CH-5 Corporate Ethical Governance and Accountability – Business and Professional Ethics for Directors, Executives and Accountants : Book Guide

Chapter 5 – Corporate Ethical Governance and Accountability Chapter Questions and Case Solutions Chapter Questions 1. What is the role of a board of directors from an ethical governance standpoint? The board is responsible for the actions of the corporation, both with regard to the achievement of the corporation’s strategic objectives to enhance shareholder value and maintain the support of the company’s stakeholders to achieve those objectives. This means that the board must build into the company’s governance framework such objectives as growth, profitability in the short- and long-run, compliance with laws, and respect for the rights of the primary stakeholders. The board must set or approve policies that will achieve these objectives, hire executives and monitor their performance in accord with those objectives, and make corrections where required. The directors must oversee the governance system, monitor it and take responsibility for it as the agents of the shareholders. 2. Explain why corporations are legally responsible to shareholders but are strategically responsible to other stakeholders as well. Corporations are created under the laws of a particular jurisdiction (Country, state, province …) and the directors, as agents of the shareholders’, must account to those shareholders and must follow the laws of the jurisdiction in which they are incorporated as well as where they operate. In addition, according to stakeholder theory, corporations need the support of their stakeholders to reach their strategic objectives on a continuing and sustainable basis. This support can best be obtained it the corporation take into account the interests of stakeholders when building and implementing its strategy. Consequently, corporations are legally responsible to shareholders and strategically responsible to a broader set of stakeholders. 3. What should an employee consider when considering whether to give or receive a gift? An employee should be aware that giving or receiving a gift may raise conflicts of interest (COI), and should understand the COI discussion in this chapter, including the material to be considered specifically that is in Table 5.6. 4. When should an employee satisfy his or her self-interest rather than the interest of his or her employer? An employee’s self-interest, should be satisfied first, if satisfying the employer would be unlawful or harm society, or harm the employee or other employees or other people physically or mentally, or in the case of a professional would offend the professional’s code of conduct. Use of an ethical decision making approach such as those discussed in Chapter 5 could be helpful. 5. How can a company control and manage conflicts of interest? See the discussion on pages 253-256 of the text. Employees must be constantly made aware of potential COI and their consequences through training and reinforcement. There must be a mechanism provided for clarification and guidance including codes and counsellors. Monitoring and sanctions are essential. Table 5.5 provides a list of helpful management techniques and issues to consider. Table 6.13 provides safeguards that are available in the accounting firms and profession, which may be of some use in corporations to manage the risk of COI problems. 6. What is the role of an ethical culture and who is responsible for it? An ethical culture provides continual guidance to executives and other employees with regard to appropriate patterns of behavior, standards of conduct, and how decision are to be made. It is a vital part of the dissemination of company policies and of the internal control compliance mechanism required by SOX of directors, the CEO and CFO. External auditors have long relied upon an organization’s internal controls for assurance that transactions, records and reports are handled properly. Without an effective ethical corporate culture, directors, executives and auditors are very much at risk. A corporation needs an ethical corporate culture to guide employees to do what the directors and senior officers have decided to be appropriate behavior. Codes of conduct are not always read or understood well or comprehensive, so employees usually consider and emulate what they believe to be appropriate norms or actions from informally observing their bosses and colleagues. An ethical culture is one where those informal observations are intentionally integrated with formal ethics program objectives and guidance. The informal signals given by senior executives are so important to good ethical governance that directors are now expected to continually assess the ethicality of the “tone at the top”, and to hire/fire/encourage good role models. Consequently, the corporation’s directors are ultimately responsible for the ethical culture, and in turn so are the senior executives, as are auditors to some extent (for not finding obvious flaws). In turn, executives and managers at lower levels are expected to be supportive. A corporate ethics officer or advisor can be quite helpful. 7. What is the most important contribution of a corporate code of conduct? Guidance to ensure minimum standards of behavior and protect the reputation of the person, profession or organization, so that no one can later say: "No one ever told me...", or "I though that's what top management wanted.” 8. Are one or more of the fundamental principles found in codes of conduct more important than the rest? Why? I would argue that all of the ethical principles named at the start of Table 5.16 – honesty, fairness, compassion, integrity, predictability and responsibility – are very important and each is essential in specific situations. However, integrity is perhaps the over-reaching principle. 9. Why should codes focus on principles rather than specific detailed rules? Principles are susceptible to interpretation to give guidance on complex or newly emerging issues. They are far easier to remember and therefore understand and use than an exhaustive, detailed listing of rules. Few people would read, or could remember what they have read of such a list. 10. How could you monitor compliance with a code of conduct in a corporation? The internal auditor should be charged with testing to see if employees have complied with the code. Tests could involve surveys, annual sign-offs, interviews, whistle-blower comments, review of HR complaints and lawsuits, and reporting of disciplinary actions. The annual sign-off process can be broadened to include a statement that each employee has done nothing to contravene the code in letter and in spirit, nor do they know of anything they haven't reported that anyone else has done. An annual report should be made to the Audit Committee in addition to more frequent communication if required. 11. How can a corporation integrate ethical behavior into their reward and remuneration schemes? Rewards could be offered for outstanding performance, such as for assistance in revealing fraud. The recognition could take the form of paper medals (certificates for the office /factory wall), publicity of good deeds, cash payment on a percentage of recovery/cost avoidance basis, or an increment of base salary. Sanctions should be applied for wrongdoing, including disciplinary interviews, reduction of raises, fines, dismissal etc. MBO-type goals may be employed to provide the appropriate basis for positive recognition. 12. Other than a code of conduct, what aspects of a corporate culture are most important and why? See the discussion beginning on page 257 of the text. Tables 5.8 and 5.9 are specifically instructive, as are Tables 5.10, 5.11, and 5.12. 13. Is the SOX-driven effort being made to check on the effectiveness of internal control systems worth the cost? Why, and why not? The SOX governance reforms, and the ensuing SEC internal control certification by the CEO and CFO, and audit thereof, have triggered costly Section 404 reviews of internal control and subsequent improvements that were overdue in many cases. Without sound internal control systems, accurate financial statements are very unlikely. Lynn Turner, former Chief Accountant at the SEC, has indicated that the aggregate cost of all the Section 404 reviews by SEC registrant companies is well below the amount lost by Enron’s investors, and that is only one such bankruptcy. It is also clear that many companies have good systems of internal control and do not need the motivation and cost of Section 404 compliance. Their costs, however, should be less than for the offending firms. See also the answer to question 14. 14. Why should an effective whistle-blower mechanism be considered a “failsafe mechanism” in SOX Section 404 compliance programs? No matter how good a company’s internal controls are, frauds will still occur because systems cannot prevent and/or catch everything – they can only lower the risk of wrongdoing. It is likely; however, that someone has seen or become concerned about an individual’s behavior or a transaction. If that person can be induced to become a whistle-blower, then the whistle-blowing mechanism could be considered a “fail-safe” mechanism or add-on to normal internal controls and/or Section 404 compliance programs. 15. If you were asked to evaluate the quality of an organization’s ethical leadership, what would the five most important aspects be that you would wish to evaluate, and how would you do so? Since their purpose is to influence ethical behavior, ethical leaders cannot cultivate the necessary respect unless they represent an ethical role model to be emulated. This requires consideration of a leader’s personality characteristics, motivation, interpersonal style, moral judgment and moral utilization level. These 5 personality characteristics can have a direct impact on effective ethical leadership: • Agreeableness • Openness • Extraversion • Conscientiousness • Neuroticism 16. Why is it suspected that corporate psychopaths gravitate to certain industries, and what should corporations within those industries do about it? [Note that answering this question will require students to search ahead to Chapter 8, to the reference in the text. However, it is not located at page 553, but at page 570.] Corporate psychopaths are defined as those who engage in a single-minded pursuit of their own self-enrichment and self-aggrandisement to the exclusion of all other considerations. They lack a conscience, have few emotions, and seem to have no feelings, sympathy or empathy for other people; they ruthlessly manipulate others to further their own aims. Though they may look smooth, charming, sophisticated and successful, they will be almost wholly destructive to the organization they work for. The only way to guard against the destructive behavior of such people if they remain in the organization is to strictly monitor them. The administration should carefully consider whether to keep on the payroll someone who is now suspected as a corporate psychopath. 17. Descriptive commentary about corporate social performance is sometimes included in annual reports. Is this indicative of good performance, or is it just window dressing? How can the credibility of such commentary be enhanced? Sometimes CSP reporting indicates good performance, while at other times it is window dressing. The credibility of such disclosure can be enhanced by: • the inclusion of negative performance or results • review and attestation by an independent reviewer/auditor/committee • comparison with benchmarks now available for similar companies • comparison with ethically screened companies or inclusion in ethically screened investor databases – Domini, EthicScan or FSTE4Good Indices or lists. 18. Should professional accountants push for the development of a comprehensive framework for the reporting of corporate social performance? Why? Yes, such a framework will assist in making directors and executives aware of what they should and can do to develop and ethical culture, manage risks and ensure a sound system of internal control. All of these will assist greatly in maintaining trust, credibility, and accurate reporting of ethical transactions that external auditors must certify. Professional accountants working within corporations will find that their professional responsibilities will be much easier to discharge if they are working in an ethical culture. 19. Do professional accountants have the expertise to audit corporate social performance reports? They have an understanding of audit and reporting principles. However, they usually lack specific knowledge of the accountability frameworks and key indicators involved. These can be learned as readily as for any other management control system. From time to time, expert engineers or environmentalists may need to consult with professional accountants to ensure that such frameworks and indicators are appropriate. Students will increasingly be aware of the developments that are taking place worldwide in regard to such reporting. For an up-to-date picture of developments, see the references in Table 5.21 and on my website, and refer to the discussion of CSR reporting and audit in Chapter 7. Case Solutions CASES ON ETHICAL CORPORATE CULTURE & BRIBERY 1. Wal-Mart Bribery in Mexico – located in Chapter 2 2. SNC-Lavalin Missing Funds Topples CEO & Triggers Investigation (online) What this case has to offer This case describes the fallout for the officers, board and company that used bribery and support to obtain contracts in a country with a repressive regime. It is a cautionary tale. Teaching suggestions Ask students whether they have ever started a business, and ask them did they do so with the expectation that their contracts would be enforced. Did they expect that ownership of company property would be respected and protected by the courts? Ask if they would consider doing business in a country with a dictator at its helm where these things cannot be taken for granted. So many of the foundation and infrastructure that business relies on, taken for granted in the U.S., may be missing in a country with an oppressive regime. In addition, one must wonder how the company expected to operate in such an environment. Surely they knew that bribes would be sought. Discussion of ethical issues 1. From a governance perspective, what can the Board of Directors do to make sure that the company’s policies and procedures are adequate to ensure ethical and legal conduct by its employees? In this situation, it appears that the company policies and controls were not adequate to alert the administration to the bribes, since there was no requirement to report the conduct to anyone in authority. The firm had policies and procedures which prohibited bribes, and a Code of Ethics and Business Conduct, as well as an Agent Code, all of which prohibited bribes, but did not stop them. The Board can require reporting of unethical conduct, and also require periodic review by executives of the rules and codes of conduct to make it clear what the company policies prohibit. 2. Mr. Aissa and Mr. Duhaime were not demonstrating strong ethical leadership. What can a firm do to improve its ethical tone at the top? Closer monitoring of executives, repeated training in ethics, and reminders of company policies all may help improve the company’s ethical tone at the top, but when executives are discovered to have behaved in this way, they must be removed. For some, no amount of training will help. 3. Is it appropriate for a company to do business in a country with an oppressive regime? Why and why not? When expanding, most businesses look for a country with stable government and economic system, at a very minimum. Business needs certainty in contracting, needs to make sure laws are enforced, and that ownership of business property will be observed. This would certainly not be the case in a country with an oppressive regime. There would be no guarantees that laws would be enforced in that country, unless it pleased the regime to do so. In fact, it is hard to imagine a business opportunity that would be worth the risk in such a place. 4. If the decision is made to do business in a country with an oppressive regime, what limitations should be put in place by the company to guide its employees against unethical involvement? As mentioned above, it would have to be an incredible opportunity for the business to overcome the uncertainty of doing business successfully in that country. It would also require the appointment of executives for that venture whose knowledge of and adherence to ethical conduct is above reproach. 3. Siemens’ Bribery Scandal What this case has to offer This case focuses on the ethical governance implications of bribery to obtain or maintain business opportunities. Several recent worldwide initiatives have recently been mounted to change the rampant regime of bribery that has existed for centuries. In 1998, 34 countries signed the Organization for Economic Cooperation and Development's "Convention on Combating Bribery of Foreign Public Officials in International Business Transactions," requiring the signing countries to implement laws like the U.S. Foreign Corrupt Practices Act prohibiting bribery of foreign officials to gain a business advantage. In 2004, more than 140 countries signed the UN's "Convention against Corruption," requiring member states to return assets obtained through corruption to the country from which they were obtained. In the U.S., the Foreign Corrupt Practices Act (FCPA) enacted in 1977 prohibits directors, officers, employees and agents of U.S. companies, as well as foreign companies with securities registered with the SEC, from making payments to foreign officials to obtain or retain business. Teaching suggestions It would be useful to explore bribery with the class, particularly the forms it can take and the history noted above. The discussion can move on to the governance issues behind the questions posed at the end of the case. There are several interesting questions related to bribery that help to start the discussion, for example: • What is the purpose of a bribe? • What forms can a bribe take? • What is the difference between a bribe and other types of discretionary payments made to facilitate business in a given country? • How can a company’s internal control system detect bribes? • What should a company do when an employee is discovered bribing other company’s employee or a government official; and • How can a company react in a timely fashion to changes in stakeholders’ expectations about what are acceptable or ethical business practices. Discussion of ethical issues 1. The senior executives at Siemens’ spent most of their working environment that condoned bribery outside Germany but not inside. However, they failed to take notice of the changes that Transparency International –championed by a German who was embarrassed by the double standard of his countrymen –was proposing, and that ultimately resulted in a new worldwide anti-bribery regime. Why did they ignore the change? There are several potential reasons why Siemens’ executives ignored the changes in public expectations about bribery: • Wrong-headed incentives, pushing executives to obtain more contracts but disregarding or even encouraging unethical methods required to win contract bids; • Lack of financial reporting transparency, including secret discretionary spending accounts or unidentified transactions without proper authorization; • Lack of recognition of anti-bribery environmental changes; • Considering bribery ethical just because it was not illegal at the time, or because everyone was doing it; • Lack of ethical corporate values against bribery; • Weak governance/control environment, no sanctions, no encouragement for ethical behavior and deficient ethics programs. 2. If you were Löscher, the new CEO, how would you show the employees and external stakeholders that you actually have a zero tolerance policy concerning corruption? The new CEO could make a public statement regarding the company’s views on bribery and should establish policies and procedures aiming to prevent and detect this practice. There are a number of possible controls that may help to detect and prevent bribery, for example: • Board members and senior executives should verify that the company has an effective anti-bribery program that includes identification and training of employees and agents who interact with foreign officials; • The company should have a reporting mechanism for violations, with sanctions, and an effective whistle-blower program; • Management could require an ethics audit of contract bids by the company’s internal auditors; and, • The company should keep strict control of discretionary spending accounts. Useful Videos, Films & Links Schubert, Siri & Christian Miller (2009) “At Siemens, Bribery Was Just a Line Item” Frontline, Feb. 13thhttp://www.pbs.org/frontlineworld/stories/bribe/2009/02/at-siemens-bribery-was-just-a-line-item.html Nicholson, Chris (2009) “Siemens to Collect Damages From Former Chiefs in Bribery Scandal” New York Times, Dec. 2ndhttp://www.nytimes.com/2009/12/03/business/global/03siemens.html Jameson, Angela (2007) “Siemens bribes reached around world” The Sunday Times, Nov. 16th http://business.timesonline.co.uk/tol/business/industry_sectors/engineering/article2881841.ece 4. Rio Tinto’s Bribes in China What this case has to offer Bribery cases often involve a company making illegal payments to government officials in order to land lucrative contracts. Sometimes, however, bribery can be between two or more companies, as it was the case involving Rio Tinto, the Anglo-Australian mineral company, and several Chinese steel companies. Rio Tinto executives received bribes from Chinese steel manufacturers in exchange from giving these steel manufacturers preferential business treatment. Moreover, the same Rio Tinto executives bribed Chinese officials to receive confidential information that led their company to increase the price of iron ore sold to Chinese steelmakers. Teaching suggestions There are several questions related to bribery between companies that may help to start the class discussion, for example: is a bribe between companies the same as a bribe given to a government official, would a bribe given to other company just be “part of doing business, and how is a bribe different from a gift. Finally, it is useful to discuss the importance and benefits of a strong ethical culture to deter unethical behavior. Discussion of ethical issues 1. The culture of giving and receiving payments is ingrained in China. On the other hand accepting and paying bribes is a violation of Rio Tinto’s code of conduct. When does a payment stop being a gift and turn into a bribe? It is sometimes difficult to determine whether a gift is really a bribe. The following questions should help to separate gifts from bribes. 1. Is it nominal or substantial? 2. What is the intended purpose? 3. What are the circumstances? 4. Is the person who receives the payment in a position of sensitivity? 5. What is the accepted practice? 6. What is the firm/company policy? 7. Is it legal? Several of these questions address the issue of whether or not a gift has an intention to “unduly influence” or “obligate” the recipient to reciprocate by giving preferential treatment to the giver. Similarly, Rio Tinto’s Code of Conduct, a document named “The Way We Work”, states that: “There are several questions that we should ask ourselves when confronted with a business decision: • Is it legal? • Are my actions consistent with The Way We Work and associated Rio Tinto policies and standards? • Will there be any direct or indirect negative consequences for Rio Tinto? • What would my family, friends or neighbours think of my actions? • Would I prefer to keep this secret? • Would I want my actions reported on the front page of the newspaper? If you do not feel comfortable with any of the answers, then the best response is not to do it.” Moreover, the company’s Code of Conduct explicitly prohibits bribery: “Rio Tinto prohibits bribery and corruption in all forms, whether direct or indirect. We do not offer, promise, give, demand or accept any undue advantage, whether directly or indirectly, to or from: • a public official; • a political candidate, party or party official; • a community leader or other person in a position of public trust; or • any private sector employee (including a person who directs or works for a private sector enterprise in any capacity.” Finally, the company’s policy on gifts and entertainment is: “Gifts and entertainment given and received as a reward or encouragement for preferential treatment are not allowed. In certain circumstances, the giving and receiving of modest gifts and entertainment is perfectly acceptable. A business meal, for example, can provide a relaxed way of exchanging information. Nonetheless, depending on their size, frequency, and the circumstances in which they are given, they may constitute bribes, political payments or undue influence. The key test we must apply is whether gifts or entertainment could be intended, or even be reasonably interpreted, as a reward or encouragement for a favour or preferential treatment. If the answer is yes, they are prohibited under Rio Tinto policy. Exchanges of gifts and entertainment, including the payment of travel expenses, must be in accordance with Rio Tinto’s Business integrity standard.” 2. The smaller Chinese steel companies bribed the Rio Tinto executives because of Rio Tinto’s policy of only dealing with large state-run steel companies. Can a business policy, such as giving priority to only one set of firms, be unethical? Is Rio Tinto ethically responsible for the bribes that were given to its employees because of its policy? A business policy to give preferential treatment to some clients is not necessarily unethical. Nevertheless, the company should think about whether the policy encourages its employees to behave ethically or to behave unethically. Rio Tinto is responsible not only for having a policy on bribing and a code of conduct, but also for having a comprehensive internal control system. As stated in the OECD recommendations for internal controls, ethics and compliance with anti-bribery regulations: “Effective internal controls, ethics, and compliance programmes or measures for preventing and detecting foreign bribery should be developed on the basis of a risk assessment addressing the individual circumstances of a company, in particular the foreign bribery risks facing the company (such as its geographical and industrial sector of operation). Such circumstances and risks should be regularly monitored, re-assessed, and adapted as necessary to ensure the continued effectiveness of the company’s internal controls, ethics, and compliance programme or measures.” The company has to be aware that China’s two-tiered system for purchasing iron ore may encourage corruption. While big steel mills are allowed to negotiate long-term fixed price contracts, most small and medium-size steel mills are supposed to buy from the spot market, the more volatile open market. The system creates arbitrage opportunities, allowing big steel mills with fixed contracts to buy far more supplies than they need and then profitably sell excess supplies to smaller mills on the black market. 3. Why were these bribes prosecuted? It is not entirely clear why these bribes were prosecuted. Several Australian officials criticized the detention of the Rio Tinto employees and suggested that Beijing was retaliating against Rio Tinto for calling off a $19.5 billion deal that would have given a Chinese state-owned company, called Chinalco, a large stake in the mining giant. On the other side, the Chinese government argued it was an isolated case of espionage that seriously harmed the country’s economic security and interests. 4. What lessons should be taken from these convictions: a. For foreign governments? Foreign governments should warn their companies and citizens of the business conditions in China, encourage them to behave ethically, and to strengthen their internal controls when dealing with Chinese companies. b. For corporations trading in and with China? Companies trading in and with China should be careful and strengthen their internal controls. Moreover, these companies have to be aware that businesses operate in China under strict control of the government and that political events may influence the way business have to be conducted there. The Rio Tinto case happened shortly after Google decided to pull its search engine out of China. Both cases highlight several issues that foreign companies have to consider when doing business in China. In addition, companies have to be aware that it might be hard to fight against the Chinese government in court. Rio Tinto’s employees were prosecuted largely in closed-door proceedings. The trials appeared to favor the prosecution and deny the defendants due process. c. For individual employees? Employees should be aware that even when they appear to be acting in the best interest of their companies, they may be acting unethically and illegally. If they obtain business opportunities through bribes, then they can face the direct consequences of their actions, without the support of their companies. Initially, Rio Tinto stated that the allegations of bribery of officials at Chinese steel mills were wholly without foundation; however, later on the company blamed the employees and denied any corporate responsibility for the bribes. d. For possible investors in China? Investors in China have to be aware of the potential ethical and reputational issues involved in doing business there. These include: dealing with state-controlled entities, corruption, limited civil rights, etc. 5. Should Rio Tinto have been charged? The bribes were given over a number of years from 2003 to 2009. It is hard to believe that the bribes, and particularly the ones paid by Rio Tinto employees, were totally unknown to the company. Although this case might serve as a warning for the company, it seems that the company should also have been punished in this case. Moreover, the company failed to have adequate internal controls to prevent the bribes. References Good Practice Guidance on Internal Controls, Ethics, and Compliance. OECD. 2010. http://www.oecd.org/dataoecd/5/51/44884389.pdf The way we work. Our global code of business conduct. Rio Tinto. 2009. http://www.riotinto.com/documents/The_way_we_work.pdf 5. Daimler Settles U.S. Bribery Case for $185 Million What this case has to offer This is a good case to discuss the implications from bribery, the need for an ethical culture within a company, the role of whistleblowers in raising red flags about bribery, and the prospect of bribery charges arising from U.S. and U.K. legislation even though the bribery occurred in other jurisdictions. A company employee, David Bazzetta learned in July 2001 at a corporate audit executive committee meeting in Stuttgart Germany, that DaimlerChrysler had secret bank accounts to bribe foreign government officials. As a result, he filed a whistleblower complaint under the U.S. Foreign Corrupt Practices Act (FCPA) that ultimately led to a multi-year investigation of surprising scope and U.S. charges against a company headquartered in Germany, for bribes made to foreign officials around the world. Teaching suggestions I start this case asking students how a bribe can be detected by a company or by the government. Arguably, detecting bribes could be difficult in a large company such as DaimlerChrysler, with worldwide operations, a large number of bank accounts and a complex financial reporting system. In these circumstances, the best possible control is a strong ethics program, discouraging employees to act unethically and giving whistleblowers the means to report these actions within the company. Moreover, the U.S. government incentives to report bribes within the FCPA constitute a strong incentive to report bribery activity outside the U.S. This case also represents a good example of a change in perceptions about bribery, and in the real legal consequences that now can flow from it. This case can foster the discussion about the measures that a company should take to timely react to changes in stakeholders’ expectations about acceptable or ethical business practices. Discussion of ethical issues 1. Apparently Daimler executives were not concerned enough with personal sanctions to change the company’s bribery practices to comply with German and U.S. statutes. How can these attitudes be changed? Daimler executives have to be made aware of the potential consequences of giving a bribe. The U.S. FCPA includes the following sanctions for bribing a foreign official: “CRIMINAL The following criminal penalties may be imposed for violations of the FCPA's anti-bribery provisions: corporations and other business entities are subject to a fine of up to $2,000,000; officers, directors, stockholders, employees, and agents are subject to a fine of up to $100,000 and imprisonment for up to five years. Moreover, under the Alternative Fines Act, these fines may be actually quite higher -- the actual fine may be up to twice the benefit that the defendant sought to obtain by making the corrupt payment. You should also be aware that fines imposed on individuals may not be paid by their employer or principal. CIVIL The Attorney General or the SEC, as appropriate, may bring a civil action for a fine of up to $10,000 against any firm as well as any officer, director, employee, or agent of a firm, or stockholder acting on behalf of the firm, who violates the anti-bribery provisions. In addition, in an SEC enforcement action, the court may impose an additional fine not to exceed the greater of (i) the gross amount of the pecuniary gain to the defendant as a result of the violation, or (ii) a specified dollar limitation. The specified dollar limitations are based on the egregiousness of the violation, ranging from $5,000 to $100,000 for a natural person and $50,000 to $500,000 for any other person [i.e. a corporation]. The Attorney General or the SEC, as appropriate, may also bring a civil action to enjoin any act or practice of a firm whenever it appears that the firm (or an officer, director, employee, agent, or stockholder acting on behalf of the firm) is in violation (or about to be) of the antibribery provisions. OTHER GOVERNMENTAL ACTION Under guidelines issued by the Office of Management and Budget, a person or firm found in violation of the FCPA may be barred from doing business with the Federal government. Indictment alone can lead to suspension of the right to do business with the government. The President has directed that no executive agency shall allow any party to participate in any procurement or non-procurement activity if any agency has debarred, suspended, or otherwise excluded that party from participation in a procurement or non-procurement activity.” 2. What internal controls could have been usefully introduced to prevent bribery at Daimler? The OECD has published a document listing 12 recommendations for internal controls, ethics and compliance with anti-bribery regulations, including: 1. Strong, explicit and visible support and commitment from senior management to the company's internal controls, ethics and compliance programs or measures for preventing and detecting foreign bribery; 2. A clearly articulated and visible corporate policy prohibiting foreign bribery; 3. Compliance with this prohibition and the related internal controls, ethics, and compliance programs or measures is the duty of individuals at all levels of the company; 4. Oversight of ethics and compliance programs or measures regarding foreign bribery, including the authority to report matters directly to independent monitoring bodies such as internal audit committees of boards of directors or of supervisory boards, is the duty of one or more senior corporate officers, with an adequate level of autonomy from management, resources, and authority; 5. Ethics and compliance programs or measures designed to prevent and detect foreign bribery, applicable to all directors, officers, and employees, and applicable to all entities over which a company has effective control, including subsidiaries on the following areas: • gifts; • hospitality, entertainment and expenses; • customer travel; • political contributions; • charitable donations and sponsorships; • facilitation payments; and • solicitation and extortion; 6. Ethics and compliance programs or measures designed to prevent and detect foreign bribery applicable, where appropriate and subject to contractual arrangements, to third parties such as agents and other intermediaries, consultants, representatives, distributors, contractors and suppliers, consortia, and joint venture partners (hereinafter “business partners”), including the following essential elements: • Properly documented risk-based due diligence pertaining to the hiring, as well as the appropriate and regular oversight of business partners; • Informing business partners of the company’s commitment to abiding by laws on the prohibitions against foreign bribery, and of the company’s ethics and compliance program or measures for preventing and detecting such bribery; and, • Seeking a reciprocal commitment from business partners; 7. A system of financial and accounting procedures, including a system of internal controls, reasonably designed to ensure the maintenance of fair and accurate books, records, and accounts, to ensure that they cannot be used for the purpose of foreign bribery or hiding such bribery; 8. Measures designed to ensure periodic communication, and documented training for all levels of the company, on the company’s ethics and compliance program or measures regarding foreign bribery, as well as, where appropriate, for subsidiaries; 9. Appropriate measures to encourage and provide positive support for the observance of ethics and compliance programs or measures against foreign bribery, at all levels of the company; 10. Appropriate disciplinary procedures to address, among other things, violations, at all levels of the company, of laws against foreign bribery, and the company’s ethics and compliance program or measures regarding foreign bribery; 11. Effective measures for: • Providing guidance and advice to directors, officers, employees, and, where appropriate, business partners, on complying with the company's ethics and compliance program or measures, including when they need urgent advice on difficult situations in foreign jurisdictions; • Internal and where possible confidential reporting by, and protection of, directors, officers, employees, and, where appropriate, business partners, not willing to violate professional standards or ethics under instructions or pressure from hierarchical superiors, as well as for directors, officers, employees, and, where appropriate, business partners, willing to report breaches of the law or professional standards or ethics occurring within the company, in good faith and on reasonable grounds; and • Undertaking appropriate action in response to such reports; 12. Periodic reviews of the ethics and compliance programs or measures, designed to evaluate and improve their effectiveness in preventing and detecting foreign bribery, taking into account relevant developments in the field, and evolving international and industry standards. 3.What should Dieter Zetsche do to ensure the highest compliance standards? The change of a company’s culture is a long process that takes time and a strong commitment by top management to promote and enforce high ethical standards. It is important to make sure employees at all levels of the company know that bribes and other similar unethical actions will not be tolerated. The recommendations outlined in the answer to the previous question may be a good way to start developing a strong compliance program. Whatever steps Mr. Zetsche takes, he must speak out actively in support of the antibribery policy and its enforcement – in other words he must provide strong ethical leadership – or his employees will not take notice of the new policies. 4. Whistleblowers on FCPA matters are eligible for up to 25% of the settlement and/or fine that results depending on a hearing by a tribunal on the import of their evidence (see page xxx for a discussion of this). How much of the $91.4 million restitution payment would you award David Bazzetta if you could make the decision? Provide your reasons for the choice you advocate. Whistleblowers providing “original information” leading to a successful enforcement action resulting in monetary sanctions exceeding $1,000,000 may be paid between 10 and 30 percent of any money the government collects as a result of the provided information. In this case, if the evidence provided by Mr. Bazzetta becomes central to the prosecution of this case, he deserves the maximum possible award. 5. Did David Bazzetta do what was expected of him as a professional accountant? A professional accountant has the responsibility to not be associated with misleading or false information. Mr. Bazzetta acted ethically in this case; however, it is debatable whether he should have gone public right away or he should have reported this matter within the company first. Mr. Bazzetta could have attempted to reach the Board of Directors before filing a complaint with the U.S. Department of Justice. It may have been a reasonable judgment on his part that, at the time, his internal report would have been ignored, or that he might have been discriminated against or prosecuted. References Bribery in International Business. OECD. 2011. http://www.oecd.org/document/13/0,3746,en_2649_34855_39884109_1_1_1_1,00.html Foreign Corrupt Practices Act of 1977 (15 U.S.C. §§ 78dd-1, et seq.) U.S. Department of Justice. http://www.justice.gov/criminal/fraud/fcpa/docs/fcpa-english.pdf Good Practice Guidance on Internal Controls, Ethics, and Compliance. OECD. 2010. http://www.oecd.org/dataoecd/5/51/44884389.pdf Lay-Persons’ Guide to FCPA. 2011. U.S. Department of Justice. http://www.justice.gov/criminal/fraud/fcpa/docs/lay-persons-guide.pdf 6. HP Bribery for Russian Contract with Anti-Bribery Prosecutor’s Office What this case has to offer This case describes how Hewlett Packard bribed officials at the government office that is responsible for prosecuting bribery cases in Russia. It is a good case to discuss the implications of giving a bribe in a foreign jurisdiction based on the assumptions that its OK since everyone is doing it, or that since bribery is OK at the time of the bribe, it not result in charges and/or convictions forever. Teaching suggestions I start this case by asking students how is it possible for a company to bribe a government official without being discovered. This case is interesting because HP tried to bribe officials within the anti-bribery office itself. Furthermore, I discuss whether a company that bribes officials in a given country has to worry about penalties in its home country. The Daimler’s Settles U.S. Bribery Case for $185 million Case is a useful companion case on this matter. Also, the new U.K. Bribery Act includes an extra-territorial reach. Discussion of ethical issues 1. Why would HP personnel think they could get away with bribing an employee in the Russian anti-bribery prosecutor’s office? There could be several reasons, for example: • HP used several bank accounts and indirect money transfers that would make difficult to trace back the money to HP; • The bribe could have been masked as a legitimate payment; and, • HP’s executives may thought that the Russian authorities were so corrupt that they would never be prosecuted in Russia, without considering that they were subject to the Foreign Corrupt Practices Act (FCPA). • Actually, under German law, HP could not be charged, so senior officials may have induced other employees to bribe to benefit the company thinking erroneously that problems, if any, would fall on the individual, not HP. 2. Why was it done through a series of companies in different countries? It was done in that way to try to make it difficult to trace the money back to HP and probe that these payments were bribes. 3. What has changed to now allow investigators to unravel such a series, whereas in the past they would have found it almost impossible? The following changes have enabled the prosecution under the FCPA: • On November 21, 1997, the 29 member nations of the Organization for Economic Cooperation and Development ("OECD") and five non-member nations adopted the "Convention on Combating Bribery of Foreign Public Officials in International Business Transactions." The OECD Convention, which was signed on December 17, 1997, and ratified by the U.S. Senate on July 1, 1998, sets forth the essential elements of a Foreign Corrupt Practices statute that each country should enact into a law. • New whistleblower provisions will motivate insiders to provide evidence aiding the prosecutors. Whistleblowers providing “original information” leading to a successful enforcement action resulting in monetary sanctions exceeding $1,000,000 may be paid between 10 and 30 percent of any money the government collects as a result of the provided information. Whistleblowers will also be paid if their information leads to successful “related actions,” i.e., administrative or judicial actions brought by other agencies, including the U.S. Department of Justice, federal and state regulatory authorities, and foreign law enforcement agencies. • The passage of the International Money Laundering Abatement and Anti-terrorist Financing Act of 2001 has made international money transfers more transparent to regulators and easier to trace back to the original source. 4. If a company decides to bribe, how many years need to go by so that they are safe from prosecution? The violations to the FCPA can be prosecuted anytime, regardless of the number of years that have passed since the bribe was given. Moreover, if a company acquires another company, the parent company is responsible for the past actions of the acquired company. 5. Even though German law does not allow companies to be charged, what are the possible consequences of the alleged bribery for HP? HP may face the following consequences: • Loss of reputation and future government contracts in Germany and other countries; • Increased time dealing with regulators in several jurisdictions as this incident may cause other similar investigations; and, • Possible prosecution in the U.S. under the FCPA. References Bribery in International Business. OECD. 2011. http://www.oecd.org/document/13/0,3746,en_2649_34855_39884109_1_1_1_1,00.html Foreign Corrupt Practices Act of 1977 (15 U.S.C. §§ 78dd-1, et seq.) U.S. Department of Justice. http://www.justice.gov/criminal/fraud/fcpa/docs/fcpa-english.pdf CASES ON CORPORATE GOVERNANCE & MANAGERIAL OPPORTUNISM 1. Spying on HP Directors What this case has to offer This is a good case to discuss the ethical implications from obtaining and using information from the company’s employees in general. It also illustrates the perils of conducting secret investigations of board members. In addition, the HP case highlights the importance of ethical guidance for the board of directors and the need for limits to the power of the chairman of the board. The board of directors exists to monitor management and it is appointed to act in the best interest of the company’s shareholders. Nevertheless, there are few internal mechanisms that are needed to ensure the proper functioning of the board. On one side, it was the responsibility of the chair to investigate the origin of the leak of confidential information and keep the investigation secret in order to discover the person who was leaking the information; however, on the other side the investigation should have been conducted within ethical and legal boundaries. On September, 2006 the press revealed that the chairwoman of Hewlett-Packard (HP), Patricia Dunn, had hired a team of independent electronic-security experts that later spied on HP board members and several journalists, to determine the source of leak of confidential details regarding HP's long-term strategy in January, 2006. The independent consultant obtained phone call records of HP board members and nine journalists, including reporters for CNET, The New York Times, and The Wall Street Journal using an unethical and possibly illegal practice known as pretexting. Patricia Dunn claimed she did not know the methods the investigators used to determine the source of the leak and resigned after the scandal. George Keyworth, the director responsible for the leak, resigned from HP’s board after 21 years of service. Teaching suggestions I start the class asking the students who should be in charge of monitoring the CEO, and then follow up by asking who should monitor the board of directors, and how? This sets up the questions at the end of the case for further discussion in order. Discussion of ethical issues 1. Should the chair of the board of directors be allowed to initiate investigations into weaknesses in a company’s internal control systems? The investigation of internal control weaknesses is usually a management function; however, as stated in the COSO integrated framework “Management is accountable to the board of directors, which provides governance, guidance and oversight. A strong, active board, particularly when coupled with effective upward communications channels and capable financial, legal and internal audit functions, is often best able to identify and correct such a problem.” The provisions of SOX Section 302 require CEOs and CFOs to certify that they are responsible for internal controls and have evaluated the company’s internal controls. Nonetheless, in this case it seems that the chair had the responsibility to investigate the leak of strategic information given that some of the suspects were members of the board of directors. Under the circumstances, it would have been prudent for Ms. Dunn to share her plan with the Executive Committee of the board and get their guidance and blessing. 2. Is the strategy of pretexting an acceptable means in order to obtain critical information that will strengthen a company’s internal control system? The legal opinion given to HP on pretexting is a masterpiece of doubletalk, and of little value. As it turned out, using pretexting is/was definitely not acceptable from several different points of view: • It involves misrepresentation designed to get information by deceit, which is quite unethical as it is unfair and violates the rights of the subjects involved. • Patricia Dunn herself recognized in her resignation letter that “The unauthorized disclosure of confidential information was a serious violation of our code of conduct; • HP settled a State lawsuit paying $14.5 million in fines and promising to improve its corporate governance practices; • HP agreed to a financial settlement with The New York Times and three BusinessWeek magazine journalists; and, • Pretexting invades privacy and is a questionable practice involving the impersonation of somebody in order to trick phone companies into handing over the calling records of that person’s personal phone accounts. 3. Should the reasons for resignations from a board of directors always be made public? In general, a policy of transparency and full disclosure should be in the best interest of the company’s shareholders. Without complete information it would not be possible for shareholders to effectively monitor agency problems within the company. Some people may disagree with this position and could argue that shareholders would be worse off if information that impacts stock prices negatively is made public. In this case, HP made Perkins resignation public without disclosing the reasons for his departure. HP reported Perkins’ resignation to the SEC four days later, again giving no reason for his resignation. In practice, most resignations are accompanied by boilerplate statements that are uninformative to the public; however, in a full disclosure environment, the impact of full disclosure on director’s reputation should be an incentive to act in the best interest of the company’s shareholders. Useful Videos. Films & Links “HP’s Boardroom Drama” CNET News Special Coverage http://news.cnet.com/HPs-boardroom-drama/2009-1014_3-6112817.html • This web-site provides current and previous coverage surrounding the internal investigation into media leaks at HP. It further provides links to the legal investigation and highlights congressional hearings, press conferences, commentary and video footage across the scandal. “Feds charge investigator in H-P boardroom case” Market Watch, Jan 11, 2007 http://www.marketwatch.com/story/feds-charge-investigator-in-h-p-pretexting-case Helft, Miguel (2006) “H.P. Read Instant Messages of Reporter” New York Times, Sept. 30 http://query.nytimes.com/gst/fullpage.html?res=9D04E0DB1730F933A0575AC0A9609C8B63&sec=&spon=&pagewanted=1 “News release: Patricia Dunn Resigns from HP Board” Hewlett-Packard, Sept. 22, 2006 http://www.hp.com/hpinfo/newsroom/press/2006/060922a.html “News release: George Keyworth Resigns as HP Director” Hewlett-Packard, Sept 12, 2006 http://www.hp.com/hpinfo/newsroom/press/2006/060912b.html 2. Lord Conrad Black’s Fiduciary Duty? What this case has to offer This is an excellent case to discuss: • the conflicts of interest risks arising when management or a dominant owner has effective control of a public company, and • appropriate governance controls needed to safeguard the interests of other shareholders and stakeholders. Conrad Black effectively controlled Hollinger International, Inc. without a majority of the corporation’s equity, through special Class B shares that carried a 10-1 voting preference over class A Shares. Using his controlling privileges, Conrad Black and other executives obtained from Hollinger payments alleged to be self-dealing without fully and properly informing the board of directors whom he had personally selected. The case highlights the importance of an independent, objective, courageous board of directors, with active and knowledgeable committees (i.e. audit, compensation and corporate governance). It provides an opportunity to discuss ethical decision-making when a legal transaction might be ethically dubious. It also highlights the importance of the fiduciary duty owed to the company – to all shareholders, not just a select few – by managers and directors, acting as trustees of the shareholders’ wealth. Teaching suggestions To start out, students can be asked three central questions on corporate governance: • why companies have a board of directors, • who should appoint the members of the board, and • what is the duty that these members owe to the company’s shareholders? One of the board’s most important roles is to oversee the company’s management for the good of the company (on behalf of all the shareholders). Otherwise, managers will be tempted to line their own pockets as Black did, and misrepresent facts and earnings to suit their own interests. Since it is rare that anyone can effectively monitor themselves, there needs to be a separation of management from ownership. It is not surprising, therefore, that boards of directors have the following basic objectives, as well as several others: • To ratify management’s strategies and monitor their performance and progress; • To hire, fire and compensate management; and, • To ensure that complete and accurate information to assess the company’s performance is publicly disclosed. The students can then be asked what problems may arise if the selection of directors is left to the discretion of the parties whose behavior the board is supposed to monitor, especially when the company is controlled by a small group of investors that also hold executive positions in the organization. The details of the case can then be reviewed, questioning the role of the board in authorizing management’s regular compensation and one-time payments. Finally it is useful to ask if all forms of management’s compensation authorized by the board of directors, even when perfectly legal, are ethical and in the best interest of the company’s shareholders. Discussion of ethical issues 1. What conflicts of interest may have been involved in Black’s activities? Conrad Black was, through a structure of holding companies, the controlling shareholder of Hollinger International Inc. even though he did not own the majority of the corporation’s total equity. Black’s potential conflicts of interest included: • with a partner, he negotiated deals selling company-owned newspapers to other entities, but included non-competition payments directly to himself and other executives. • paid personal expenses and bought an apartment with company’s money. • selected the members of the board of directors, who were supposed to oversee his activities. The conflicts of interest are evident. Black was CEO of the company, controlling shareholder without a majority of shares, and the person in charge of appointing members of the board. He could and did choose people who were his friends or admirers, or who were unlikely to challenge him objectively and independently. 2. Were Black’s non-compete agreements and payments unethical and/or illegal? These payments seem to be on the borderline of legality. If the board of directors approved the payments (there is some doubt about the quality of information provided them) and Conrad Black is able to prove that he did not conceal self-dealing causing damages to other shareholders, the payments might be deemed legal. [In fact, he was convicted on some, but not all of the deals. Even if the payments are considered legal, they are unethical. Black was receiving remuneration as CEO of the company selling the newspapers and should be acting in its best interests. All proceeds of the sale should have gone to Hollinger unless the directors knowingly approved a change in his remuneration. The fact that he and his partner wanted to be paid for not personally competing with the newly sold newspaper conflicts with their role as officers of Hollinger. They should have been acting in the interest of the company, not of themselves. If the company buying the newspapers wanted personal protection from Black and his partner, that should have been a separately negotiated contract. By including the non-compete payments, the rights of other shareholders were negatively affected, and since the disclosure to the board was not timely or transparent, the interests of the board and other shareholders were dealt with unfairly. While it is possible to argue that Black and his partners were shareholders, so they were in a sense short-changing themselves, that argument overlooks the injustice done to the other shareholders who did not receive direct payments. Black and his partners were clearly self-dealing. He appears to have had the perspective that he built the company and could do what he liked with it and its resources. While this may be fine if he was the sole owner, when equity is raised from public shareholders, their interests need to be recognized and protected. 3. What questions should have been asked by International’s directors? Directors should act in the best interest of all the company – of all its shareholders. They should have: • discovered the non-competition payments and other expenses, • asked how they could possibly increase the overall company’s value, • ensured that the company’s internal auditors should have been reporting to the Audit Committee on these issues, • verified that that non-compete payments were actually received by Hollinger International, or have arranged for internal auditors or counsels to do so, and • if reporting on the non-compete agreement payments was opaque, the directors should have demanded a full and transparent accounting. Obviously the directors were used to leaving such matters to Black and his managers, and did not exercise independent and objective judgment, or have the courage to confront Black. 4. If the boards of directors of his various companies approved these non-compete agreements, are the board members on the hook and Black off? Not necessarily. The directors’ liability will depend on the kind and quality of information they received from Black and how they validated such information in approving the non-competition fees. Directors can raise a "good faith reliance" defense to many of the liabilities to which they are subject. This defense allows directors to point to a reliable source of information as justification for their actions. However it does not permit them, in the absence of that specific justification, to show that they acted reasonably. Therefore it is not clear if the directors will be completely responsible, thus leaving Black free of guilt. Conrad Black can still be charged if the non-controlling shareholders can prove that he breached fiduciary duties owed to Hollinger by him as an employee through unfair use of the company’s assets. It is also important to note that several provisions in securities legislation are intended to protect minority shareholders from executive managers’ self-dealing. Definitely, he can be still “on the hook” for these payments. 5. Black controlled key companies through multiple voting rights attached to less than a majority of shares. Was this illegal and/or unethical? Differences in voting rights and shareholding structures are common practice in public companies. This practice is not illegal, provided it is properly disclosed. Public companies are usually subject to the Market for Corporate Control Principle. Stockholders have no loyalty to incumbent managers and, if the wish, they can usually chose to sell their shares in a given company at the market price at any point in time. This sale will drive the stock price down, attracting potential buyers and eventually cause a corporate takeover leading to changes in executive management. However, when the primary controlling shareholder is also the top executive, the market for corporate control might not be effective enough to dislodge him. It is then the responsibility of the board of directors to act for all shareholders with independence and objectivity in overseeing management’s performance. However, it would be unethical, and perhaps illegal in some cases, for a controlling shareholder to use such majority voting rights to appoint the members of the board who are not likely to represent all shareholders. Unfortunately, it has been known to happen, and is a governance flaw that investors must consider prior to purchasing shares in such a company. 6. What risk management techniques would have prevented Black’s potential conflicts from becoming harmful? A strong control environment constitutes the most pervasive means to deter fraud. An appropriate control environment includes a culture of ethical values such as integrity, honesty, fair-dealing, and competence; as well as a management philosophy and operating style that reflects those values, and the reinforcing oversight, attention and direction provided by a supportive board of directors. The awareness of company personnel, and internal controls that correspond to this culture should provide reasonable assurance that fraud will be prevented or detected. Some elements of the control structure that might prevent or early detect conflicts of interest include legal, accounting, and internal audit departments, as well as an independent board of directors. The legal department, or office of the general counsel, typically plays a key role in reviewing disclosure documents for compliance with applicable laws and regulations. The internal audit function performs a supervisory function within the company to examine, analyze, and make recommendations on matters affecting the company's internal controls. The audit committee of the board of directors has a responsibility to the company's shareholders to oversee management's performance. Subsequent events On December 10, 2007, Judge Amy J. St. Eve of United States District Court sentenced Lord Black to six and a half years in prison on three fraud charges involving self-dealing, non-compete payments and one charge of obstruction of justice for removing 13 boxes of documents from the Toronto offices of Hollinger International. Instead of keeping a low profile after his conviction, Mr. Black became even more voluble. He managed to publish and publicize a 1,152-page biography, “Richard M. Nixon: A Life in Full”. He spends his time in a Florida penitentiary teaching history to overflow classes of inmates, and writing newspaper columns. Useful Videos, Films & Links Conrad Black Accusations, Criminal Charges, Trial and Trial in Depth available through the Heritage Institute http://www.heritageinstitute.com/governance/black/background.htm • Heritage institute also provides a link to a report from the internal committee at Hollinger that initially accused Black and his partner David Radler of operating a "corporate kleptocracy" and allegedly stealing more than $400 million from the corporation. Waldie, Paul (2010) “Black can’t return to Canada yet” Globe and Mail July 23rdhttp://news.bbc.co.uk/2/hi/business/3276689.stm “Conrad Black Trial Excerpts” CBC News In Depth Coverage, March 21st 2007 http://www.cbc.ca/news/background/black_conrad/trial-excerpts-cramer.html “Conrad Black: Where did it all go wrong?” BBC World News Feb. 27th 2004 http://news.bbc.co.uk/2/hi/business/3276689.stm 3. Manipulation of MCI’s Allowance for Doubtful Accountants What this case has to offer This case illustrates the problems an employee can get into when the firm develops a high-paced culture of growth at any cost and will not tolerate any dissention, even if the dissenting opinion is the voice of reason and prudence. It also illustrates that employees must have the courage to be forthright when communicating bad news to their superiors. Teaching suggestions I would suggest that students in the class outline generally accepted accounting principles with respect to accounts receivable. Any student who has audit experience can explain the steps that auditors follow in order to satisfy themselves that the net accounts receivable and the bad debt expense are reasonably stated. Generally accepted accounting principles require that accounts receivable be stated at the amount that will ultimately be collected. This is the gross amount, less the allowance for doubtful accounts. Although the true allowance cannot be predicted in advance, a reasonable provision can be estimated based on the available facts. These would include: - the firm’s credit policy, - the age of the outstanding accounts, and - the history of collection and write-off rates over a number of periods. In the case of MCI, the credit policies were too lenient, and had not been reviewed or changed as a result of economic conditions and sales volumes. The aging was being artificially manipulated because there were inadequate internal controls to prevent Walt Pavlo and his team from: - converting delinquent accounts receivable to promissory notes, - accepting common stock instead of cash, and - lapping payments. Discussion of ethical issues 1. After being told that the guideline for bad debts for 1996 was $15 million, what should Walt do? Walt should have been more forceful in his presentation to his boss. If his boss would not acknowledge the problem then he should follow the chain of command and report the issue to his boss’ boss. At the extreme, if all else fails, then Walt should consider becoming a whistle-blower. He should raise the issue directly to the audit committee or to the auditors. The consequences of this could be dire, but not as severe as the $150 million write-off that MCI eventually recorded after it was taken over by WorldCom. By accepting the $15 million guideline, Walt contributed to his own downfall and eventual penitentiary sentence. 2. What are the risks for MCI in setting an unrealistic allowance for doubtful accounts? The allowance is simply today’s estimate of the amount of receivables that will not be collected in the future. The actual amount of the uncollectibles remains the same, regardless of the amount of the estimate. So, by setting the allowance too low, the firm is simply pretending that a further loss recognition problem does not exist. The firm can bury its head in the sand, but the reality of the uncollectibles will become apparent when the firm does not receive the cash from those customers in later periods. The major risk of not having a reasonable allowance is that a controllable problem can go unchecked and thereby increase to become a major issue. In the case of MCI, approximately $180 million was not going to be received (this is the amount of the eventual write-down). But setting the allowance at only $15 million the firm was not being honest with itself nor its investors. The problem was not being acknowledged and therefore not being addressed on a timely basis. If investors and/or the government believe that the firm deliberately overstated net income by understating the bad debt expense by understating the allowance for doubtful accounts, then the firm can be sued for fraudulent financial reporting. 4. Stock Options and Gifts of Publicly Traded Shares What this case has to offer This allows the students to discuss a variety of issues, including: - when does the exercise of CEO discretionary power become opportunistic, - the ethics of a variation of the classic pump and dump strategy, the scheme whereby an investor will artificially increase a firm’s stock price with false or misleading information, in order for the investor to sell a price much higher than the purchase price of the shares, and - the professional and fiduciary responsibilities of accountants working within an organization. Teaching suggestions This is a good opportunity to review the major ethical theories and apply them to corporate charitable donations, redirecting donations to stem cell research and managerial opportunism. Utilitarianism. Currently Revel Technologies donates to a variety of charities. Moving the funds from many charities to only one charity may not be of the greatest benefit to the largest number of people. However, this argument implies that the social benefits of the recipient agencies can be measured. Students should be asked why they think that a cure for MLD will not result in other benefits to society, greater than perhaps the benefits of curing cancer. It is important to stress with the students that utilitarianism is a simple theory to articulate, but is very difficult to measure social costs and benefits. Deontology. This theory argues that we should not treat others as means to our personal ends. Is redirecting donations, to a charity that the CEO has a personal interest in, using Revel Technologies as a means to the personal goal of the CEO? Does it violate the principles of justice and fairness that the CEO is allowed to make arbitrary decisions? On the other hand, if the shareholders are prepared to have Revel Technologies make charitable donations, then it may not matter to them where the donations are directed, as long as they go to legitimate charities. As such, the redirection does not violate any understanding that the shareholders have with the organization. Virtue Ethics. Many people have strong views on the subject of stem cell research. Is it acting virtuously to allocate funds to a form of research that may be contrary to the religious convictions of some of the firm’s shareholders? If the firm is adopting a more holistic approach, should they be balancing their donations based on the religious and social attitudes of their relevant stakeholder groups? Discussion of ethical issues 1. Is it right that a CEO can direct the charitable donations of his company to the charity of his choice? There is a separation between ownership and control. The shareholders own the firm, but they delegate running the business to the CEO. As such, the shareholders give a great deal of discretionary power to the CEO to run the business as the CEO sees fit. The CEO in turn reports to the board of directors who must assess whether the CEO has, in fact, been acting in the best interest of the shareholders. The board is to assist in strategic planning, and providing advice and counsel on critical issues. They leave the rest of the decision-making to the CEO. As long as the CEO does not use this discretionary power opportunistically, then there is no problem. A problem only occurs when the CEO makes choices that are in the best interests of the CEO and that may not be in the best interests of the firm. In this case, is re-directing donations opportunistic or not? 2. Comment on the ethical aspects of Pierre’s stock option/stock donation strategy. There are two different strategies in this case: one quite legal and the other unethical, and perhaps illegal. Stock Donations Many wealthy CEOs have little surplus cash, but quite a lot of very valuable, in the money, stock options. Many charities receive large gifts from wealthy business executives. However, the charities were concerned that their cash receipts might decrease because these executives did not have a lot of surplus cash. The Canada Revenue Agency plan, created a win/win scenario. An executive can exercise stock options without incurring any capital gains tax as long as the executive donated the shares to a registered charity. The executive would also receive a tax receipt for the amount of the donation. The charity would receive common stock in a publicly traded company that the charity could immediately sell for cash, or hold and receive dividend revenue. So this was a win/win situation. The charity receives a marketable asset and the taxpayer claims a charitable deduction for tax purposes. Pump and Dump Strategy The pump and dump strategy involves artificially inflating the price of a stock, normally by releasing false information (pump), in order to be able to sell the stock (dump) at a price higher than the initial purchase price. This case is a reverse of the technique. By withholding the release of the financial statements that contain bad news, Pierre is artificially keeping the stock price at $19, higher than it would be if the investors knew the bad news. He will only release the bad news after he donates his stock to the charity and receives a tax receipt at the artificially high price of $19. Then the financial statements will be released and the stock will drop to about $17. Pump and dump is an unethical strategy because it capitalizes on information asymmetry. Pierre has information that is useful to the marketplace, but he withholds that information for personal gain. Pierre is using his insider information to take advantage of all the other investors. As such he is acting opportunistically, using the other investors as a means to his own personal advantage. 3. If you were Gloria, what should you do? Would you change if you were a donations specialist, a lawyer, or a professional accountant? As a professional accountant, Gloria cannot be associated with any information that is false or misleading. She may consider that delaying the release of the financial statements is misleading to the other investors on the basis that if they had that information then the stock would be trading at the $17 level rather than the current $19 level. If so, then she has a professional responsibility not to go along with Pierre’s schemes, and instead to report her concerns to the audit committee, or to the board of directors. If Gloria is in-house counsel, then as a lawyer she has a fiduciary responsibility to look out for the best interests of the firm, which may not necessarily be the best interests of her boss. In this case, Gloria should raise her legal concerns with Pierre. If that does not convince him to eschew the strategy then she should report her concerns to the board of directors. As a loyal employee Gloria has a duty as the donations officer to adhere to both her job description and the requests of her superior. One of the functions of a job description and standard operating procedures is to protect employees from doing questionable actions. Gloria should, once again, remind Pierre that Revel Technologies has standard operating procedures, and that if he wants the donations to be re-directed then he should make that request to the donation committee, not to her. If this does not work, then she should follow the chain of command, and report the issue to the donation committee. The committee has the responsibility for deciding whether or not they concur with Pierre. 5. The Ethics of Repricing and Backdating of Employee Stock Options What this case has to offer This is a good case for addressing agency theory, executive compensation and stock options. Given that, for many executives, there is a huge discrepancy between their cash compensation and the stock options they receive, it is important for students to understand that when cash, bonuses and stock options lose their proportionality, they may no longer be strong motivation techniques for enhancing the long-term value of the firm. Teaching suggestions Consider bringing in a chart with the names of the highest paid executives, the amount of their cash compensation, their bonuses, their stock options and their total pay. These data are available from many periodicals, including Forbes, Business Week, and the Report on Business. The following data are from USA Today on the 10 highest paid executives in 2007. Name Company Salary Bonus Options Total J. Thain Merrill Lynch 0 15.0 68.0 83.1 L. Moonves CBS 5.3 18.5 43.5 67.6 R. Adkerson Freeport-McMoRan 2.1 5.4 55.0 65.2 L. Ellison Oracle 1.0 8.4 50.1 61.2 B. Simpson XTO Energy 1.3 35.5 19.5 56.6 L. Blankfein Goldman Sachs 0.6 27.0 26.0 54.0 K. Chenault American Express 1.2 6.5 41.3 50.1 J. Mack Morgan Stanley 0.8 0 40.2 41.4 G. Murphy Gap 0.8 2.2 35.8 39.1 E. Breen Tyco 1.6 3.2 28.3 34.1 (http://www.usatoday.com/money/companies/management/2009-02-05-executive-compensation-2007_N.htm) After reviewing the table, there can be a general discussion about compensation, its form and its purposes. Compensation can be given through salary, bonuses, stock options, allowances and non-pecuniary perks such as vacation time, and large offices with large staffs. Compensation is used to hire and acquire employees, to motivate them, to reward them for good performance, and to punish them for poor performance. The problem with compensation is untangling the relationship between each part of compensation and the various purposes. Salary is used to acquire people, but does it motivate them to work hard? Is a bonus a reward for past performance, or a motivation for future performance? The students should realize that the term ‘compensation’ is multifaceted and multilayered. Next, consider discussing the fundamentals of agency theory. There is a separation between ownership and control. Those who own the firm want a reasonable return on their investment, but they do not want to operate the firm. Management is hired to operate the firm, and is paid compensation to do so. However, the interests of management may not be aligned with the interests of the investors. Management may not want to take risks on behalf of the investors lest the risky venture fails and the manager is fired. So, compensation schemes are set up to align the interest of the manager with the investors by giving the manager an ownership interest in the firm through stock options. Because they are now owners of the firm, their interest should be aligned. This is the basic rationale of agency theory. Discussion of important issues 1. Do you think that stock options actually motivate employees to workfor the long-term good of the company? Stock options are an attempt to align the interest of managers with those of the investors. Investors are interested in a reasonable return on their investment; as result they are risk takers. Managers are assumed to be interested in compensation and are risk averse. Stock options allow the manager to acquire an ownership interest in the firm. By having an ownership interest in the firm, the manager should be inclined to adopt an investor perspective, i.e. the manager should work towards having the stock price increase thereby generating a reasonable return for both the investor and the manager. So, according to agency theory, stock options should align the interests of the manager with those of the investor. The premise is that investors have a long-term perspective. However, if management can exercise their stock options and then immediately sell their shares, then management may have only a short-term perspective. As such, management may make decisions that have only a short-term advantage, but no long-term benefit of the firm and the investors. Furthermore, if management is risk averse, then managers would not want to hold shares in only one company. Instead they would want a diversified portfolio, in order to minimize their portfolio risk. This also contributes to short-term thinking by the manager. The manager exercises the stock options to receive enough money to buy a long-term diversified investment portfolio. 2. Do you think that stock options inadvertently encourage manager to engage in questionable accounting activities, such as earnings management, to artificially increase the company’s net income and thereby the value of the executives stock options? Stock options are a means of transferring risk onto the manager. Managers will take on risky projects so as to increase net income and have the stock price rise. As the stock price increases, the value of the options increase. When the options are exercised and the shares are then sold, the manager receives cash, an indirect form of compensation. Managers know that if the risks they take on behalf of the investor fail, then they will probably be fired, and receive no more compensation. Since managers normally have a short-term orientation, and they fear losing their compensation, this encourages many managers to engage in earnings management. Earnings management is a technique to artificially increase net income, and hopefully stock price, through accounting and operational strategies. For example, management may artificially increase earnings by changing the allowance for doubtful accounts, the inventory obsolescence reserve, the estimated warranty provision and/or a pension cost estimates. None of these strategies alters cash flows but they do alter reported earnings. Other strategies, that will alter cash flows, include changing credit terms and approvals, shipping goods before they are ordered, altering the level of research and development and/or reducing advertising expenditures. All of these are designed to reduce expenses, increase net income and increase stock price so that the stock options become more valuable to the manager. The students can then discuss the pros and cons of each strategy. Some aspects of the accounting strategies include the following. - Net income is altered without changing cash flows. - Accounting estimates reverse in the next period, so the strategies are normally short-term. - These accounting estimates are not disclosed in the financial statements, and so they are not readily apparent to the investor. Aspects of the cash flow strategies include the following. - Net income is reduced and short-term cash is saved. - These strategies may have a long-term detrimental effect because important activities such as R&D and advertising are reduced or eliminated. - 3. Do you agree or disagree with the four ethical arguments summarized above and contained in more detail in the article by Railbom, Massoud, Morris, and Pier? Explain why. Under the theory of justice, equals should be treated equally, and unequals treated unequally in proportion to their inequalities. Since all investors are equal, a theory of justice analysis would not condone treating executives differently from all other investors, whether by means of backdating, repricing, spring-loading or bullet-dodging of stock Utilitarianism argues that the ethically correct decision should be one of benefit to most shareholders. Clearly, these manipulative actions do not benefit most, but only some shareholders, at the expense of others. Under a utilitarian analysis, this conduct is unethical. Deontology would view backdating, repricing, spring-loading and bullet-dodging as lies, and such actions would be condemned. How can it be a virtue to manipulate the price of stock? Virtue ethics would recognize the discrimination and misrepresentation of these acts, and would not condone them. 4. Should a board of directors approve repricing or backdating stock options for outstanding executives whose current stock options are underwater due to uncontrollable economic factors, and who will be lured away unless some incentives to stay are created? What other incentives might work? Stock options are a means of transferring risk onto the manager, and risk means that there is the possibility of both success and failure. If the firm is unsuccessful, then net income falls as does the stock. In this situation the investor has lost money and the value of manager’s options fall and may be underwater (below the strike price). If the manager can have the options rewritten, so that they are no longer out of the money, then the manager has won while the investor has lost. This is not fair. If both parties are at risk, then they should both reap the benefits when the venture succeeds and both share the losses when it fails. To do otherwise is not treating equals equally. Stock options are a form of executive compensation. Compensation can be used to reward good performance. By re-writing stock options, the firm may be rewarding poor performance rather than good performance. Some will argue that stock options need to be rewritten in order to prevent good managers from leaving and joining another firm. Managers are to be responsible for their decisions, both the successful and unsuccessful ones. Managers with integrity admit their mistakes and take the consequences of their actions. Irresponsible managers will attempt to blame others while moving to another firm in order to minimize their financial losses. Also, if the managers made decisions that led to the losses of the firm, the decrease in stock prices, and the options become worthless, then these may not be the managers that the investors want to have operating the firm. It is best to not rewrite the stock options and instead let the managers leave. CASES ON FRAUDLUENT & QUESTIONABLE FINANCIAL REPORTING 1. Satyam Computer Services, The Enron of India What this case has to offer This case resembles several of the large accounting scandals in the U.S. It highlights several failures within the company’s corporate governance mechanisms and the negative consequences of excessive power concentrated in the hands of the company’s Chairman, who allegedly perpetrated the fraud alone. Satyam is a company whose principal business is outsourcing, and the company relies highly on reputation to attract clients. This case also raises concerns about the extent to which a company that outsources operations to a third party should make sure that the third party behaves ethically and has strong corporate governance and internal controls. The outsourcing company must ensure that ultimately the outsourced information is processed safely and without any business interruptions. Finally, this case is an example of a successful turnaround after a large scandal. With the help of the government of India and new investors, the company took several commendable actions to clean its reputation and continue operating. Teaching suggestions The first questions that come to mind in this case are what happened with the company’s controls over financial reporting and who was responsible for the fraud. As it has been the case with previous accounting scandals, the fraud scheme seems to be relatively easy to identify but nobody noticed it or reported it. I go through the list of people that could have raised a flag but did nothing, for example: directors, accountants, internal and external auditors. I highlight that it was unlikely that Mr. Raju perpetrated the fraud by himself without the knowledge of anybody else within the company. I also discuss the measures taken by the company after the fraud and whether or not they would be effective at restoring the company’s reputation and avoiding a similar fraud in the future. Discussion of ethical issues 1. Will the Satyam fraud damage India’s reputation as a reliable provider of information technology outsourcing? Given the size of Satyam and its importance as an outsourcing company, serving over one third of the US Fortune 500 companies, this fraud could cause a major disruption of India’s enormous outsourcing industry and may force many large companies to investigate and perhaps revamp their back office operations in India. Before the company was acquired by Mahindra Group there was a high level of uncertainty about the outsourcing operations of Satyam. The government of India’s speed and decisive nature of actions in the aftermath of the crisis helped to stabilize the company’s operations during the first months of 2009. At the same time, a new board of directors nominated by the government quickly identified Mahindra as strategic investor for the company, which infused funds and helped to restore confidence among Satyam’s stakeholders. 2. How long will it take to restore Satyam Computer’s reputation, and how would you recommend that the restoration be facilitated? The recovery of the company’s reputation is going to be a long process that will take several years. In the Chairman’s Letter, published together with the 2008-09 and 2009-10 annual report of Mahindra Satyam, the new Chairman notes that: “As you may be aware, the Mahindra Group has always been known for its value system, which uncompromisingly applies to all the Group Companies: • Be responsive to customers • Zero tolerance on unacceptable standards for ethics and governance • Uphold the dignity of all associates • Provide an environment that values professionals • Make quality our mantra in all aspects of work” In addition, the Letter highlights the importance of strengthening internal controls: “Strengthening our internal controls and reporting systems has acquired its own piquancy and urgency in the current context. We would wish to ensure that financial irregularities and frauds of the nature which the Company has gone through, can never happen again. Measures have been initiated for making the financial systems robust, tamper proof and transparent.” The company seems to have taken a number of good steps to recover from the loss of reputation after the fraud. Several actions, already taken by the company, included: • Changing the composition of the board of directors to have a majority of independent directors; • Appointing independent and financially savvy directors to serve in the audit and compensation committees of the board of directors; Initiating a review of compensation policy, performance management system, sales incentive policy, recruitment policy, travel policy, etc.; • Adopting a whistleblower policy; • Adopting a revised code of conduct and ethics policy for the board of directors and employees of the company; • Nominating a Corporate Ombudsman to monitor the implementation of the code of ethics, including the whistleblower policy; • Strengthening the internal audit function by appointing a reputed and independent external agency as its internal auditor, under the oversight of the company’s audit committee; and, • Performing a company-wide internal control evaluation and strengthened several weaknesses in controls over financial reporting. Beyond these measures, the company must maintain high ethical standards for many years before its reputation will be fully restored. As a company whose principal business is outsourcing, Satyam relies highly on reputation to attract clients that need their back office information safely processed and without business interruptions. 3. Mr. Raju did not commit this fraud on his own. What types of individuals probably assisted him either actively or by keeping quiet about what they knew he was doing? In a fraud of this magnitude, several individuals probably assisted Raju or kept quiet about the fraud. This would include, for example, the company’s CFO, the Chief Auditor, and other accounting and internal audit personnel. Moreover, the board of directors and the external auditors were also partially responsible for failing to exercise proper due care in overseeing the company’s financial reporting. 4. To whom should potential whistleblowers have complained? A potential whistleblower could have gone through the following steps to complain: • Talk to an immediate superior or relevant company officials in the accounting or internal audit department; • Notify the audit committee of the board of directors; • Communicate with the external auditors; • Present a formal complaint to the Indian Securities and Exchange Board; and, • Go public as a last resource (after seeking appropriate legal counsel). 5. Mr. Raju likened his fraud experience to “riding a tiger, not knowing how to get off without being eaten.” This is an aspect experienced by some people trapped on a slippery slope from small to ever larger fraudulent acts. If Mr. Raju had come to you for advice during the tiger ride, what would you have advised him? Mr. Raju has to understand that sooner or later the fraud will be uncovered and that accounting fraud is a crime. As time goes by the size of the fraud and its consequences will be bigger. He has to think about the consequences for his family, colleagues, and the thousands of employees working for the company. He also has to learn from several other large corporate frauds that ended badly for their perpetrators. He could avoid a larger disaster by acting sooner. 6. Should PwC worldwide have to pay any investors for their losses caused by faulty audit work of personnel in PW India? It depends on the type of agreement between the affiliate of the accounting firm in India and the global partnership. In principle, just by sharing a common name, PwC has already been affected by the fraud. Furthermore, the global partnership is liable if it failed to ensure that the audit conducted by its affiliates in India complied with the firm’s global audit standards and procedures. In general, external audits are not designed to detect fraud, but it seems that relatively straight forward audit procedures such as thorough bank confirmations and reconciliations, as well as other forms of asset verifications, would have uncovered the fraud. References: Mahindra Satyam. Annual Report for the years 2008-09 and 2009-10. 2011. http://www.mahindrasatyam.com/investors/annual-reports.asp 2. Nortel Networks’ Audit Committee Was In The Dark What this case has to offer Nortel Networks is one of the most notorious companies to emerge from the 1990’s dot-com stock bubble that burst spectacularly. Nortel’s own stock – which accounted for more market capitalization than any other stock in Canada – went from $124.50 to $0.63. Following the collapse of its Internet business, Nortel entered into a dramatic restructuring process focusing on containing losses and returning to profitability. The company’s downsizing and restructuring efforts lowered morale and motivated Nortel’s management to manipulate profits by recording and releasing inappropriate accruals/provisions. Even though these provisions were not material in an individual basis, their aggregate value made the difference between a profit and a reported loss. Achieving profitability triggered rewarding bonuses to all Nortel employees and significant bonuses to senior management. The inappropriate provisioning was discovered after the Audit Committee of Nortel’s board of directors hired a legal firm to review a restatement of $900M of liabilities in the third quarter of 2003. These inadequate practices began in early 2002, when the company started its restructuring efforts. The case offers several interesting points for discussion, including: • Nortel’s loss of its earlier strong ethics reputation, and its ethical culture, • Audit Committee processes and how they might have avoided finding themselves in the dark, unaware of the fraudulent “cookie jar” accounting manipulation going on, • Techniques for accounting manipulation, and the role of provisions and contingencies as “cookie jar” reserves, • Audit processes and why the auditors were unaware of the fraud, • The potential negative impact of a management compensation scheme strongly tied to pro forma profitability, • Management of an investigation into fraudulent accounting manipulations. Teaching suggestions I start the case with a brief background of Nortel, giving the students a sense for the company's size, operations, and significant market changes that drove its share price up to C$124.50 and eventually down to less than one dollar in 2002. In light of these events, I ask the students what actions could have been taken to restructure the company and build back Nortel’s share value. I also ask what the implications of the Internet’s business downturn were. My objective here is to show that the company needed a thorough strategic change including a new compensation scheme tied to strategic milestones beyond pro forma earnings. Then I ask my students to what extent they believe a company's success is a direct result of its top executives' performance. Later I inquire who should be setting the top executives' incentive package. I tie their answers to the role of the board of directors and the responsibilities of its committees. The board needs independent and objective members with strong industry, strategic, governance and financial skills. In order to fulfill specific purposes, the board appoints specialized committees such as audit, conduct review, compensation and corporate governance. Nortel’s board and its audit committee did not exercise enough due care asking enough questions, in a timely manner, regarding the provisioning process and overall control structure. Nor did they – like the Enron board – have any whistleblowers tipping them about the manipulations going on; probably due to a failure to create an ethical corporate culture that encourage such openness. I then deal with the questions posed at the end of the case, which follow below, stressing the role of the various players and pieces of an ethical culture. All are required to ensure that problems are minimized. Even when they are all operating effectively – a due diligence requirement of the board – unethical problems cannot be eliminated entirely. Discussion of important issues/questions 1. Why would Nortel Networks, a Canadian company, hire a U.S.law firm to undertake an independent review of factors that led to restatement of accounting reports? The choice of an investigator was multifaceted. A law firm was probably chosen so that any findings not reported publicly could be held in confidence due to the attorney-client privilege that is not available with accounting, consulting, or investigative firms. This would prevent other findings from being used against the directors in a lawsuit. The law firm could (and did) employ an investigative firm and their findings would similarly be protected. In addition, hiring a well-known U.S. firm with contacts and standing with the SEC – the most aggressive regulator facing Nortel – would add credibility to the exercise and lend support to the stock valuation during the investigation. 2. Why did the independent review focus on the “establishment and release of contractual liability and other related provisions” (also called accruals, reserves, or accrued liabilities)? The legal review mandated by the audit committee expected to verify the company’s liability restatement of $900M. The audit committee wanted to gain understanding of the events that caused significant excess liabilities to be maintained on the balance sheet. These contractual liabilities were a result of previous years' provisioning process, based on judgments made of the company's obligations. 3. How did the failure to follow US GAAP permit the manipulation of Earnings before Taxes (EBT) and lead to fraudulent behavior? As per general accounting principles, accrued liabilities arise from recognition of expenses for which payment of cash or other assets will be made in a future period (i.e. interest, taxes, and payroll payable). Sometimes the amount of a future payable is uncertain due to future conditions and/or external factors, and the amount of the liability has to be estimated using the best information available at the time. In such cases a provision is made for the estimated amount thus charging an expense against profit. When the actual event occurs (creating a triggering event), any unused provision is supposed to be reversed creating a credit that enhances profit. Nortel executives chose to add to and reverse or draw down its reserves arbitrarily without regard to a proper triggering event, thus manipulating profit up or down to qualify for bonuses based on pro forma profit targets. Contingent losses are one type of these estimated liabilities. A contingent loss is a possible loss (or expense), derived from past events, which will be resolved as to existence and amount by some future event confirming or rejecting the loss. Nortel overstated contingent contractual agreements (debit in the liability side) and losses (credit expenses) in 2002 and subsequently released or reversed these accruals (estimates) increasing revenue and decreasing liabilities. The contractual liabilities acted as “cookie-jars, overstating losses in a bad year and then reversing these losses into income in the following periods. 4. Describe the Nortel Return to Profitability (RTP) and Restricted Stock Units (RSU) bonus plans. What did the board of directors expect these plans to achieve? The board intended to motivate employees to stop losses and generate profits, while motivating employees to stay with Nortel. The bonus plans also were intended to motivate executives over time to maintain a profit trend.  The RTP bonus plan contemplated a one-time bonus payment to every employee, save 43 top executives, in the first quarter in which Nortel achieved pro forma profitability. The 43 executives were eligible to receive 20% in the first profits quarter, 40% in the second, and 40% upon four following quarters of cumulative profitability. Pro forma profits had to exceed or equal the total cost of the bonus in that quarter.  The RSU bonus plan made a significant number of share units available for award by the board of directors to the same 43 executives in four installments tied to profitability milestones. 5. Were the misstatements of EBT and bonuses paid material in an accounting sense? Materiality – measured by the ability of a change to affect the decision of an informed lay reader of financial statements – refers to a threshold that varies somewhat depending on the circumstances. In a normal audit, for example the aggregate materiality threshold may be set as a percentage of net income (i.e. 5%). However in this case, given the importance of the tipping point turning a loss into profit, and its connection with bonus payments, the draw downs of provisions (reversals) would have been less than 5% of profit, but since they turned a loss into a profit – an important tipping point – they were definitely considered to be material. The company released $361M in Q1 2002, and $370 in Q2 2002. 6. Why didn’t Nortel’s auditor discover the misstatements? At the time of writing, we do not know why the auditors did not discover the cookie jars or there fraudulent use. Provisioning involves significant judgment on the part of company executives. Auditors review and challenge the provision estimates but rarely have more expertise than client personnel, and do not hire outside valuation experts unless there is reason to suspect misrepresentation. Nortel’s finance executives apparently stretched the judgment inherent in the provisioning process to create a flexible tool to achieve EBT targets. Making accounting estimates frequently requires management to develop models and assumptions regarding possible outcomes, including timing, transactions or events that are uncertain at the time of the estimation. Guidance on audit procedures for validating accounting estimates, including materiality and restatements, remains unclear and dispersed throughout different sections of the Auditing Standards. However, auditors should ensure that the client is using an appropriate model and considering reasonably accurate assumptions. In some cases auditors may opt for consulting with legal or actuarial experts in reviewing very material estimates. Sometimes auditors are too concerned with the present year and place too much confidence on previous years’ judgment. If the auditors deem a liability to be valid because it was reviewed in previous years, they may only ask management for current explanations to validate the liability’s reversal. Auditors should also verify the validity of the original liabilities when they were subsequently reversed. It is conceivable that the auditors did not thoroughly review the end-of-period adjusting entries related to the cookie jar reversals because they were unaware of them, or considered them to be not material. 7. Why didn’t the audit committee or the board as a whole, anticipate the manipulations? The audit committee should have queried management regarding the components of the income statement, including the accrual reversals, particularly when the financials triggered the pro forma based bonus plans. It appears that Nortel's directors did not ask the appropriate questions, or did not receive straight answers. Nortel’s audit committee did not demonstrate enough accounting expertise and savvy to direct internal auditors to review and report on end-of-period and other discretionary adjustments (where there is potential for management override of internal controls) before approving the financials and the bonus payouts. Apparently the audit committee placed too much trust in management. The board of directors as a whole failed to:  Foster an adequate control environment;  Assess financial reporting risk appropriately;  Ensure that adequate people and systems supported the control structure; and,  Exercise adequate monitoring of management estimates. When businesses are restructuring, management is generally concerned with earnings targets and often cut expenses dedicated to internal controls. There is little attention paid to “back office” functions including accounting, internal audit and human resources. As a result, increased control risk result in a higher chance that management’s manipulation of earnings may occur without detection. 8. What questions should the Audit Committee of the board have asked? See discussion above. Also they should have asked questions targeted to address achieving not only earnings targets but also key strategic milestones to rebuild shareholder value. Also, they should have asked what was the role of the reversals and how these reversals were determined. 9. What internal control flaws permitted the fraudulent manipulation to occur without detection? The following is a list of potential flaws. Some will not be clarified until expert witnesses testify.  Control environment: o Lack of thoroughness in audit committee oversight o Lack of accounting knowledge of audit committee members o Lack of auditor's due care in examining management's estimates o Unclear control structures, roles and responsibilities o Weak ethical culture and lack of a thorough ethical awareness program  Risk assessment: o Ineffective risk assessment by the board of directors, failing to identify risk factors (business risk), dubious transactions (opportunity to commit fraud), and inadequate compensation programs (motive for fraud)  Control activities: o Lack of personnel with strong accounting and reporting skills and expertise, and proven records of integrity and ethical behavior, particularly in key finance positions o Inadequate training in accounting issues  Information and communication: o Inadequate ongoing communication between audit committee, internal and external auditors, and management  Monitoring: o Lack of effective whistleblower programs o Lack of effective internal and external audits 10. Would the new SOX requirements have prevented the manipulation per se –why or why not? The Sarbanes Oxley Act of 2002 includes helpful broad provisions such as establishing a public company accounting oversight board (PCAOB), maintaining auditor independence, improving corporate responsibility and enhancing financial disclosure. In addition, it spawned several more specific requirements that might have prevented this manipulation. For example, SOX requires a complete evaluation, CEO and CFO certification, and audit of the company’s internal controls and financial reporting system (Section 404) , creation of entity level controls such as whistleblower programs, and accountability of senior manager and directors for financial information (Section 302 certification), while emphasizing directors’ and auditors’ independence. On the other hand, they might not have prevented this manipulation because of the risk of management override in a weak control environment, and the fact that internal controls cannot prevent all frauds – they can only minimize the possibility of fraud occurring. 11. How have the expectations of the Audit Committee changed since SOX with regard to corporate culture? How can the audit committee ensure that these are met? Prior to the enactment of SOX, there was a general sense that the CEO was really in charge of the company and its affairs. SOX reaffirmed the primacy of the board of directors, clarified roles and set expectation for performance. In the new framework, the audit committee is the overall guardian of financial integrity for shareholders. Audit committee members must be critically aware of their oversight responsibilities, and must completely understand them. How their responsibilities are carried out may vary, but a failure to address them may have consequences for the audit committee, the board and, most of all, the shareholders. Every audit committee must assume three fundamental responsibilities:  Overseeing the process related to the company’s financial risks and internal control;  Overseeing financial reporting and related systems; and  Overseeing internal and external audit processes. There is a new understanding of the importance of corporate culture as part of the internal control system that is essential to the preparation of reliable accurate financial reports. Consequently, the audit committee would have to report and remedy any cultural inadequacies as part of their duty to review internal controls. The audit committee is now seen to be in charge of the internal and external auditors – serving as the functional head of the internal audit department and also assuming the dominant role in appointing and reviewing the work of external auditors – and actively questioning management in financial reporting integrity issues. External auditors must now report to the audit committee discussions with management, opinions expressed and where those opinions were not followed. 12. Should the Audit Committee or the whole board be held legally liable for the weaknesses noted in the review? Why and why not? Management is responsible for designing and implementing an effective system of internal control. The audit committee must determine that management has implemented policies that ensure the company’s risks around financial reporting are identified and that controls are adequate, in place, and functioning properly. As part of its assessment of the processes relating to a company’s risks and control environment, the audit committee should request from management an overview of the risks, policies, procedures, and controls surrounding the integrity of financial reporting. The audit committee should supplement those representations with information from the internal and external auditors. The audit committee makes inquiries of the internal and external auditors regarding internal controls as part of its responsibilities for overseeing the controls over financial reporting. The audit committee and other members of the board are liable if they are negligent in performing their oversight duties. While the board delegates its authority for close scrutiny of financial matters to the audit committee, they cannot escape liability for negligence unless they can demonstrate that they checked that the work of the audit committee was been done properly. However, the members of the audit committee are the front line of defense and usually possess higher levels of financial expertise than the rest of the directors, so their responsibility and liability would be greater. Case law will determine the relative levels of liability during the next 5-10 years. 13. In February 2005, Nortel hired a new Chief Ethics and Compliance Officer using an incentive compensation scheme based upon profits. Is this a sound arrangement? Given the recent fraud motivated by Nortel’s bonus scheme, this is not the best way to maintain or appear to this officer's independence and objectivity. Sensitive posts such as this should be structured to maintain independence not only in substance but also in appearance. Furthermore, it is a basic assumption of any compensation scheme that employees should be rewarded only for achieving milestones on variables directly controllable by them. It is unlikely that the ethics officer will have any direct impact on the company's profits in the short run, so if a bonus plan must be employed, it would be better to use stock options that would not be able to be sold until a year or so after the departure of the executive. 14. Nortel has issued a new code of conduct with striking similarity to their previous version. Why might this new code be more effective than the last? A code of conduct has to be part of a thorough and comprehensive ethics program to be successful. An ethics program cannot succeed unless all elements of the plan as discussed in the text, are in place. Most importantly, the outspoken commitment (see text discussion on ethical leadership) of senior executives is essential to get employees to be concerned about ethical behavior and buy into the program. In the Nortel situation, with so recent a fraud in everyone’s mind, a new code, even if little changed, will resonate with all employees and leaders should have no problem exhorting adherence. 15. In retrospect, what were the major failings of the Nortel Audit Committee? Were they the same as those for the board as a whole? As noted in the answer to question 12, the board and the audit committee have overlapping responsibilities. The board of directors failed to oversee management in maintaining an adequate control environment and ensuring the integrity of financial reporting. The integrity and attitude of senior management and the board of directors, including its committees (referred to as the “tone at the top”) is the most important factor contributing to the integrity of internal controls, including those surrounding the financial reporting process. The “tone at the top” becomes the cultural core of the company and suggests a model of appropriate conduct for every level. The audit committee failed, at a more technical level, to oversee the compliance with GAAP and the integrity of the provision process. Moreover, besides their technical accounting role, the audit committee is expected to continuously evaluate specifically whether management is properly promoting an ethical culture (which is supportive of strong internal control systems). To facilitate the review, the committee should request updates and briefings from management and others (internal and external auditors, chief ethics officer, and so on) on how compliance with policies and other relevant company procedures is being achieved. Useful Videos, Films & Links “Canada’s technology star becomes financial black hole” CBC News, Sept. 16th 2009 http://www.cbc.ca/money/story/2009/01/14/f-nortel-backgrounder-january09.html “RCMP lay fraud charges against former Nortel execs” CTV News Video, Jun. 19th 2008 http://www.ctv.ca/CTVNews/TopStories/20080619/rcmp_nortel_080619/ “CBC Archives: In Depth Nortel” CBC News, Feb. 27th 2008 http://www.cbc.ca/news/background/nortel/newsarchive.html ETHICS CASES 1. Adelphia – Really the Rigas’ Family Piggy Bank What this case has to offer This case focuses on the fiduciary duty of managers, directors and auditors and allows examination of the potential implications of family control in publicly-owned companies. It offers a lesson about the importance of an independent and objective Board of Directors that effectively challenges management, with the necessary technical skills and knowledge to understand the business and its financial reporting. Adelphia, controlled by the Rigas’ family, grew rapidly from a local cable company to an international telecommunications provider. However, unrestricted (unchallenged really) access to company resources, allowed executives to use company funds for personal gain. To cover extensive self-dealing and overall poor financial performance, the company understated its debt by $16 billion, overstated revenue, and misrepresented its customer numbers in press releases. As often happens, a person or family that begins a business, or takes it to considerable success, forgets that using money from the public requires accountability to the public and their regulators – they can’t just continue to use company resources as if they were the sole owners with accountability only to themselves. Teaching suggestions I suggest starting by asking students what is the major problem presented by the case and managing the discussion until it produces the paragraph immediately above. This will facilitate a discussion of: • differences between family-owned and publicly-owned businesses, • what the responsibilities are of a public company to its investors, • what these responsibilities imply for the fiduciary duty of managers and directors • what allowed the Rigas’ Family to set these duties aside, and • what barriers should be in place to stop management’s opportunistic behavior? Finally, a discussion is in order of the auditors’ responsibility in case of fraud, and the need for a sound evaluation of potential risks linked to appropriate audit procedures. Discussion of ethical issues 1. What breaches of fiduciary duty does the Adelphia case raise? Fiduciary duty involves the responsibility of a second party to act in the best interest of a first party in a relationship of trust. This duty is especially important when the first party is vulnerable to the actions of the second party. There are four elements to consider in determining breach of fiduciary duty: the duty itself, breach of duty, direct causation and damages. Breach of duty becomes likely when the second party does not behave in a way that a reasonable person acting in the first party’s best interest would have behaved under similar circumstances. Note that professionals are held to a higher standard of care than an ordinary reasonable person would be. They should put the interests of their clients before their own, hold themselves free of conflicts of interest, and be reasonably knowledgeable of their profession abiding a professional code of conduct. Managers and directors are considered trustees of the shareholders’ property. In Adelphia’s case there is a clear breach of fiduciary duty of the Rigas’ family as managers and of all members of the Board, who were supposed to act in the public shareholders’ best interest, but acted against the public shareholders (and other stakeholders) and for themselves, disregarding evident conflicts of interest. As for the auditors’ responsibility to Adelphia’s shareholders, other factors should be taken into account including vulnerability, trust, reliance, discretion and the professional's code of conduct. However, the Auditors would not breach that duty if they performed their audit according to the professional standards of care. 2. Why do you think the Rigas family thought they could get away with using Adelphia as their own piggy bank? A potential rationalization argument is possible if the Rigas’ Family, former sole proprietors of the business, mistakenly think that other minority shareholders “owe” them for creating and expanding the company in their behalf. 3.What allowed the Rigas family to get away with their fraudulent behavior for so long? The Rigas’ family got away with their fraudulent behavior for so long due to several weaknesses in the control environment: Rigas’ Family members occupied key management posts; management’s lack of integrity, poor ethical values, competence, and an understanding of legitimate expectations of ethical behavior; management's aggressive growth philosophy and operating style; family preferences assigning authority and responsibility; and, weak oversight from a non-independent board of directors with a majority of family members. The external auditor’s oversight was limited by management’s misrepresentation. An auditor’s responsibility involves the detection of material misstatements caused by fraud, but normal audit procedures are not directed to specifically uncover fraudulent activity. However, audit risk assessment should include an evaluation for potential fraud, and significant risks should be investigated. 4. What concerns should have been raised in the following areas of risk assessment in Adelphia’s control environment: Integrity and ethics, commitment, Audit Committee participation, management philosophy, structure, and authority? Because the Rigas continually engaged in self-dealing, a demonstrated lack of integrity and ethics was shown. The Audit committee, if one existed, was probably controlled by John Rigas, the CFO. The management philosophy, structure and authority were essentially that of a family-owned business, not of a publicly-traded corporation. 5. What concerns should have been raised in the following areas of risk assessment in Adelphia’s strategy: changes in operating environment, new people and systems, growth, technology, new business, restructurings, and foreign operations? In Adelphia, the need for meeting targets and for keeping the company’s debt levels within market averages provided strong motivation to commit fraud. Opportunity for fraud was present due to lack of independent directors, quick changes in operating environment, and risk of collusion due to family relationships in key management positions. 6. What is your opinion on the importance ofindependence in corporate governance? What are the most recent rules on corporate governance for public firms? Independence is a basic element to ensure objective judgment. Directors and auditors are key control elements that can assess and stop management’s opportunistic behavior in a timely manner. Recent SOX and market regulations, such as the NYSE Corporate Governance Rules, require a majority of independent directors in public companies. Under these rules, no director qualifies as independent unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Companies must identify which directors are independent and disclose the basis for that determination. The relationship includes ties such as previous employment with the company in the last three years, and relationships of immediate family members. As for external auditors, the Sarbanes-Oxley Act and accounting Codes of Professional Conduct require independence from the client in fact and appearance, precluding the auditor from personal relationships with the auditee as partner, shareholder or officer in the year of the audit and a period before and after the engagement. In addition, the audit firm must not provide significant consulting services that may impair professional judgment in auditing the client’s financial statements. Consult the text for SOX/SEC recommendations/regulations. 7. Discuss which changes could be done to the Adelphia’s control system and corporate governance structure to mitigate the risk of accounting fraud in future years. The investing public and lending institutions must ensure that there is sufficient independence of mind and expertise on the board to create and monitor an effective governance system. At the outset, a thorough review of Adelphia’s existing governance system and key people is called for by an independent firm, and key employees (CFO, CIO, Chief General Counsel, Chief Ethics Officer, and Chief Internal Audit Officer) should be replaced. The internal audit group should be charges with ongoing review of the policies and compliance, and should report to the reformed Audit Committee. A protected whistle blowing mechanism should be instituted which also reports on financial and non-financial matters to the Audit Committee and the Governance Committee. SOX/SEC regulations are to be followed, and ethics training is to be undertaken. Above all, executives are to be hired who have demonstrated the proper ethical “tone at the top” and are proactive and outspoken in regard to the need for high ethical standards. 8. What is the auditor’s responsibility in case of fraud? Although fraud risk factors (motive, opportunity, lack of ethics or rationalization) do not necessarily indicate that fraud exists, but often do warn accurately. When obtaining information about the entity and its environment, the auditor should consider whether the information indicates that one or more fraud risk factors are present. Auditors should identify risk factors in planning the audit, in their consideration of internal control and inherent risk, and from past knowledge of the client and the industry. Moreover, they should be aware of the risk factors throughout an audit, not just at the planning stage. 9. What is the proper audit procedure to ensure: a. completeness of liabilities in the financial statements? b. that all related parties have been included or disclosed in the consolidated financial statements? Completeness is the most difficult assertion to prove in auditing financial statements. Looking for missing liabilities or operations with related parties might be very challenging. The first procedure to ensure completeness of such items is to interview management and take their signed statements of representations wherein they declare that the accounts are correct and/or disclose problems such as related party transactions, related companies, and company commitments whether recorded or not. Additional procedures are necessary such as review of the minutes of the Board meetings, review of subsequent events, and the performance of analytical procedures. Discussions may reveal other related interests and/or activities that are worthy of additional scrutiny. Audit professionals who are knowledgeable about the industry and client affairs should apply their knowledge to identify potential risks. Law firms used by the company and the Rigas’ Family should be asked to disclose potential problems that could affect Adelphia or its assets where loans or advances have been made to Rigas’ family members. 10. Do you think analytical procedures would aid the detection of fraud? What is the responsibility of the auditor applying analytical procedures? Applicable analytical procedures include comparisons to industry ratios and reasonability tests. Auditors have to be aware of business trends and relevant statistics. This is the reason why audit partners and audit teams specialize by industry. In this case, for example, the number of subscribers is a key statistic for the analysts following the cable industry. An unreasonable increase of the number of subscribers should be a red flag for the auditor. 11. What should the 450 lending institutions have done to protect themselves from subsequent lawsuit? Lending institutions would be well-advised to create a due-diligence protocol/process for new and existing clients wishing financing that covers the full ethical culture and governance system of the enterprise and the ethics of the transaction proposed. Useful Videos, Films & Links “Rigas Family: Times Topics” The New York Times, Dec. 7th 2010 http://topics.nytimes.com/topics/reference/timestopics/people/r/rigas_family/index.html. • News about Rigas family, including commentary and archival articles C-Span “Adelphia Executives Arrests” Department of Justice, Jul. 24th 2002http://www.c-spanvideo.org/program/171459-1 • Discusses the arrest of several members of Rigas family who were accused of stealing hundreds of millions and causing investor losses of $60 billion while in control of Adelphia Communications. Press Release (2002) “SEC Charges Adelphia and Rigas Family with Massive Financial Fraud” Securities & Exchange Commission, July 24thhttp://www.sec.gov/news/press/2002-110.htm 2.Tyco – Looting Executive Style What this case has to offer Tyco International is one of the most widely known cases of pervasive fraud perpetrated by top executives. Millions in company funds were misallocated, unreported and/or misrepresented by former CEO L. Dennis Kozlowski, CFO Mark Swartz, and General Counsel Mark Belnick. Their personal misuse of funds, lavish expenses, appetite for excesses, and flagrant denial of any wrong-doing are examples of the worst consequences of leaving management without adequate monitoring and restraint. Essentially, Kozlowski, Swartz and Belnick treated Tyco as their private bank, taking out hundreds of millions of dollars of loans and compensation but not telling the directors. This case is interesting because it points out that extreme weaknesses in governance processes, in an environment of deceit, too much trust by directors, and/or low ethical awareness, might open the door for unscrupulous executives to commit and conceal fraud. As such, the case provides a means for exploring governance structure and process, and the roles of the players involved. These players include: directors, executives, external and internal auditors, whistle-blowers, as well as others. Teaching suggestions In order to lay the groundwork on governance and the issues involved in the case and the questions listed at the end, I ask the following questions, in order: 1. How closely should the actions of executives be monitored by the board of directors – very closely, or with a great deal of trust? [Discussion of the role of the Board] 2. How and through what mechanisms and/or individuals should directors get the monitoring information they desire? [Discussion of governance mechanisms and players] 3. How can directors assure that they are getting all the information they need and are not being misled? [Discussion of internal controls, checks, whistleblower schemes …] 4. Could any of the reported self-interested actions of Kozlowski, Swartz, and Belnick be considered reasonable given their position and the size of the company? [Discussion of reasonability of remuneration, perquisites] Discussion of important issues/questions 1. The pattern of illegal and improper conduct described above took place for at least 5 years prior to June 3, 2002. What red flags or governance mechanisms should have alerted the following people to this pattern: a. Tyco management accountants? b. Tyco internal auditors? c. Tyco external auditors? d. Tyco board of directors? In public companies, there is separation of ownership from management. This creates need for a third party monitoring management in behalf of shareholders (i.e. the principal- agent problem) and society. The core mandate of the board of directors is to be this third party overseeing management, and to engage other mechanisms and people to facilitate this function. The board of directors, as part of their stewardship role, should demand from management a complete picture of the company's performance, including financial results, and of the actions of its executives and employees. In order to ensure that such information fairly presents the company's financial situation and actions, the board of directors receives reports from the company's internal auditors on its policies and adherence to them, and hires external auditors to review the company's financial statements and specific other activities. The corporate governance mechanism relies upon policies to guide expectations for behavior, and if these expectations are not met, the independence, objectivity, vigilance, skepticism, and ethical behavior of accountants, auditors and directors should lead to finding and correcting the problem. Therefore: a. Management accountants should have raised their concerns about waste of resources (no value for the company's money) in lavish parties, unreasonable loans to executives and excessive compensation. However, Tyco's accountants might not raise any issues because of fear to their bosses or because some of them were also involved at more senior levels. b. Internal auditors should have detected unusual expenses in the same way as accountants when reviewing the company's operations, executive offices expenditures and management compensation programs, as well as compensation committee minutes and authorities. c. External auditors should have detected very high (i.e. over material) executive expenditures or uncollected loans through their audit procedures, including a review of authorization of material expenses and loans by the company's Board of Directors. The partner in charge of the engagement may not have exercised proper due care or might have decided not to disturb a good relationship with the client. d. Directors should have monitored more closely managements' compensation, opening independent communication channels with internal and external auditors. They should have avoided potential conflicts of interest prohibiting management to receive loans from the company over a certain threshold, and requiring them to ask for pre-authorization of certain expenses, and post-expenditure reporting. 2. Identify and discuss the most important weaknesses in Tyco's a. internal controls and b. governance systems. Internal controls should provide reasonable assurance that fraud will be prevented or detected. A strong control environment constitutes the most pervasive element to deter fraud. Control environment includes integrity, ethical values and competence, management's philosophy and operating style, and the attention and direction provided by the board of directors. In Tyco's control environment, integrity, independence and separation of duties were seriously compromised. Tyco’s policy and/or compliance reinforcement were insufficient to encourage employees who must have witnessed excessive transactions, to blow the whistle. Either they didn’t know what was right, or didn’t know what to do about it, or didn’t have the courage to do so.High level executive collusion went on unreported. The legal department, or office of the general counsel, typically plays a key role in reviewing disclosure documents for compliance with applicable laws and regulations. The legal department also assists management in establishing and maintaining internal controls to prevent and detect noncompliance with other laws and regulations. The General Counsel was also involved in Tyco's fraud with the CEO and CFO. The internal audit function should examine, analyze, and make recommendations on matters affecting the company's policies and internal controls. Internal auditors did not raise any issue regarding anti-fraud controls or management illegal actions. The board of directors has a responsibility to the company's shareholders to oversee management's performance, and relate it to compensation and benefit plans – but they did not do so. At least one of Tyco's directors was receiving additional pay as consultant. 3. Would a post-Sarbanes-Oxley Act whistle-blowing program to the Audit Committee of the board have eliminated the improper and illegal actions? Why or why not? Whistle blowing is one of the most common ways by which fraud is uncovered. Effective whistle blowing programs should be: • Independent • Strictly confidential • Direct line reporting to the board of directors' audit committee • Timely in responding to issues raised • Available and known to all employees • Supported by a companywide ethics awareness program. However, these programs themselves are no guarantee that all improper and illegal actions will be stopped. There is no substitute control for a solid ethical culture within an organization. 4. If you have been a professional accountant employed by Tyco during this time, and you wanted to blow the whistle, who would you have gone to with your story? The first step is to discuss the accuracy of facts with your supervisor and try to escalate the issue using the regular chain of command. If this does not work, you should consider talking to the ethics officer, ombudsman or company's general counsel. However, if this is not possible or not effective, you should then use the company's whistle blower program. If the company does not have an internal whistle blower program, you may use external whistle blower programs including regulators' hotlines or the ethics office of your professional accounting body. The important step is to make sure that the company’s audit committee finds out what is going wrong. Finally, if there is no useful reaction, as a last resort you could talk with your lawyer and consider going public. 5. Why were so many Tyco employees willing to go along quietly with the looting by senior executives? There was a combination of factors: lack of clear communication that unethical behavior will not be tolerated (ethical awareness), bad example set by senior management (tone at the top), lack of effective whistle blower programs, and fear of retaliation from their bosses. 6. How many years in jail do you think Kozlowski should have received for his white-collar crimes? Discussions on this topic are extensive and often involve contradictory ethical and legal arguments. For Tyco's former bosses, their frauds were clear and huge. A significant penalty was important to show that such management misconduct will not be tolerated in public companies, and thus deter fraudsters in similar cases, and to restore investors' confidence that is at its lowest level in years after several fraud scandals involving executives’ opportunistic behavior. Additional Events April 17, 2006. “Tyco to pay $50 million to settle SEC fraud charges” related to the looting of the company according to a report by Kevin Drawbaugh of Reuters in the Toronto Star, April 18, 2006, page C6 May 13, 2006. “Tyco’s Kozlowski to pay millions to resolve tax case”, Bloomberg News, Report on Business, The Globe and Mail, May 13, 2006, page B7. This included $3.2 million in back sales tax, interest and penalties, plus $18 million in back income taxes. The original investigation into Kozlowski’s cheating on the 8.25% sales tax on $14 million in paintings triggered further SEC investigations that led to his ultimate downfall. Useful Videos, Films & Links “The Rise and Fall of Dennis Kozlowski” Business Week Cover Story, Dec. 23, 2002 http://www.businessweek.com/magazine/content/02_51/b3813001.htm?chan=search Tyco Fraud Info-Center http://www.tycofraudinfocenter.com/ “Tyco to pay 50 mln usd to settle SEC accounting fraud charges” Forbes.com, Apr. 18th 2006 http://www.forbes.com/feeds/afx/2006/04/17/afx2675905.html “Timeline of the Tyco International scandal” USA Today, June 17th 2005 http://www.usatoday.com/money/industries/manufacturing/2005-06-17-tyco-timeline_x.htm 3. HealthSouth – Can 5 CFOs Be Wrong? What this case has to offer The HealthSouth case points out how key weaknesses in the corporate governance structure may allow accounting fraud pass without detection, highlighting how difficult is to make CEOs and Directors accountable for such fraud and for the ultimate loss of shareholder value. In spite of the apparently overwhelming evidence of his involvements in the fraud, Richard Scrushy was acquitted while the former CFO's were subject to penalties between 15 and 30 years in jail and fines totalling $11.2 million. This is a good case to discuss the effectiveness of the penalties involved in the enforcement of the Sarbanes-Oxley Act of 2002. In 2002, looking forward to lower Wall Street expectations, the company’s revenue decreased blaming a one-time item, however earnings kept going down progressively thereafter. A year later, a SEC's investigation uncovered serious accounting irregularities. The company overstated revenues for the years 1996-2002 by $2.74 million. Former CEO Richard Scrushy, together with 5 former CFO's and other accounting employees, was charged with accounting fraud under pursuant to Sarbanes-Oxley Act provisions. Crucial accounting lessons from this case include the significant potential role of accruals and adjusting entries in accounting fraud, and the risk of management’s override of internal controls. The accounting manipulation happened right after preliminary end-of-period results were reviewed in management meetings during the “off books” adjusting period. Also, the case provides elements to discuss what the involvement of CEOs and directors should be in preparing financial statements as well as what their degree of financial expertise should be. Needless to say the ethical awareness and sensitivity of participants was severely lacking, as was their ethical courage to say no when asked to undertake unethical and illegal acts. Teaching suggestions I start by asking the students what is the nature and purpose of corporate governance – this is about who controls corporations and why. Then I ask what are the benefits of separation between management and ownership. Thirdly, I ask about management’s responsibility in taking accounting decisions, i.e. who in the company is responsible for accounting choices, what should be the involvement of CEOs and directors in the process for preparing a company's financial statements, and what should be an appropriate degree of accounting expertise for CEOs and Directors. The central issue for discussion, given the finding of the court, is how could accounting fraud happened without the CEO knowing about it, since there is evidence that he told senior accounting officers to “fix” the problem when earnings did not match analysts’ expectations. I link this point with the moral character of the former CEO, since there is evidence that “Earlier frauds, bankruptcies, or questionable business dealings are part of the history of several companies owned at least in part by Scrushy and/or HealthSouth, and controlled by Scrushy with interlocking boards of directors to HealthSouth”. Also it is important to bring out the difficult profit environment for the US Healthcare industry in which HealthSouth stood out. Finally I discuss the accounting entries used to perpetrate and conceal the fraud: reducing a contra revenue account, called “contractual adjustment,” and/or decreasing expenses, (either of which increased earnings), and correspondingly increasing assets or decreasing liabilities. Discussion of important issues 1. What were the major flaws in HealthSouth’s corporate governance?  Overall weak ethics environment/culture, and low ethical awareness and/or low moral courage to report problems  Inadequate understanding of professional duty by professional accountants and lawyers  Inadequate whistle blower process to uninvolved person reporting to the Board  Insufficient oversight of related party transactions  Lack of independence of the board of directors  Inadequate understanding of accounting issues by members of the board of directors  Failure of probing Board Audit Committee  Deficient audit risk assessment and audit procedures 2 & 5. What should HealthSouth’s auditors,Ernst & Young, have done if they had perceived these flaws? What is the auditor’s responsibility in case of fraud? Auditors should use a systematic approach to identify events or conditions that could be root causes of a potential fraudulent action. Fraud is difficult to detect because it is generally concealed by the perpetrators by withholding evidence, misrepresenting information or inquires, falsifying documentation and collusion. Even though it is not expected that normal audit procedures will detect these irregularities, auditors should assess if fraud risk is sufficiently controlled by a combination of prevention, deterrence and detection measures. The auditors’ assessment should include understanding and evaluating the risk factors that indicate incentives and pressures to perpetrate fraud, opportunities to carry it out, and attitudes or rationalizations to justify a fraudulent action. If the fraud risk is considered high, auditors should perform additional procedures to ensure appropriate revenue recognition, existence and ownership of assets, validity of sales, and completeness of expenses and liabilities. In this process, auditors should pay special attention to client’s accruals and audit’s materiality assessment. 3. How – in accounting terms – did the manipulation of HealthSouth’s financial statements take place? On a quarterly basis, the company’s senior officers presented Scrushy with an analysis of HealthSouth’s actual earnings compared with the analyst’s expected earnings. At these meetings, referred as “family meetings”, senior accounting personnel discussed what false accounting entries could be made to meet the expected earnings. The entries primarily consisted of reducing a contra revenue account, called contractual adjustment or decreasing expenses, and correspondingly increasing assets or decreasing liabilities. The contractual adjustment account was a revenue allowance account that estimated the difference between the gross amount billed to the patient and the amount that various healthcare insurers would pay for specific treatments. A $800 million overstatement, equal to 10 percent of the total company’s assets, was book in a fictitious asset line called AP Summary, under Property, Plant and Equipment. HealthSouth accounting personnel designed the false journal entries to avoid detection by the external auditors. For example, instead of increasing revenues directly, the entries decreased the contractual adjustment account; this account had a limited paper trail based on estimates. HealthSouth also knew that the auditors only questioned additions of fixed assets at any particular facility if the additions exceeded a particular threshold. Increasing the AP Summary account the entries never exceeded that threshold. False documents and altered invoices supported additions of fictitious assets. 4. Why did all the people who knew about the manipulation keep quiet? There was a combination of factors, including: lack of clear communication of wholesome company values and expectations respecting shareholders and other stakeholders and that unethical behavior will not be tolerated (ethical awareness); bad example set by senior management (tone at the top); lack of effective whistle blower programs; fear of retaliation from their bosses. There was an unethical culture cultivated by ‘group-think’ about deception. 6. What are the proper audit procedures to ensure existence of assets in the financial statements? What are the proper audit procedures to validate estimates? Physical inspection is the basic audit procedure to ensure existence of assets such as property, plant and equipment. This procedure may be used together with inspection of other corroborative evidence, such as invoices or cheques paid to vendors. Auditors must ensure, subject to a comprehensive materiality threshold, that all assets in the balance sheet exist and also belong to the client. Furthermore, through regular business activities, assets increase as a result of contracting liabilities or from the revenue generating process. Existence and ownership of asset tests also confirm the completeness of liabilities and validity of sales (i.e. pertain to the entity and have occurred in the accounting period). Making an accounting estimate often requires management to develop models and assumptions regarding possible outcomes, including timing, transactions or events that are uncertain at the time of the estimation. Guidance on audit procedures for validating accounting estimates, including materiality and restatements, remains somewhat unclear and dispersed throughout different sections of the Auditing Standards. However, auditors should ensure that the client is using an appropriate estimation model and is considering reasonably accurate assumptions. In some cases auditors may opt for consulting with an actuarial expert when reviewing very material estimates. 7 & 8.What areas of risk can you identify in HealthSouth’s control environment before 2003? What areas of risk can you identify in HealthSouth’s strategy before 2002?  Business risk: An increased business risk gives rise to a higher probability that management will overstate revenue or conceal losses by using incorrect or inappropriate accounting practices. HealthSouth – while trying to meet analysts’ targets – reported profitability and growth were far better than the industry average, while operating in a very competitive industry on a path towards consolidation. Under pressure to maintain good financial performance, others in the industry were involved in fraud at different levels, providing inadequate services, billing in excess and cutting costs beyond reasonable standards.  Control risk: an increased control risk results in a higher chance that management’s manipulation of earnings may occur without detection. The company recruited enthusiastic impressionable young and relatively inexperienced staff from the local community in Birmingham Alabama. They were malleable and apparently easily induced into unethical and fraudulent corporate practices. The CEO’s authority was thus unchallenged. The company lacked effective whistleblower and ethics’ awareness programs. Some participants in the fraud admitted to the U.S. Attorney that they feared physical or psychological retribution if they came forward with details of the fraudulent accounting practices. Over the years, some shareholders complained that HealthSouth was run like a personal company of Mr. Scrushy, with many investments in ventures that stood to be profitable for Scrushy and other executives and directors. Few directors appeared to question Mr. Scrushy or any of his decisions. 9. What changes could be made in HealthSouth’s control system and corporate governance structure to mitigate the risk of accounting fraud in future years? In 2005 the company released restated results for the period from 2000 to 2003. HealthSouth President and CEO, Jay Grinney, estimated that the restatement of the company’s financial statements required more than 1,000,000 of outside consultant hours incurring costs over $250 million. With 3.8 m shares, Richard Scrushy was still member of the company’s board of directors. The following measures may help to improve the company’s governance structure:  Board of directors with more members  A majority of independent directors  More audit committee meetings  Financial experts on the audit committee  Separate CEO and Chairman of the Board roles  Auditor’s and executive’s appointment by recommendation of the Audit Committee  Internal audit functional reporting to the board’s audit committee  Companywide ethics awareness programs  Confidential whistleblower programs for accounting and ethics concerns  see other Sarbanes-Oxley reforms 10. Was Scrushy’s defense ethical? Scrushy alleged he lacked accounting knowledge to understand the fraud and the implication of the proposed journal entries. His defence used several potentially unethical tactics to convince a local court that Scrushy, previously an investment banker, was unaware of the accounting manipulations, including his religious inclinations and folksy character, his support to local causes, and the apparently “dubious moral character” of the CFOs testifying against him. The trial took place in Alabama, and the defendant’s lawyers successfully manoeuvred to have seven blacks on the jury and five whites, all from working class backgrounds. The jurors apparently believed that a CEO could be unaware of manipulations arranged by his company’s accountants, at his direction. On the other hand, a person is entitled to a trial by his peers and their emotions may be appealed to. The court process provides that the opponent’s interests are to be protected, in part by his/her lawyer, as well as the rules of the court. Consequently, it can be argued that unethical tactics, if any, should have been exposed (i.e. rendered impotent) by the opposing lawyer. Sometimes, however, this is not possible, and in this case there may have been other influence attempts made on the jurors inside and outside of the courtroom, such as threats or intimidation implied by the set of black bible class members who sat behind Mr. Scrushy throughout the trial. Useful Videos, Films & Links Weidlich, Thom (2010) “UBS to Pay $217 Million to Settle HealthSouth Case” Bloomberg, Apr. 23 http://www.businessweek.com/news/2010-04-23/ubs-to-pay-217-million-to-settle-healthsouth-case-update2-.html “SEC Charges HealthSouth Corp., CEO Richard Scrushy with $1.4 Billion Accounting Fraud” Securities and Exchange Commission Litigation Release (March 20th 2003) available at http://www.sec.gov/litigation/litreleases/lr18044.htm “HealthSouth Whistleblower Lectures UAB Students on Company Fraud” University of Alabama News http://vimeo.com/7710751 “Special Report: Richard Scrushy Trial” The Birmingham News http://www.al.com/specialreport/birminghamnews/healthsouth/ This site provides the Scrushy indictment, trial details, press releases and SEC filings. “Timeline of Accounting Scandal at HealthSouth” Washington Post, Sept. 30th 2004 http://www.washingtonpost.com/wp-dyn/articles/A24671-2003Oct14.html “Topics: HealthSouth Corporation” New York Times, http://topics.nytimes.com/topics/news/business/companies/healthsouth-corporation/index.html 4. Royal Ahold – A Dutch Company with U.S.-Style Incentives What this case has to offer This case is interesting because it ties stock option compensation and accounting irregularities in a European-based multinational company. Nevertheless, granting management stock options is a common practice in North American companies and some research suggests it is a good mechanism to align managers' and shareholders' interests. The case points out the risks derived from aggressive expansions, joining companies with different control cultures, under pressure to meet analyst expectations. It presents interesting accounting issues including revenue recognition for vendors' rebates, and full control versus joint venture control in consolidation of subsidiaries. Teaching suggestions I start the class with a brief discussion about performance-based management compensation, and the advantages and disadvantages of granting management stock as a way to improve a company's financial results. • Key advantages of stock option compensation: o Motivates managers to improve financial performance, aligned with the personal gain derived from exercising stock options over the company's shares o Reduces the company's cash needs, given that the options granted are not paid in cash, thus making cash available for pursuing growth opportunities o Links rewards with performance in an way easy to understand and control, potentially reducing or eliminating the cost of tracking metrics for performance measurement • Key disadvantages of stock option compensation: o Motivates managers to produce short term gains, disregarding long term results o Causes a dilution effect, reducing shareholders' participation in the company o Poses a threat for the shareholders, as it might be tempting for managers to manipulate public financial results in the absence of effective internal control mechanisms I then introduce the case, explain the background of the company and ask the class to identify the risk elements present before the fraud was uncovered. I also ask about the two accounting issues, and depending upon the accounting foundations of the students, to tease out the proper accounting treatment for revenue recognition for vendors' rebates (no recording of unearned rebates – see below, verification of sales beyond representation letters, comparison to past results), and consolidation of subsidiaries with full control versus joint venture participation (100% profit pick-up vs. percentage pick-up). Next, I ask students what is their opinion of the auditor's role in the case. Some interesting points are: the auditor's responsibility in case of fraud, the auditor's actions after some irregularities were uncovered including the decision of not make them public, and the appropriateness of relevant audit procedures (i.e. preliminary risk assessment and confirmation of receivables). Finally, I wrap up by discussing the appropriateness of the changes made by Royal Ahold in its corporate governance structure in preventing future manipulation of financial results. Discussion of important issues/questions 1. A vendor may offer a customer a rebate of a specified amount of cash or other consideration that is payable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified period of time. When should the rebate be recognized as revenue? At what value should the rebate be recorded as revenue? Cash consideration received from a vendor is presumed to be a reduction in the prices of the vendor's products or services and should be accounted for as a reduction in cost of sales and related inventory, when recognized in the customer's income statement and balance sheet. Amendment to EIC-144 issued in January 2005 requires disclosure of the amount of any vendor allowances that have been recognized in income but for which the full requirements for entitlement have not yet been met. 2. The SEC investigation found the individuals involved in the fraud “aided and abetted the fraud by signing and sending to the company’s independent auditors confirmation letters that they knew materially overstated the amounts of promotional allowance income paid or owed to U.S. Foodservice.” Is the confirmation procedure enough to validate the vendor’s allowance amount in the financial statements? No. While the confirmation process – if properly controlled by the auditor, can be a useful tool, but there should also be a check of some of the actual transactions where the amounts are significant for verification in order to avoid the problem of falsified or misunderstood confirmations. 3. The SEC investigation also revealed “a significant portion of U.S. Food Service operating income was based on vendor payments known as promotional allowances.” How might irregularities have been discovered through specific external audit procedures? Interestingly, Ahold’s auditors, Deloitte & Touche insisted that they warned the firm about problems in its U.S. unit. The auditors also pointed out that Ahold did not supply them with full information. These problems were never disclosed to the public. Deloitte said during the inquiries that they identified the problems during the 2002 audit, and gave the details to Ahold’s Board immediately before the audit was concluded in 2003. Royal Ahold revealed the accounting irregularities voluntarily. Ahold blamed a group of executives of fraud and the company did not face any penalties. See the answer to question 2. Irregularities may generally be discovered by detailed review of transactions, particularly when fraud is suspected or the risk is considered high. There are three common elements present in cases of fraud: motivation, opportunity and lack of ethics or rationalization of conduct. In this case, probable motives were a stock option compensation program and the continuance of a period of aggressive expansion. Opportunity was present because the company did not update its reporting lines, and did not strengthen its internal controls following its high growth period. Also, the culture of the US subsidiary was probably not the same as the culture of the European Parent. Finally, lack of a companywide integrity and ethics program left awareness of ethical issues at the level of the individual. The presence of some of these elements should cause the auditors to set inherent and control risks as high, and therefore compensate with additional detailed test. 4. Royal Ahold made several changes in its corporate governance structure. Discuss how those changes will mitigate the risk of accounting fraud in future years. Ahold undertook several corporate governance changes to prevent future accounting irregularities:  Rotation of the members of the Board of Directors, paying special attention to succession issues, targeting improving their overall independence, objectivity and skills set required to oversee a complex organization;  Thirty-nine executives and managers were terminated, and an additional sixty employees faced disciplinary actions of different degrees, showing that unethical behavior would not be tolerated;  Developed a one-company system with central reporting lines, facilitating division of duties and authorization of non-routine transactions.  Initiated a company-wide financial integrity program aimed at 15,000 managers, raising overall ethical awareness. However, other measures might also be appropriate including an accounting concerns hotline and ongoing approval of performance based compensation programs by the Board of Directors. Related Events May 22, 2006. “Ex-Ahold executives fined for fraud”’, Toby Sterling of Associated Press, Toronto Star, May 23, 2006, page C4. In a very disappointing ruling, the CEO and the CFO were each fined 225,000 euros (approx. $300,000) and given nine-month suspended sentences for falsely asserting that companies in Brazil, Argentina, and Scandinavia should be consolidated because they were fully controlled when only 50% of them were owned. According to the judge, neither of the men benefited personally as a result of the resulting overstatement of profits. The CEO is estimated to have been worth 43 million euros. Useful Videos, Films & Links Mui, Yian (2006) “Royal Ahold to Sell US Foodservice Unit” The Washington Post Nov. 7thhttp://www.washingtonpost.com/wp-dyn/content/article/2006/11/06/AR2006110600290.html Crouch, Gregory & Jennifer Bayot (2003) “Market Place; Royal Ahold Accounting Scandal Leaves Dutch Employees with Heavy Debts” New York Times Feb. 26thhttp://www.nytimes.com/2003/02/26/business/market-place-royal-ahold-accounting-scandal-leaves-dutch-employees-with-heavy.html?scp=11&sq=Royal%20Ahold&st=cse SEC Charges Royal Ahold and Three Former Top Executives with Fraud; Former Audit Committee Member Charged with Causing Violations of the Securities Law” Securities and Exchange Press Release, Oct. 13th 2004 http://www.sec.gov/news/press/2004-144.htm “Ahold Europe’s Enron” The Economist, Feb. 27th 2003 http://www.economist.com/node/1610552 5. The Ethics of Bankruptcy: Jetsgo Corporation What this case has to offer This case presents a true story of firm that used deception and lies, called ‘white lies’ by the owner of the airline, to minimize the cost of bankruptcy. It allows students to discuss the concept of lying, understand its consequences, and determine if there are any situations in which lying is an acceptable business alternative. Teaching suggestions Before discussing the details of the case, there should be two general discussions: the first on the nature of bankruptcy and purpose of bankruptcy laws, and the second on the ethical aspects of lying. Darwinian economics argues that bankruptcy is a natural event. Firms that cannot effectively compete are forced out of the marketplace. In the struggle for survival only efficient and effective firms survive. Because of the high cost of going bankrupt, firms will strive to ensure that they provide the goods and services that people need and want in an effective and efficient manner in order to generate sufficient positive cash inflows to remain economically viable. Bankruptcy protection laws are intended to allow a period of time for firms to reorganize. Firms are provided protection from creditor claims under laws such as Chapter 11 of the United States Bankruptcy Code or the Companies’ Creditors Arrangement Act in Canada. The purpose of these laws is not to help firms avoid their economic obligations. Instead, they remove some of the financial pressure, thereby allowing the firm to rearrange certain aspects of its operations and structures so that it can resume its place as an on-going business. Lying is a lapse from moral idealism. Sissela Bok (1978) argues that when wrongdoing, such as lying, is excused (“Nobody is getting hurt and I can’t afford to do otherwise.”), trivialized with a euphemism (“Everybody does it. It’s just the way the business world works.”) or denied (“Nobody cares about this anyways.”), then it may be an example of succumbing to pressure. The liar must identify the pressures that are causing the person to be hypocritical. She also notes that what the liar perceives to be harmless, a white lie, may not be so in the eyes of the one who is being deceived. Discussion of ethical issues 1.For many organizations, bankruptcy protection is just another operational and financial strategy. Discuss the ethical aspects of intentionally remaining silent, collecting money and then suddenly announcing that the company is bankrupt? Bankruptcy protection laws can be abused when solvent firms enter bankruptcy as a cost effective strategy. The firm may use bankruptcy protection to: - avoid making legitimate payments, - adjust pension plans without consolation or renegotiation with employees, - break union agreements, and /or - circumvent terms of contracts. Bankruptcy laws are not intended to help firms to entirely avoid their obligations. As such, a key ethical aspect is to investigate whether all stakeholders are being treated fairly. These aspects can be addressed by asking the following questions. - Is the firm using the bankruptcy laws in ways in which they were not intended? Are solvent firms using them as a cost effective means to avoid honoring their legitimate liabilities? - If bankruptcy is just another cost-effective financial stratagem, then does this encourage firms to take unnecessary risks? If the risky venture succeeds, then the firm benefits. But if the venture does not succeed, then the firms can easily move in and out of bankruptcy, with only the creditors suffering as their claims are not fully honored. 2. Do you accept that the little ‘white lie’ told to the pilots was justifiable? A white lie is often used to protect the feeling of another. Complementing someone’s hat or attire is a social nicety. The problem with the white lie is that the recipient of the lie does not know that the comment is untrue. In the Jetsgo case, LeBlanc feared that the pilots would not fly the planes to Quebec City if they were told the truth. So, this is not a white lie in which the truth was altered as a polite social gesture. Instead, it is a deception intended to benefit only the liar. The central problem with deception is that it tends to erode trust, which is a key element in the economic system. 3. Was it operationally wise for Jetsgo to keep the online reservation system open until the company officially declared bankruptcy? Was it an ethically correct or incorrect decision? Keeping the on-line reservation system open all day on March 20, when he knew it would be permanently closed at midnight that evening was a deception and very unfair to many passengers. These people made their reservations in good faith were misled and deluded into thinking that their reservations would be honored and that their flights would occur as scheduled. Deception is considered to be unethical because the people who are lied to are not allowed to make an informed decision. They are being treated as means to achieve the liar’s objective. As result, when the subterfuge is discovered, they normally feel wronged and manipulated. 4. Should Leblanc have waited until the busy Spring-break holiday period was over to then close down operations? Laura Nash (1990) notes that unethical behavior and actions often occur because managers ask the wrong questions. - Instead of asking whether this will reduce costs, or achieve a personal objective, ask whether this is consistent with the values the firm. Will this decision result in value creation? - How will this decision affect the quality of the firm’s relationship with its customers? If the manager cannot answer these questions positively, then the manager may be in the wrong line of business. Perhaps, Jetsgo should not have been in the discount airline business. Perhaps the financial and ethical obstacles were too great. If a manager feels that deception, lying and subterfuge are the only means to staving off bankruptcy, then perhaps the manager should admit that operating the business successfully is beyond his capabilities. In such situations, the ethical alternative is to hire good talent to run the firm or rearrange the business model so that lying, deception and subterfuge are not part of the operating strategy of the firm. References Bok, Sissela. 1978. Lying: Moral Choice in Public and Private Life (Random House) Nash, Laura. 1991. Good Intentions Aside: A Manager’s Guide to Resolving Ethical Problems (Harvard Business School Press). Useful Videos, Films & Links “Jetsgo lost $55 million in 8 months, court told” CBC News Friday March 11, 2005http://www.cbc.ca/canada/story/2005/03/11/jetsgo-lapierre050311.html Alexander, Doug (2005) “Canada’s Jetsgo Ceases Operations, Stranding 17,000” Bloomberg, March 11 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLSjmZ0MF7lM&refer=canada Austen, Ian (2005) “Canada Suddenly Grounds All Flights” New York Times, March 12 http://query.nytimes.com/gst/fullpage.html?res=9F0CE1DA143CF931A25750C0A9639C8B63 “Jetsgo’s founder Leblanc says he is sorry” CTV News Video, March 18, 2005 http://www.ctv.ca/CTVNews/TopStories/20050318/Jetsgo_apology_050317/ “Discount airline Jetsgo declares bankruptcy” CTV News Video, May 14th 2005 http://www.ctv.ca/CTVNews/Canada/20050514/jetsgo_bankruptcy_20050513/ STOCK MARKET CASES 1. Société Générale Rogue Trader What this case has to offer Rogue traders, such as Jérôme Kerviel, can severely damage an organization, such as Société Générale (SocGen), or even bankrupt a firm, as did Nick Leeson’s rogue trades that brought down Barings Bank. It is important that students remember that • no internal system can prevent all rogue trades from occurring, • there is a cost-benefit trade-off when installing internal controls, and • it is important to have a positive organizational culture that does not encourage rogue activities. Teaching suggestions The class can begin with a discussion of the key elements of corporate governance and accountability. They can discuss • how an organization could unintentionally install a negative organizational culture, and • how that negative organizational culture could be re-enforced. Then the students can discuss the opposite. • The elements that would go into developing a positive organizational culture, and • how the organization could reinforce that positive organizational culture. Afterwards, the questions at the end of the case could be taken up. Discussion of ethical issues 1. Did Jérôme Kerviel perpetrate a fraud? Why or why not? Fraud is a legal concept. Essentially it means that an individual or organization intentionally deceived another for personal gain. In this case, Kerviel did not personally gain from his unauthorized trades nor was he convicted in a court of law of having perpetrated a fraud on anyone. However, he was guilty of a breach of trust. His employer, SocGen, was relying on him to stay within his proscribed trading limits, which he failed to do. As such, he did violate the trust that SocGen had placed in him. 2. When such mammoth unauthorized trades occur, and the bank is bankrupted or severely damaged financially, should the board of directors, who have the ultimate responsibility for the bank’s activities, or its executives whose job it is to protect the bank, go to jail rather than the rogue trader? The board of directors has the responsibility of overseeing management, and management has the responsibility of ensuring that the organization operates in an efficient and effective manner within the law and in accordance with standards of normal ethical business behavior. If people fail to live up to their responsibilities, they should be held accountable for their shortfalls. This means that management should be held accountable for the activities of its employees if those employees are not properly trained and supervised. The report of the special committee of the board highlighted numerous failures of management to install effective internal controls. As such, management is partially responsible for the loss and therefore should be disciplined. The degree of the disciplinary actions would be a function of management’s degree of culpability in not installing adequate controls to supervise employees. Jail for directors or management would be unlikely unless it could be shown that the individuals involved recognized that a problem existed and purposely failed to take action to prevent it. Fines would be a more normal sanction to be applied. 3. Were the bank’s actions in liquidating Kerviel’s positions ethical? Unfairness in financial markets can occur when there is volatility, i.e., when there is a mismatch between buyers and sellers. Although the market will eventually correct for any mismatch, during the mismatch period, investors may be harmed by either paying to too much or selling too low. The size of SocGen’s liquidating trades was equal to eight percent of all trades that were conducted on the various exchanges in that three day period. Eight percent of all trades may be enough to move the marketplace. The bank was concerned that if they revealed the magnitude of the anticipated trades that this information might adversely affect the price the bank would receive. This, in turn, might increase the size of the bank’s losses. On the other hand, by flooding the market over a three-day period, the bank may also have been creating an unfair marketplace in which prices did not reflect all available information. In other words, investors could have sold at prices that were too low, and investors purchased without knowing all of the market risks. 4. Did the French officials who authorized the liquidation behave ethically? In the U.S. the Securities Exchange Act of 1934 authorizes the SEC to intervene in the marketplace to correct any volatility or excess price swings thereby ensuring ‘fair and orderly’ markets. This suggests that the French officials who authorized the liquidation were acting in an ethical fashion, but that they should have intervened if they thought that the size of the Bank’s trades was unfairly moving the marketplace. 5. There is considerable debate about whether better controls can ever stop a rogue trader. What is your opinion, and why? There is a trade-off to be considered for all internal prevention costs between their costs and their benefits. It would be cost prohibitive to install a control system that completely prevented rogue trades from occurring. That is why it is important to develop a much more cost-effective, positive organizational culture that will discourage rogue activities. It is important that organizations carefully screen their employees to ensure that they do not put into a position of trust a person who lacks the moral fiber to not abuse that trust. It is also important that employees see that the organization is monitoring and supervising them. This shows employees that if they engage in rogue trades their activities were will be caught. A rogue trader would also be dissuaded by the prospect of heavy sanctions. 6. If enhanced controls really can’t stop all rogue traders, how are companies to be protected from them? Companies can protect themselves from rogue traders by install the key elements of corporate governance and accountability that are outlined in Chapter 5, especially those elements that are summarized in Figure 5.7 on page 257. Useful Videos, Films & Links Nicholson, Chris (2010) “Kerviel: Bosses Never Said a Thing” New York Times, Nov. 17thhttp://dealbook.nytimes.com/2010/11/17/kerviels-comeback-they-never-said-a-thing/ Clark, Nicola (2010) “Rogue Trader at Société Generale Gets 3 Years” The New York Times, Oct. 5thhttp://www.nytimes.com/2010/10/06/business/global/06bank.html?_r=1&partner=rss&emc=rss “Société Generale trader Kerviel says risks ‘encouraged’” BBC News, June 8th 2010 http://www.bbc.co.uk/news/10259720 2. Galleon’s Insider Trading Network What this case has to offer This case is the story of an apparently successful hedge fund manager that based his trading strategies on inside information from tipsters and not on sound market research. Billionaire Raj Rajaratnam used a vast network of contacts to profit from tips on non-public information from a number of companies such as IBM, Google, Hilton Hotels, and Intel. This is a very good case to discuss what constitutes inside information and insider trading. It represents the first time that wiretap information was allowed to be used as evidence in insider trading cases, and therefore lifts the veil of secrecy that prevented earlier attempts at prosecution. Teaching suggestions I start the discussion asking students how a trader, or hedge fund manager, can gather information to develop a successful trading strategy. I then ask for an explanation of the concept of illegal insider trading and discuss the apparent fine line between gathering information and obtaining confidential information from insiders. After discussing some of the key case facts, I ask students whether or not Galleon’s trading was illegal and/or unethical. Finally, I highlight two takeaways from this case, first, that given that insider trading is illegal it should be persecuted as any other form of fraud; and second, that the liability for insider trading violations cannot be avoided by passing on the information as long as the person receiving the information knew or should have known that the information was confidential to the company (i.e. was its property) and its insiders. I also point to the change in potential for prosecution that wiretap evidence will bring in the future. Discussion of ethical issues 1. Should inside traders, who are non-violent, white collar criminals, be subject to Mafia-style investigation tools? Insider trading is a crime equivalent to theft. The U.S. Supreme Court explicitly adopted the misappropriation theory of insider trading in the case United States v. O'Hagan. The U.S. SEC guidance on insider trading cites the Supreme Court’s decision as a legal landmark in making insider trading a crime: “In the course of its opinion, the Court identified two discrete arguments for prohibiting insider trading. First, the Court stressed that prohibiting insider trading is: . . . well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence. Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated non-public information is unchecked by law. An investor's informational disadvantage vis-à-vis a misappropriator with material, non-public information stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill. Second, the Court acknowledged the "information as property" rationale underlying insider trading prohibitions: A company's confidential information . . .qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty . . . constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another.” Given the criminal nature of insider trading, regulatory agencies can and should use any legal means to collect evidence to prosecute insider trading. The consequences of insider trading can be very severe for those who suffer loss. 2. How can a stock trader know when she or he is receiving inside information that would be illegal to act upon? It is not always easy to decide whether or not trading on certain information can be deemed insider trading. The SEC guidance on insider trading explains that; “Illegal 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, non-public information about the security.” Furthermore, a fundamental component of illegal insider trading is being aware that certain information is non-public: “Rule 10b5-1 provides that a person trades on the basis of material non-public information if a trader is "aware" of the material non-public information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.” As a way to avoid illegal insider trading, Rule 10b5 establishes that: “A person other than a natural person also may demonstrate that a purchase or sale of securities is not "on the basis of" material non-public information if the person demonstrates that: The individual making the investment decision on behalf of the person to purchase or sell the securities was not aware of the information; and The person had implemented reasonable policies and procedures, taking into consideration the nature of the person's business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of material non-public information. These policies and procedures may include those that restrict any purchase, sale, and causing any purchase or sale of any security as to which the person has material non-public information, or those that prevent such individuals from becoming aware of such information. Based on the above guidance, if a trader receives or seeks to obtain direct information from an insider and that information is believed to be non-public, it is the trader’s personal responsibility as well as his firm’s responsibility to avoid trading on such information. In such cases, the trader or his firm could seek additional legal counsel if it is not a straight forward case to determine if the information received could be considered insider information. 3. How can a stock trader avoid using insider information? The answer to this question is related to the answer of the previous question. Using insider information is directly linked to the means to which a trader obtains information. If direct information is obtained from a person with a fiduciary duty and that information cannot be found or directly inferred from publicly available information, that information should not be used by a trader. Most cases of insider trading involve not only one instance but several instances where traders used non-public information. Furthermore, illegal insider trading cases may be detected through market surveillance systems. Regulators can use computer programs to find changes in volume and price that are outside normal patterns. Trading just before a major corporate event is a red flag for illegal insider trading. 4. Would a private investor be subject to the same rules against using insider information as a stock trader? The same rules apply for private investors as for stock traders. In fact, the SEC has enforced insider trading rules 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 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. 5. Should a person giving a tip (the tipper) be subject to the same penalties as the user (the tippee)? The liability for insider trading violations cannot be avoided by passing on the information as long as the person receiving the information knew or should have known that the information was company property. Insider trading violations also include tipping information. A person giving a tip is an accomplice of the person using the information. All parties that may have been involved are at risk of being found guilty of insider trading. References U.S. Securities and Exchange Commission. 2011. Insider Trading. http://www.sec.gov/answers/insider.htm U.S. Securities and Exchange Commission. 1998. Speech by SEC Staff: Insider Trading –A U.S. Perspective. http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm 3. KPMG Partner Shares Confidential Information with a Friend – located in Chapter 6 4. Conflicts of Interest on Wall Street What this case has to offer This case illustrates some of the complex set of conflicts of interest that exist in the investment community, and offers the opportunity to discuss some of the means available to manage them. It represents the first occasion where an enterprising District Attorney took the lead on a securities case when the SEC and other agencies rune by friends of Wall Street were slow to act. Eliot Spitzer, the DA involved, made things happen that should signal changes on the Street. Teaching suggestions I start off by asking by Eliot Spitzer acted when the Sec and other agencies did not. This sets the stage for a discussion of conflicts of interest, and those shown in the case (question 1). Then I turn to the penalties assessed, and their adequacy. Question 2 about the adequacy of the rule changes comes next, followed by questions 3 and 4. Discussion of ethical issues 1. Identify and explain the conflicts of interest referred to in this case? The following conflicts are identified in the case: • Self-interest of brokers vs. the interest of investors: • Brokers and brokerages have investments on which they speculate and do not disclose their own interests fully, but upon which they also advise investors who expect the brokers to act only in the investors’ interest, • Self-interest of analysts vs. investors: • Analysts tout investments that they believe are poor because: • They are remunerated from profits for IPOs or trading in those investments • They are influenced to do so to benefit others – children in a private school • Their bosses tell them to • They want to curry favor with repeat issuers of IPOs, or excellent prospect for future investment banking business • Self-interest of retail brokers getting early information on IPOs vs. the public who cannot and therefore invest in an unfair market. 2. What additional rules should the SEC make? The SEC should consider instituting additional rules such as: • Investment firms should disclose their investment positions to their clients whenever they are buying or selling a stock, bond or commodity they have a position in for that client • A code of behavior should be developed covering analysts, brokers and so on, and compliance programs should be developed and monitored, with appropriate sanctions • And so on. 3. What should be included in the investor education that the settlement funds are earmarked for? The objective here is to encourage discussion and thinking in the class about the knowledge required by investors, and the investment community. The investor education program should contain such programs as web-based, easy-to-access, self-training for investment assessment in various levels from elementary to advanced, potential conflicts of interest to be aware of, risks to be aware of in investments, ongoing timely commentaries by leading knowledgeable analysts, and so on. It is too bad some money cannot be spent on ethics programs for investment analysts and brokers, and on compliance programs for them. 4. Was it appropriate for the New York Attorney General’s Office to have become involved in securities regulation, or should this have been left to securities regulators? Yes, Eliot Spitzer’s initiative was timely and had a beneficial impact. The problem arose in his geographic jurisdiction, and it was not so arcane that it was beyond the capacity of his office to correctly consider and arrive at a just result. The SEC does not have exclusive jurisdiction over malfeasance in the securities field. Useful Videos, Films & Links Berenson, Alex & Andrew Ross Sorkin (2002) “How Wall Street Was Tamed” New York Times, Dec. 22 http://www.nytimes.com/2002/12/22/business/how-wall-street-was-tamed.html Valdmanis, Thor (2003) “Few believe $1.4B deal will change Wall St.” USA Today, April 29thhttp://www.usatoday.com/money/industries/brokerage/2003-04-29-settle-cover_x.htm “Eliot Spitzer Talks to Fareed Zakaria about Wall Street Bonuses (Video)”| Huffington Post Jan. 17th 2010 http://www.huffingtonpost.com/2010/01/17/eliot-spitzer-talks-to-fa_n_426422.html Ignatius, Adi (2002) “Eliot Spitzer: Wall Street’s Top Cop” Time, Dec. 30thhttp://www.time.com/time/magazine/article/0,9171,1003960,00.html “The Bias of Wall Street Analysts” Harvard Business School, Oct. 8th 2004 http://hbswk.hbs.edu/item/4430.html 5. Loyalty, But to Whom? What this case has to offer Too often, employees misguided by thinking too narrowly and/or too short-term about the benefits and costs of their actions. Many employees act to satisfy interests that conflict with the legitimate, ethical strategic objectives of their employer, or of their profession, or even of themselves in the longer term. This is a case that illustrates how a well-intentioned but short-sighted action caused a lot of trouble for the actors and the employer. This sub-optimal decision making is one of the problems that trouble governance systems, and underscore the need for a strongly supported, well-developed ethical corporate culture to provide the necessary guidance for employees. Glen Grossmith told me that he was just trying to help a team-mate – a guy with whom they had worked for quite a while. At the time, he didn’t see significant harm in doing what he did. As noted at the conclusion of this note - this case illustrates that a consequentialist or utilitarian approach needs to be supplemented with both deontological and virtue expectations approaches to yield a sound, defensible, and ethical decision. Teaching suggestions This case identifies a common occurrence that students should be able to identify with. The reasoning behind “take one for the team” or “help the team” “group think” is what keeps police and unions from whistle-blowing on each other, and for other employees to rationalize not behaving according to company goals. Referring to the police and the union mores will bring the problem into focus, but the instructor may not want to do this at the outset – preferring instead to introduce the extra examples when the class has defined the problems and issues inherent in the case. I would suggest asking for the class to define the problems and issues inherent in the case, introduce the extra examples, and then take up the questions posed at the end of the case, followed by a summary of the material in the ‘What this case has to offer’ section above. Discussion of ethical issues through the case questions 1. Loyalty is a highly desirable ethical value, and disloyalty is serious unethical and often illegal activity. Explain how and to whom Grossmith, Horcsok, and Webb (G, H, and W) were disloyal. G, H, and W were disloyal to UBS because they did not follow its ethical guidelines, which were intended to protect the integrity of clients and hence the market. They were disloyal to the U.S. client and perhaps to a professional body they might be members of that specified a code of conduct. Loyalty involves respecting the interests of others and not acting contrary to the best interests of clients, their employer, and the market regulators. 2. Although Grossmith’s actions did not negatively affect the wealth of any client, why did UBS fire him? Glen was probably fired because he knowingly falsified documents, and in so doing broke company policy, and market regulations. He was a two-time offender. Also the company needed to show an example of their vigilance so that the rest of their employees would get the message as well as the regulators. In the end, if regulators had not been satisfied that UBS was enforcing the company code and ethical culture, the company, its executives and directors could have been vulnerable to charges of failure to maintain proper governance oversight and procedures. Finally, the company may have seen the firing as a chance to save the bonus money, but this is probable too cynical. 3. How should an employer like UBS encourage employee loyalty? An employer needs to mount a comprehensive ethics program that includes clear guidance to employees, with appropriate training, monitoring, rewards and sanctions. Above all, employees need to understand why loyalty is important to themselves, to their clients, the employer, and to the market. Most importantly, top management must ‘walk the talk’. Because they do not see any harm from unethical and sometimes illegal actions does not make them OK or permissible. A consequentialist argument (the end justifies the means) would lead the employee astray in these cases. This case illustrates that a consequentialist or utilitarian approach needs to be supplemented with both deontological and virtue expectations approaches to yield a sound, defensible and ethical decision. Useful Videos, Films & Links “Former UBS traders fined, suspended” CBC News July 18th 2005, http://www.cbc.ca/money/story/2005/07/18/ubs-050718.html “Former Senior Traders of UBS fined by RS for Violating Trading Rules” Market Wire, July 18th 2005, http://www.marketwire.com/press-release/Former-Senior-Traders-of-UBS-Fined-by-RS-for-Violating-Trading-Rules-548820.htm 6. Bankers Trust: Learning from Derivatives What this case has to offer Bankers Trust is the story of a company that emphasized maximizing profit at almost at any cost. Certainly, its employees placed earning commissions before the interests of their clients. Therefore the case illustrates the operating value differences between “buyer beware” and “seller beware”, and it shows that Bankers Trust (BT) did not have high interest in the fiduciary responsibilities that have motivated the brokerage community to institute “know you client rules” etc. Conflicts of interest abound, and unfair sales practices, non-compliance with company policies, taped conversations (privacy), and charges of using RICO as a blackmail tactic are issues well worth discussing with your class. Teaching suggestions/Discussion of ethical issues I would suggest beginning the case by having someone in the class give a recap of it. I would then ask what the class understood by the term derivatives, and how they think the derivatives that BT was selling worked, in general. In this case, although the details of the contracts are not known precisely, it would appear, since P & G would make money if interest rates went down and lose if rates went up, that the derivative contracts cost $195.5 million more than P & G expected due to interest rate increases. This loss is high, in part, because P & G leveraged their contracts, so a small investment could give rise to a big win or a big loss. The next matter to deal with is whether BT was acting as a principal or an agent when selling the derivative contracts to P & G. What did BT think, and what did P & G think? What does the class think? If BT was acting as an agent, then P & G has the right to expect BT to act in P & G’s best interests. If BT was acting as a principal, and P & G ought reasonably to have known this, then P & G would not expect BT to be acting in P & G’s best interests and presumably should/would have instituted defense mechanisms to guard against being taken advantage of. Modern stockbrokers are in much the same position in that they sell some securities (bonds) from their own inventory for profit and some they arrange for the client to purchase with a commission to the broker. Modern stockbrokers are expected to discharge their fiduciary responsibilities to their clients by assessing their knowledge level, risk preferences and ability to sustain losses etc. under “know your client guidelines.” If the stockbroker advises a client to invest in a security beyond a reasonable risk level for that client, the stockbroker is liable to receive a fine and is subject to lawsuit for failing to discharge their fiduciary duties. Also, if a modern stockbroker fails to notify his/her client that a sale is being made as a principal rather than as an agent, the sale can be overturned and the broker fined. Modern laws have made it dangerous for a broker to ignore these conflicts of interest. For normal clients of stockbrokers, the operating policy of seller beware is now in force rather than that of buyer beware as it had been up until about 1990 or so. However, the question is: Was P & G a normal client? The answer is no because it was a big multinational and had a massive portfolio including derivatives that it had managed for years. I then ask: Did the BT salesman take unfair advantage of P & G even though P & G was an expert client, and does that make any difference? Unfortunately for BT, according to the tapes, the BT salesman knew that P & G did not understand the leverage aspect of the transaction he had sold them. Therefore he knew he was taking advantage of P & G. Moreover, since the loss could be astronomical, it could be argued that he was taking unfair advantage of P & G. What does the class think? At this stage you have the answers to questions 2, 3, and 4, and I would recap them or ask the class their views, and I would then press on with question 1. The settlement has never been publicly released so we don’t know the specifics as yet. Question 5 is intended to bring together the other issues of the case, including: Unethical corporate culture of BT The buyer beware/profit at the expense of our clients attitude that was fostered at BT got BT into great difficulty and threatened its reputation worldwide. It was a policy that did not foster the continued support of its clients who are a most important stakeholder support group for any company. As such it was an unsustainable strategic building block. Was P & G responsible? No. Its internal policies were not followed, and its personnel did not understand the risk involved in the contracts. They tried to get P & G to explain, but P & G refused to show its proprietary risk model, and knew that the client had not grasped the explanation. P & G could have been more responsible and so should probably share some of the loss. Privacy of taped conversations Usually this is unethical. However, conversations are usually taped in the brokerage industry in order to verify who said what at a later date. Moreover, the parties are told that the taping is occurring and tacitly agree to it. RICO blackmail By adding RICO charges to the lawsuit, P & G was upping the risk of loss from the lawsuit substantially. Presumably, if the RICO charge was frivolous, the cost to get it dismissed would have involved legal and investigative time, but not a triple pay out. Therefore it would not have increased the settlement much unless the charge had some merit. The claim of “blackmail” was probably a counter-ploy to relieve the stress on BT’s reputation and put P & G somewhat on the defensive. The RICO issue probably hastened a settlement. You might ask the class: Does the end justify the means? Useful Videos, Films & Links Holland, Kelley et. al. (1997) “Cover Story: The Bankers Trust Tapes” Business Week, June 13thhttp://www.businessweek.com/1995/42/b34461.htm Andrews, Edmund (1998) “BANK GIANT: THE OVERVIEW; Deutsche Gets Bankers Trust for $10 Billion” New York Times, Dec. 1sthttp://www.nytimes.com/1998/12/01/business/bank-giant-the-overview-deutsche-gets-bankers-trust-for-10-billion.html “Derivatives: Alive, but oh so Boring” Business Week, Jan. 30th 1995 http://www.businessweek.com/archives/1995/b340981.arc.htm 7. Barings Bank: Rogue Trader What this case has to offer Nick Leeson was definitely a rogue trader, but he didn’t get into trouble on his own – he had help. The story of how he did so involves conflicts of interest, a poor corporate ethical culture and compliance system, misguided motivational systems, poor control reports, and unwitting advice from senior management. Conflicts of Interest, Cultural Aspects, Relevance of Controls This case offers interesting insights into typical problems in the three areas noted. Students can readily see the common conflicts faced by employees, management and owners, and how these groups can be blinded by tradition, habit and the erroneous assumption that everyone is honest – or at least they won’t bite the hand that feeds them. The experience of forensic investigations experts given in the text at page 225 provides an interesting insight on this as it suggests that as many as 60% of employees will commit a fraud if given the chance, and a further 20% will do so without any opportunity. Therefore only 20% of employees can be relied upon not to commit a fraud under any circumstances. The theory is based on expert observer experience and not on rigorous scientific testing, but it is probably not far off. Would you gamble on a 20% chance of winning? That’s what managements do that work on faith without adequate controls. Teaching suggestions I would begin by having a class member or two recap the salient points of the case. This should show that Nick was operating on his own. He had evidently decided to make unhedged investments on his own to increase his profits to recoup his losses that had been hidden in the Error Account No. 88888. He was in control of the investment operation and the record-keeping back office that should have provided information that would have brought questions on his increasing losses and need for cash. The Head Office of Barings had warnings in term of reports of potential lack of control and of the need of lots of cash, but did nothing because they thought Leeson was making a lot of money, and they were needy and greedy. I would also ask for a clarification of how Leeson was making his deals to see that the class understood derivative investments. I would then ask the questions posed at the end of the case. Discussion of ethical issues 1. How would you deal with a star trader who would be extremely sensitive to additional controls that implied he or she wasn’t trusted or would generate more time on paperwork and explanations? Unfortunately, exceptions to compliance or control systems usually end up badly. The star gets into trouble because s/he are unaware of problem areas, or think that rules are not for them to observe. Therefore, the star must be convinced or cajoled into accepting the ethical culture and compliance system. Top management must set a strong, committed example, and be convinced what they are doing is important or else the star may not accept the overture. The star may well respond to a self-interest argument – that the system will protect the reputation and financial health of the organization, and thereby protect him from other employee actions. He, as a leader should serve as a good example to others. After all, he wouldn’t want to see another case like Barings Bank, or… 2. What ethical and accounting controls would you advise ING to institute at Baring’s? I would recommend instituting the following in order to move the firm away from reliance on faith in the “old boy” or “old school tie” networks:  a full ethical culture program, including: a code of conduct, training, initial and annual sign-off, reinforcement and encouragement mechanisms, whistleblower protection plan, generic reporting to a board committee, etc.  daily (on-line if possible) report of hedged and exposed securities positions sent to upper line management and top management,  daily, or online if possible, report of cash flows of over $50 million (10% of equity) to be sent to upper line management and top management.  separate supervision of trading (front) and record-keeping (back) offices,  have internal audit check that all company policies are followed, and report to an Audit Committee with non-employee Directors from the Board on it (who are supposed to be protecting the public interest) so that actions are not ignored without outside Directors knowing about it. 3. Who was more at fault – top management or Nick Leeson? Management was more at fault than Nick Leeson. They had early warning of inadequate controls and did not do their job as stewards of the company assets to protect them. They could have moved much earlier and have prevented the bankruptcy and takeover. Leeson is not blameless, of course, but it is the old story of someone leaving something of value open to misuse (a pie on the window sill) thus tempting someone else to steal or misuse it. Leeson went to jail for about two years and is now in poor health, and the Barings lost their Bank. Is this fair? Useful Videos, Films & Links 25 Million Pounds – 1996 Documentary film about Nick Leeson & The Barings Bank Collapse by Adam Curtis, available at http://www.blatantworld.com/documentary/25_million_pounds.html Rogue Trader: How I Brought down Barings Bank and Shook the Financial World1996 autobiography by Nick Leeson written while in prison Norris, Floyd (1996) “Upper-Class Twists Made Me Do It” The New York Times, Mar. 31sthttp://query.nytimes.com/gst/fullpage.html?res=9C03EFDF1239F932A05750C0A960958260 Rouge Trader (1999) movie about Nick Leeson by James Dearden CASES ON PRODUCT SAFETY 1. Dow Corning Silicone Breast Implants What this case has to offer This case offers the chance to examine why an excellent code of conduct, and an excellent ethics audit or ethical assurance program may prove to be ineffective. Dow Corning Inc. had a celebrated ethics control system which did not surface the problem of health risk associated with their silicone breast implants which were prone to rupture. The investigation of why involves looking at the following ethical issues: 1. What are the critical success factors involved in making a code of conduct and an ethical assurance program effective? 2. How to instill the desire to comply with the company's ethical guidelines. 3. How to apply ethical principles to crisis decisions and announcements. 4. The need to balance legal risk with ethical performance. 5. Should products used for purposes of vanity be subject to the same ethical/safety concerns as one which is used for purposes of utility or health improvement? Teaching suggestions The case builds upon a Harvard Case which provides the details of the company's code of conduct, the process of preparation of that code and of the audit process used the examine compliance with the code. This is a very useful discussion of background details which can be very instructive for those facing the refinement of less developed systems. I have the students come to class having read the full case, and begin the discussion with a short statement covering the issues laid out above. Sometimes the class wants to discuss whether the company is at fault because the purpose of the product is viewed (usually by men) to be purchased to satisfy female vanity. I facilitate this because it serves to raise the awareness of the men in the audience about the problem from a women's perspective and gets into the relationship of appearance to mental health. I then get the class to describe the code of conduct and the related compliance process in their own words. When we are all at the same level of understanding I use the questions at the end of the case to shape the discussion, covering the issues described below. I use the Dow Corning Breast Implant Case, either to start off the discussion of codes of conduct, or to reinforce the discussion on codes. The case induces strong discussion, and takes about 30-35 minutes. Discussion of ethical issues Vanity vs. utility: Although men usually see the breast implant as just a response to female vanity, the women is the class are quick to point out the many breast implants are installed as part of the after treatment for breast cancer involving mastectomy. Consequently, these implants are not considered to result from frivolous whimsy. In addition, and more importantly, the women will make the connection between physical appearance and mental health. The men can then see that poor mental health can have an impact on health costs and job performance, so the breast implant issue suddenly becomes important to the men in the class for reasons other than avoiding legal risks. Often a woman or I, who am balding, playfully raise the issue of hair transplants for men, and this seems to settle the vanity issue. This discussion is useful in setting up the need to include both sexes in ethical audit/assurance programs in order to have the best chance to surface single-sex issues - those which have special significance for one sex but which may not appreciated by the other. 1. Why didn’t the Dow Corning ethics audit program reveal any concerns about the silicone-gel breast implant line? Usually the class suggests several reasons for the failure of the ethics audit program to surface the breast implant issue at an early stage so that it could be acted upon and resolved as early as possible, including the following: • the audit team may not have been tuned in to women's problems (a single sex issue), • the audit team may have not have included a manager grounded in the science or health disciplines, • the audit focus may have been internal rather than external, so that the press reports on the problem were not surfaced, • the group input sessions with local personnel involved up to 35 people, so some attendees may have been too shy to speak, or may have considered whistle blowing in such a large group to be too risky, • whistle blowing without anonymity, when a lot of jobs are at stake was too much to expect, • original memos had been written by a person who had "left" the company, and this may have dissuaded further discussion, • the issue of cause of leakage (installation, accident) and culpability was not sufficiently clear from the company's or employee's perspective, • some personnel apparently believed the problem to be already under review in a testing program and therefore not worth raising again. These faults can be summarized under the following topics some of which relate to the code and culture of the company: • audit team: expertise and sensitivity • audit focus • audit processes • whistle blowing processes • trust • understanding of the intent and scope of the process. 2. What are the critical factors necessary to make such an ethics audit program work effectively? This case offers an opportunity to reinforce the issues discussed in the text on pages 104-108. In particular, the following are germane to the case: • continued endorsement of the process by top executives, • clear communication of performance guidelines, and identification of an ombudsman or other person for clarification of problems, • continued training/sensitivity sessions to insure that participants understand the need for, scope of, and relevant issues to the process, • creation of a condition of trust or whistleblower protection, so people will come forward and report wrongdoing, • comprehensive compliance processes, including scans of the internal and external environments, • formal, periodic reports to compliance officers on problems discovered earlier and under investigation, • knowledgeable, sensitive assessors of problems, • performance measures, linked to reward and discipline systems, • internal and external reports of performance. • governance of the process by a senior officer reporting, at least annually, to a committee of the Board. 3. Was the announcement on March 20 well-advised and ethical? The short answer is no on both counts. The spokesman did not convey much empathy for the women who had suffered from the leakages. He would have been better advised to acknowledge the possibility of a problem and indicate that further investigations were under consideration or underway. Instead he came across as non-caring and legalistic, which is not appropriate for a company in the health products field. The stance taken would weaken the image of the company with potential customers for all products of the company even though this particular product is relatively low in revenue contribution. In addition, the stance taken with regard to paying for some excisions, where health insurance is not available, is unethical. It is unfair for the other fee-paying members of the plan to have to pick up the cost of a problem caused by Dow Corning, and the company is trying to shift the cost of remediation from their shareholders to the fee-payers. Where a national or government health plan exists, such an action would shift the cost to the taxpayers. 4. Are there any other ethical dilemmas raised by the case? This case opens up the chance to discuss the need to keep ethics in mind when handling a crisis. Crisis management, which is discussed in Chapter 5, offers approaches minimize the harm from crises, including the early recognition and acceptance of the reality of a crisis, and the recognition that ethical reactions can provide the best long-run solutions. For further discussion, please see Chapter 5. One of the interesting aspects to this case is that Dow Corning Inc. was a joint venture of Dow Chemical Co. and Corning, Inc. and they had to seek protection from the courts to prevent the liability arising from breast implants to impact on the parent company resources other than their investment in the joint venture. This they were able to do, based on the argument that they had no knowledge of the concern, and were not the controlling mind involved in dealing with the problem. Subsequent Events For a chronology of events see http://www.pbs.org/wgbh/pages/frontline/implants/cron.html. For details of the payment as of June 1, 2004 pursuant to a second settlement (the first, which was negotiated in May 1995, collapsed) see http://www.leighday.co.uk/doc.asp?doc=457&CAT=970. Useful Videos, Films & Links Kolata, Gina (1999) “Panel Confirms No Major Illness Tied to Implants” New York Times, June 21 http://query.nytimes.com/gst/fullpage.html?sec=health&res=9B03E6D9103BF932A15755C0A96F958260&n=Top%2fReference%2fTimes%20Topics%2fOrganizations%2fI%2fInstitute%20of%20Medicine Feder, Barnaby (1995) “Dow Corning In Bankruptcy Over Lawsuits” New York Times, May 16thhttp://select.nytimes.com/gst/abstract.html?res=F60613FB3E5A0C758DDDAC0894DD494D81 Tabor, Mary (1995) “Ex-Dow Corning Executive Faults Company’s Ethics on Implants” New York Times, Sept. 23 http://www.nytimes.com/1995/09/23/us/ex-dow-corning-executive-faults-company-s-ethics-on-implants.html 2. Ford/Firestone Tire Recall What this case has to offer The Ford/Firestone Tire Recall is a classic in many ways. Here are two companies that have had a history of damaging recalls, but they did not learn or retain enough to avoid a repeat the errors of handling earlier damaging crises. The companies suffered because they had not developed an ethical corporate culture that provided formal and informal guidance when problem arose. The case shows illustrates many of the problems developed in the crisis management material in Chapter 6 – denial rather than early action to control damage, belief that the world is too large for domestic consumer and capital market to take notice of foreign activities, no ongoing system of data collection and review, and so on. The case also illustrates that the biggest cost to the companies involved in a product liability case is not the fines – it is the cost of lost reputation, of lost trust by consumers that translates into future lost sales. Teaching suggestions This is a case that students find most interesting. After asking several students to recap the case, I deal with the questions at the end of the case. I frequently use this case as an assignment, and have developed the materials that are presented below. In addition, I deal with the 3 questions located at the end of the material located below. Discussion of ethical issues Since I have used this case as an assignment, I have developed for feedback “Overview Comments” and a “Full Set of Comments” that contain the issues raised by my classes in regard to each of the 7 questions at the end of the case. I have reproduced each below as a way of conveying what I think is relevant for the ethical issues involved. Overview Comments on Ford/Firestone Case I have returned a “Full Set of Comments” that were raised about the Case, and another page that shows (by underlining) the comments raised by your group and my overall comments and mark. In general … My take on the Ford/Firestone Tire disaster is that they failed to recognize and develop an effective response because their corporate cultures had not embraced a risk assessment dimension focused on safety-related, consumer interests. Neither company was alert to or looking for safety-related problems, nor did they have systems in place to collect and analyze relevant data, and report against acceptable standards. Neither company could be considered a “learning company” due to these shortcomings. This failure, and the slow reporting to NHTSA, was due to many factors - short-term focus based on legal advice crafted in view of very low legal penalties, incorrect projection of consumer outrage, lost sales and new legal consequences, and so on as noted in the “Full Set of Comments”. Clearly F & F did not foresee the largest cost – lost reputation/future revenue – involved. The ethical risks involved in this disaster are many. They would be discovered from an assessment of where the expectations of all stakeholders were not satisfied or likely to be satisfied. These ethical risks have a significant potential impact on reputational risk and the corporate value chain. This leads to the ethics risk management advice noted in the “Full Set of Comments”. EMBA 20 Ford/Firestone Tire Grading Answer/Comments – Full Set of Comments ______________________________________________ Ethics Issues/Questions: 1. Why no learning from earlier disasters: no culture/philosophy change, no training, short-term focus, concealment vs. disclosure, past evasion success – low cost & no personal cost, no legal imperative, poor risk management procedures, data analysis function lacking, no ethics officer/monitor, no personal memories, denial, Firestone’s problem not Ford’s, Ditlow’s statement useful 2. Why not earlier discovery:No safety related data bank, insufficient analysis and awareness of downside, lax employees, inspectors, labor unrest and poor risk management in Decatur, decision to not report Saudi problem to NHTSA, blamed someone else, no F & F cooperation, no organizational accountability established, no stakeholder dialog, NHTSA slow to investigate 3. Why no report earlier to NHTSA:Not technically/legally required if case by case treatment, could wait out 8 year limit, $1,000 per document withheld cap on fines if discovered – defense strategy dominates action, poor risk assessment of downside costs, short-term focus, lack of F & F collaboration 4. Largest cost: Lost reputation: revenue and costs estimates made – note that previous fine cost only 5 cents per car 5. CBA Corrections – most depend upon assumptions: Lost reputation estimate clarified/corrected – tire costs & numbers, present value, loss of share value to investors, higher costs of capital, intangible costs of dead, loss to each stakeholder, time and effort of F & F, productivity lost, insurance costs, difference in perspective/costs if nylon cap used, environmental impact, drop in market cap = lost reputation cost, job losses, ongoing litigation costs too low, possible criminal charges, U.S. market only so should expand to international 6. Ethical risks involved: Definition of ethical risk – see text, To each stakeholder group – safety, rate of return, employment, deceit – “customer notification enhancement action”, reputation risk and place in value chain - viability/success/reputation/values/hypernorms - honesty, fairness, compassion, integrity, predictability, responsibility; global perspective, lack of trust, more regulation 7. Ethics Risk Management Advice: Create or enhance Culture, Code, Cooperation with NHTSA, Stakeholder Analysis, Decision Analysis, Cost Benefit Analysis, Public Relations, more proactivity, strategic issue management team, factor in reputation losses, more early warning/detection and prevention effort, be accountable and transparent with problems, ensure that suppliers follow similar appropriate risk management practices, risk management strategy linking org. values, customer commitment and compliance, 6-step issues management, whistleblowers rewards & protection plan, complaint review, involvement and reporting to top management, domestic-international linkage, elimination of unreasonable risks, appropriate internal controls 8. Other Questions Raised: a) Was recall ethical? No, it was unfair (slow) to many warm weather customers b) Lessons for Crisis Management? See commentary above c) Whose was the responsibility for the warrantee issues? Both Ford and Firestone, as well as the NHTSA. GM does not leave this to their suppliers and have developed a group that tests and monitors tires. Also, how can a regulator do their job without any (independent) data source? Other Factors Considered: Thoroughness/Depth of Analysis/Exhibits Creativity Overall Grade Subsequent Events Per the Associated Press, Monday March 15, 2004, Pam Easton, “Judge approves $149 million Bridgestone-Firestone settlement, downloaded from www.ca.us.biz.yahoo.com on March 15, 2004. On March 15, 2004, a judge approved a $149 million settlement of 30 class-action lawsuits on behalf of some owners of the 14.4 million potentially defective Bridgestone-Firestone tires that were recalled in 2000. At least 271 U.S. traffic deaths [and over 800 injuries] have been attributed to the tires, most of which were on the Ford Explorer but the settlement pertains only to those who had not suffered any injury or property damage. “The settlement calls for Bridgestone … to pay an estimated $70 million to replace tires, $41 million to manufacture better tires, $15.5 million on a consumer education campaign, and $19 million for attorney’s fees. The company has also paid 3.5 million to notify owners of the settlement. The settlement could affect up to 15 million people. The 45 named plaintiffs each could receive up to $2,500.” Others could have their tires replaced. A Firestone spokesman said the company was pleased with the settlement. One of the Plaintiffs’ attorneys, however, said that it was “really no settlement at all. Everything in the settlement was already being done by Firestone.” “Bridgestone and Ford settle tire recall feud”, Reuters and Bloomberg, Toronto Star, October 13, 2005, D16. Bridgestone agreed to pay $240 million to Ford covering about 11 percent of Ford’s cost of replacing up to an estimated 13 million tires in 2001 Useful Videos, Films & Links Greenwald, John (2001) “Inside the Ford/Firestone Fight” Time, May 29thhttp://www.time.com/time/business/article/0,8599,128198,00.html C-Span “Firestone Tire Recall” Senate Committee Commerce, Science and Transportation, Sept. 12th 2000 http://www.c-spanvideo.org/program/159191-1 • Witnesses testify about the recall of Firestone tires while Ford and Firestone officials insist on each other’s culpability Shaffer, Marc & Barak Goodman (2002) “Rollover: The Hidden History of the SUV” Transcript (Original airdate: February 21, 2002) Frontline http://www.pbs.org/wgbh/pages/frontline/shows/rollover/etc/script.html Solution Manual for Business and Professional Ethics for Directors, Executives and Accountants Leonard J. Brooks, Paul Dunn 9781285182223