives are fairly and not excessively paid. ii. They also have a responsibility to evaluate the executive’s performance. 1. Often, the executive being evaluated and paid also serves as chair of the board of directors. 2. The board is often comprised of members hand-selected by the senior executives. 3. In addition, the compensation board members receive is determined by the chief executive officer, creating yet another conflict of interest. VIII. *Reference: Figure 10.3 – Duties of the Board and Senior Executives That May Give Rise to Conflicts of Interest i. One of the larger concerns to have arisen in recent years has been the cross-fertilization of boards. 1. The concern spawned a website called www.theyrule.net, which allows searching for links between any two given companies. 2. For example, PepsiCo board member Robert Allen sits on the Bristol-Myers Squibb board alongside Coca-Cola board member James D. Robinson III. This type of situation lends itself to the appearance of impropriety and gives rise to a question of conflicts. ii. Cronyism or basic occurrences of overlapping board members might occur, of course, simply because particular individuals are in high demand as a result of their expertise. 1. Where the overlap results in a failure of oversight and effective governance the implications can be significant to all stakeholders involved. 2. In one example, three individuals served on the boards of three companies, with each serving as CEO and chairman of one of the companies. Unfortunately, the companies were found to have backdated stock options, and each firm found itself subject to either SEC inquiries or civil legal proceedings. IX. Insider Trading *Chapter Objective 10 Addressed Below* a. No discussion of the ethics of corporate governance and finance would be complete without consideration of the practice of insider trading by board members, executives, and other insiders. i. The issue became front page news in the 1980s when financier Ivan Boesky was sent to prison for the crime of insider trading. ii. It once again gained iconic status when Ken Lay and his colleagues at Enron were accused of insider trading when they allegedly dumped their Enron stock, knowing of the inevitable downturn in the stock’s worth, while encouraging others to hold on to it. iii. More recent cases involving financiers and bankers such as Raj Rajaratnam, the billionaire founder of the hedge fund Galleon Group (discussed below), and Fidelity Investments employee David K. Donovan Jr., who was convicted in 2009 for giving his own mother inside information on which she then traded. b. The definition of insider trading: Trading by shareholders who hold private inside information that would materially impact the value of the stock and that allows them to benefit from buying or selling stock. i. Illegal insider trading also occurs when corporate insiders provide "tips" to family members, friends, or others and those parties buy or sell the company's stock based on that information. ii. “Private information” would include privileged information that has not yet been released to the public. iii. That information is deemed material if it could possibly have a financial impact on a company's short- or long-term performance or if it would be important to a prudent investor in making an investment decision. c. Insider Trading Defined: The Securities and Exchange Commission defines insider information in the following way: ‘Insider trading’ refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include ‘tipping’ such information, securities trading by the person ‘tipped’ and securities trading by those who misappropriate such information. Examples of insider trading cases that have been brought by the Commission are cases against: corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments; friends, business associates, family members, and other ‘tippees’ of such officers, directors, and employees, who traded the securities after receiving such information; employees of law, banking, brokerage and printing firms who were given such information in order to provide services to the corporation whose securities they traded; government employees who learned of such information because of their employment by the government; and other persons who misappropriated, and took advantage of, confidential information from their employers. i. Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the commission has treated the detection and prosecution of insider trading violations as one of its enforcement priorities. ii. If an executive gets rid of a stock he knows is going to greatly decrease in worth because of bad news in the company that no one knows except a few insiders, he takes advantage of those who bought the stock from him without full disclosure. iii. Insider trading may also be based on a claim of unethical misappropriation of proprietary knowledge, that is, knowledge only those in the firm should have, knowledge owned by the firm and not to be used by abusing one’s fiduciary responsibilities to the firm. iv. The law surrounding insider trading creates a responsibility to protect confidential information, proprietary information, and intellectual property. 1. That responsibility also exists based on the fiduciary duty of “insiders” such as executives. 2. Misappropriation of this information undermines the trust necessary to the proper functioning of a firm and is unfair to others who buy the stock. 3. Insider trading is considered patently unfair and unethical since it precludes fair pricing based on equal access to public information. d. Ethical Defense: Trading on inside information is not without its ethical defense. i. If someone has worked very hard to obtain a certain position in a firm and, by virtue of being in that position, the individual is privy to inside information, isn't it just for that person to take advantage of the information since she or he has worked so hard to obtain the position? Is it really wrong? Unethical? 1. Another example: If your brother has always been successful in whatever he does in the business world, is it unethical to purchase stock in the company he just acquired? Others don’t know quite how successful he has been, so are you trading on inside information? Would you tell others? 2. What about officers in one company investing in the stocks of their client companies? No legal rules exist other than traditional SEC rules on insider trading, but is there not something about this that simply feels “wrong?” Decision Point The Know-It-Alls This Decision Point poses the question: Where does a private investor find information relevant to stock purchases? Barring issues of insider trading, do all investors actually have equivalent access to information about companies? Students should consider the following questions when assessing this scenario: • What are the ethical issues involved in access to corporate information? • Where do private investors go to access information about stock purchases? On whose opinion do they rely? Does everyone have access to these same opinions? If not, what determines access to information in an open market? Instead, is there equal opportunity to have access to information? • Who are the stakeholders involved in the issue of access? Who relies on information relevant to stock purchases? • Who has an interest in equal access to information? • What alternatives are available when considering access to information? How can we perhaps best ensure equal access? • How do the alternatives compare, and how do the alternatives affect the stakeholders? e. Access: Some people do seem to have access to more information than others, and their access does not always seem to be fair. i. Example: Consider how Martha Stewart found herself in jail. Stewart was good friends with Sam Waksal, who was the founder and CEO of a company called ImClone. Waksal had developed a promising new cancer drug and had just sold an interest in the drug to Bristol Myers for $2 billion. Unfortunately, though everyone thought the drug would soon be approved, Waksal learned that the Food and Drug Administration had determined that the data was not sufficient to allow the drug to move to the next phase of the process. When this news became public, ImClone’s stock price was going to fall significantly. On learning the news (December 26, 2001), Waksal contacted his daughter and instructed her to sell her shares in ImClone. He then compounded his violations by transferring 79,000 of his shares (worth almost $5 million) to his daughter and asking her to sell those shares, too. Though the SEC would likely uncover these trades, given the decrease in share price, it was not something he seemed to consider at the time. Waskal was eventually sentenced to more than 7 years in prison for his actions. ii. How does Martha Stewart fit into this picture? The public trial revealed that Stewart’s broker ordered a former Merrill Lynch & Co. assistant to tell Martha that Waksal was selling his stock, presumably so that she would also sell her stock. One day after Waksal sold his shares, Stewart sold almost 4,000 shares. iii. Some investors do seem to have access to information not necessarily accessible to all individual investors. iv. A similar, but more far-ranging situation, was revealed in November 2009 when the FBI and U.S. Attorneys announced arrests stemming from a large insider-trading operation at the hedge fund Galleon Group. The Securities and Exchange Commission accused the billionaire Raj Rajaratnam and dozens of others associated with the Galleon Group of insider trading that resulted in more than $33 million in profit. They were accused of trading on secret details of corporate takeovers and quarterly earnings leaked to them by company insiders. v. If others are not in the public eye (like Waskal, Stewart and Rajaratnam), can the SEC truly police all inappropriate transactions? Is there a sufficient deterrent effect to discourage insider trading in our markets today? If not, what else can or should be done? vi. Or, is this simply the nature of markets, and those who have found access to information should use it to the best of their abilities? What might be the consequences of this latter, perhaps more Darwinian, approach to insider trading, and whose rights might be violated if we allow it? vii. Consider whether we might have learned anything from the experiences of the past decade, and how we might proceed most effectively, as you review the Decision Point, “The Winds of Change.” Decision Point The Winds of Change This Decision Point addresses the implications for change resulting from the Enron debacle. Dr. Lisa Newton analyzes the possible responses that we could utilize as a society. Contemplate her arguments that some responses will not work and consider whether you agree or disagree: • More regulation: “The people who are making the money eat regulations for breakfast. You can’t pass regulations fast enough to get in their way.” Regulations are bad for business, she states; they do not have sufficient foresight; and virtual and global business leaves us with little to grasp in terms of regulation. • Business ethics courses: Newton contends that they are ineffective in guiding future action, and they do not sufficiently impact motivations. • Changes in corporate cultures: “What the company’s officers do, when they act for good or (more likely) evil, does not proceed from the corporate culture, as if the corporate culture caused their actions…What people do, habitually, just is their character, which they create by doing those things. What a corporation does, through its officers, just is its culture, created by that behavior. To say that if we change the culture we’ll change the behavior is a conceptual mistake – trivial or meaningless.” Does anything work? “Back to those other eras; this is not the first time that, up to our waists in the muck of corporate dishonesty, we have contemplated regulations and ethics classes and using large rough weapons on the corporate culture. And nothing we did in the past worked.” Instead, Newton posits, “capitalism was always known not to contain its own limits; the limits were to be imposed by the democratic system, whose representatives were the popularly elected watchdogs of the economy.” Business crime comes not from “systemic capitalist contradictions” or sin; instead it …arises from a failure of the instruments of democracy, which have been weakened by three decades of market fundamentalism, privatization ideology and resentment of government. Capitalism is not too strong; democracy is too weak. We have not grown too hubristic as producers and consumers [as if the market were, when working right, capable of governing itself]; we have grown too timid as citizens, acquiescing to deregulation and privatization (airlines, accounting firms, banks, media conglomerates, you name it) and a growing tyranny of money over politics. Newton then explains that “we need, as Theodore Roosevelt well knew (20 years before his cousin presided over the aftermath of the 1929 disaster), democratic oversight of the market, or it will run amok. As it has.” Her conclusion? “Ultimately, our whining and hand-wringing about corporate culture, or executive incentives, or other technicalities of the way businesses run themselves, is useless. Business was never supposed to run itself, at least not for long. We the people were supposed to be taking responsibility for its operations as a whole. We have evaded this responsibility for almost a quarter of a century now, and that’s long enough. It is time to remember that we have a public responsibility hat as well as a private enterprise hat, to put it on and put the country back in order.” Is taking public responsibility the answer to ethical lapses in business? Students should consider the following questions when assessing this scenario: • What else might you need to know in order to effectively evaluate Professor Newton’s conclusion? • What ethical issues are involved in the challenges she addresses? • Who are the stakeholders? • What do you think about her evaluation of the alternatives above? • How do the alternatives compare? How do the alternatives affect the stakeholders? Opening Decision Point Revisited Global Banking Fraud: Individuals or Institutions? Investigations into the LIBOR scandal showed widespread intentional fraud among many individual employees and executives at Barclays. But from the earliest days of the scandal, allegations were being made that other banks were equally involved. While admitting guilt, Barclays denied that it was the only bank involved in misreporting data. In a recorded interview, one Barclays employee told investigators that: “We did stick our head above the parapet last year, got it shot off, and put it back down again. So, to the extent that, um, the Libors have been understated, are we guilty of being part of the pack? You could say we are…Um, so I would, I would sort of express us maybe as not clean-clean, but clean in principle.” In a conversation between a senior executive at Barclays and a representative of the British banking administration, which was reported by the U.S. investigation, the Barclays employee defended the bank, saying, “We’re clean, but we’re dirty-clean, rather than clean-clean.” The BBA representative responded: “No one’s clean-clean.” By the end of August 2012, the investigation had spread to include allegations of fraudulent LIBOR reporting by HSBC and Royal Bank of Scotland, the two other largest banks in the United Kingdom, as well as more than a dozen other international banks. The scandal even spread to the British government. Barclays’ CEO Bob Diamond testified that at the height of the financial collapse in fall 2008, he received a call from Paul Tucker, deputy governor of the Bank of England. According to Diamond, Tucker called on behalf of “senior Whitehall” figures and put pressure on Mr. Diamond to lower his reported LIBOR rates. The allegation is that the higher rates would undermine confidence in Barclays at a time that financial markets needed boosting, and it increased the likelihood that the British government would need to bail out Barclays as it already had done for other failing banks. Mr. Tucker claims that he was misunderstood by Mr. Diamond. • If the LIBOR scandal is as widespread as ongoing investigations suggest, are there ethical issues involved in this case that are different than those involved if only Barclays is guilty? What are they? • Who is responsible for the ethical integrity of such institutional practices as the LIBOR? Is anyone at fault for this fraud other than the individuals involved in reporting the false information? Instructor Manual for Business Ethics: Decision Making for Personal Integrity and Social Responsibility Laura P. Hartman, Joseph R. Desjardins, Chris MacDonald 9780078029455, 9781259060588, 9781259417856