Chapter 8 – Subprime Lending Fiasco – Ethics Issues Chapter Questions and Case Solutions Chapter Questions 1. How much and in which ways did unbridled self-interest contribute to the subprime lending crisis? Almost everyone in the subprime mortgage meltdown was only looking after their own narrow self-interest and not the board interest of their clients or the economy. • The homeowners, who knew that they could not afford to own a home, were ignoring the fact that the when the mortgage came up for renewal they would not be able to afford to pay the renewed mortgage at its higher interest rate. • The sales agents, who were only concerned with making commissions on sales, were not looking out for the best interest of their clients who could not afford these homes and mortgages. • The banks were only interested in generating higher interest revenue, without looking at the credit-worthiness of the borrowers and the risks associated with defaults. • The investors who bought the high yield mortgage-backed securities were ignoring their fiscal responsibilities by not conducting due diligence on the risks associated with these securities. 2. How could increased regulation improve the exercise of unbridled self-interest in decision making? Market failures often occur when there is an inefficient allocation of costs and benefits. Externalities are costs or benefits that are borne by third parties, i.e., parties who are not part of the initial contract. An example is air pollution that is a cost that is borne by society. The marketplace is unable to control pollution and so government regulation is required. The collapse of the subprime mortgage market and the associated collapse of the mortgage-backed securities market are also examples of market failures. Increased government regulation may have helped to prevent or minimize the negative aspects of these market failures. For example, Canadian banking regulations prevent Canadian chartered banks from being overleveraged; the American banks had no similar legislative constraints. Many American banks failed as a result of the crisis, but no Canadian banks failed. Although many managers do not like to have their managerial discretion constrained through government regulation, legislation can be useful when people forget their responsibilities to the rest of society, or when the opportunity for unrealistic gain is too great. 3. How could ethical considerations improve unbridled self-interest in ethical decision making? Ethics help to constraint unbridled self-interest by broadening the decisionmaker’s horizon. Decisions have impacts on a variety of stakeholders, including the decision-maker. When the decision-maker takes into account the interests of other stakeholders, then the decision-maker is less likely to make a decision that only helps the decision-maker at the expense of the other stakeholders. 4. Identify and explain five examples where executives or directors faced moral hazards and did not deal with them ethically. • Creating securities that had no hope of being realizable • Selling very risky securities without disclosing the risks fully • Rating agencies knowingly providing inflated ratings • Over-leveraging of banks and investment firms • Paying incredibly excessive remuneration based on questionable incentives • Banking on the fact that their company was too big to fail and endangering investors as well as costing bailout funds. 5. How much should the exiting CEOs of Fannie Mae and Freddie Mac have received when they were replaced in September 2008? Executive compensation is multi-faceted. Compensation is used to attract and retain employees; it is used to motivate and reward good performance; and it is used to discipline bad performance. If employees are responsible for both their good and bad decisions, then they should be compensated according to the successes and failures of those decisions. However, compensation is a second-best contract since the link between effort and results cannot be clearly observed and measured. To what extend did the actions or in-activities of the CEO’s of Fanny May and Freddy Mac contribute to the crisis? How could their culpability be measured? If it can be measured, then the size of their exit package should reflect their degree of culpability and the extent of their bad performance. However, we have only rough measures of the effort-performance link and so the exit packages may be perceived by some as too generous and by others as too severe, based on the perceived strength or weakness of the effort-performance link. 6. The government bailout of the financial community included taking an equity interest in publicly traded companies such as American General Insurance (AIG). Is it right for the government to become an investor in publicly traded companies? Arguments can be made both for and against government bailouts. (See the discussion of Ethics Case Mark-to-Market Accounting and the Demise of AIG.) Taking an ownership interest means that the government is better able to protect and oversee its investment in the bailed out company. This is similar to any other block holder (an investor that owns ten percent or more of the firm’s stock) that can influence the firm because of its sizable ownership and investment in the firm. 7. Should CEOs who made large bonuses by having their firms invest in mortgage-backed securities in the early years have to repay those bonuses in the later years when the firm records losses on those same securities? Arguments can be made both for and against having executives repay their mortgage-backed security bonuses after their firms incur losses as a result of investing in mortgage-backed securities. (See the discussion of the Ethics Case Subprime Lending – Greed, Faith & Disaster.) The problem with executive bonuses is that it is often difficult to see and measure the link between managerial effort and the firm’s success or failure. There are many exogenous factors that influence firm performance, and it is not always clear which of these factors were and were not within the control of management. 8. Should the CEOs who refused to have their firms invest in mortgage-backed securities in the early years because the risks were too great receive bonuses in the latter years because their firms did not incur any mortgage-backed security losses? How would determine the size of these bonuses? Bonuses are used to both reward past performance and encourage future performance. The problem with bonuses is establishing the link between managerial effort and firm performance. In this case, did the firm avoid a loss on the subprime mortgage meltdown because of an insightful decision of management? Or, did this occur because of an error of omission, that management was not paying attention and missed an opportunity to get in and out of mortgagebacked securities before the market collapsed? Bonuses are second-best contracts and so the link between effort and outcome cannot be easily measured or observed. 9. Should organizations that have a risk-taking culture, such as the one developed by Stan O’Neil at Merrill Lynch, enjoy the gains and suffer the losses, without recourse to government bailouts? Investors know that there is a risk in investing in the stock market. Stocks can go up or down. If the investor is fully informed, understands the potential risks of the investment, and then makes an intelligent investment decision, the investor cannot complain about subsequently losing money in the stock market. The investor has a legitimate complaint if the investment was made on the basis of false, misleading or deceptive information. 10. Are the criticisms that mark-to-market accounting rules contributed to the economic crisis valid? See the discussion of Ethics Case Mark-to-Market Accounting and the Demise of AIG for a full analysis of the link between mark-to-market accounting and the economic crisis. 11. The global economic crisis was caused by the meltdown in the U.S. housing market. Should the U.S. government bear some of the responsibility of bailing out the economies of all countries that were harmed by this crisis? There were a number of factors that contributed to the current economic meltdown. They are listed in Chapter 8. They include greed on the part of lenders and homeowners; carelessness on the part of investors and credit rating agencies; as well as the lack of government regulation and oversight. No one segment of society bears all or a substantial portion of the blame for the crisis. Nor is the blame restricted to just one country. So, the equitable solution would be for all participants to share in the bailout. But given that this is impossible, the U.S. government is taking the lead in the economic bailout followed by the governments of other nations around the world. 12. Given that the marketplace for securities is global, and that the risks involved can affect people worldwide, should there be a global regulatory regime to protect investors? If so, should it be based on the regulations of one country? Regulations, in part, reflect the cultural values or standards of a nation. This is why it is often difficult to harmonize rules. For example, there is no one global GAAP, there are a number of different accounting regimes, some of which reflect cultural differences with respect to how business is viewed in that particular society. There is also the problem of enforcement. Although future developments through the OECD may change the situation, one country cannot currently enforce standards in another country. This is one of the problems with the World Trade Organization (WTO) that succeeded the General Agreement on Tariffs and Trade (GATT). Even though over one hundred counties signed the GATT and are now members of the WTO, there are still numerous unresolved disputes among signatory nations. The same two problems – cultural differences and enforcement – might very well apply to global regulatory securities regime. However, there is an increasing trend for global organizations to lay down guidelines that countries and corporations are harmonizing too. 13. Should members and executives in investment firms be forced to be members of a profession with entrance exams and with adherence to a professional code such as is the case for professional accountants or lawyers? This would be an interesting and useful development, but would be resisted, I am sure, by the investment community since they either don’t see what they do as having a fiduciary duty needing a sharpened focus, or believe that the regulations and enforcement in place are sufficient. To some extent, the CFA (Certified Financial Analyst) designation fulfills this role since it has exams and a code, but there isn’t a strong disciplinary culture or track record on the part of CFAs. Historically there has been a free-market (bounded by law not ethical practice) mentality that investment firm participants have internalized, and they will see extra regulation as wasteful, and be slow to change. 14. Does the Dodd-Frank Act go far enough, or are some important issues not addressed? See, for example, the following publications: • “Does FinReg Address the Material Issues Surrounding our Nation’s Financial Crisis?”, Paul Bator, The Raddon Report, July 21, 2010, http://www.theraddonreport.com/?p=3560 • “The Dodd-Frank Act and Basel III Intentions, Unintended Consequences, Transition Risks, and Lessons for India”, Viral V Acharya, http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/Dodd-Frank-Basel-and- India-by-Viral-Acharya.pdf • “The Dodd-Frank Financial Reform Bill”, Mark Thoma, CBS Moneywatch.com, July 15, 2010, http://moneywatch.bnet.com/economic-news/blog/maximumutility/the-dodd-frank-financial-refrom-bill/725/ 15. What were the three most important ethical failures that contributed to the subprime lending fiasco? To some extent the answer depends on opinion rather than fact, but there are several possibilities, including: • Passing extraordinarily risky securities onto unsuspecting investors without proper, clear disclosure of those investment risks in the investment documents. • Many people in the chain knew of the extraordinary risk, but kept on without blowing the whistle. • Rating agencies giving very risky securities higher than warranted ratings thereby not protecting investors, which was the agencies’ function. • Investment houses that knowingly over-levered themselves in the pursuit of profit, thus requiring bailouts. • Regulators who failed to protect the public. • Double-dealing investment houses that sold securities and then undermined the market for them. • And many more. Case Solutions 1. Questionable Values Produce Resignation at Goldman Sachs What this case has to offer This case allows the reader to reflect on Goldman’s culture, the impact of not having a culture of integrity, and what that led to during and after the subprime lending crisis. Teaching suggestions Ask students to explain why Goldman Sachs has not changed its culture, even after the subprime lending crisis? Responses should be interesting. Ethical issues According to Greg Smith, the culture he describes existed in 2012, long after the 2008 financial crisis and subsequent fallout, suggesting that the lessons have not been learned and the problems are at least as bad as they were before the crisis. 1. How could the culture described be changed? Only with a complete change of mindset and management. The culture appears to be so ingrained that it learned nothing from the debacle of 2008. A ethical code of conduct must be created, publicized to the staff, and set in motion through training. Upper management needs to refer often to the ethical goals, and sustain them, firing anyone who violates it. 2. Who will need to cause this culture to change? Upper management will need to change it, unless upper management is a part of it. 3. What will have to happen to cause this change? Apparently, something far worse than the financial crisis of 2008. 4. Is it likely that Goldman Sachs will be able to hire the best and brightest recruits unless they change the culture described? Why and why not? Some will be drawn to it (corporate psychopaths), but those recruits who want a good, full, productive life without looking over their shoulders will decline to join this subculture. 5. Corporate psychopaths would likely be attracted to a firm with Goldman’s modern culture. How would Goldman ensure that they are not hired? Part of the vetting process for potential new employees should include psychological profiles that would discover any potential corporate psychopaths. 2. Naked Short Selling – Overstock.com lawsuit against Goldman Sachs &Merrill Lynch What this case has to offer The case provides details of how the two investment advisors counselled clients to undermine the value of Overstock’s shares, and misused their brokerage functions to assist in this endeavor. Teaching suggestions Ethical issues 1. Should short selling be outlawed? Short selling is such an integral part of the financial markets, that its hard to imagine banning it altogether. Although it is frequently abused, the short sale can be very useful to financial institutions. And it has at its core the basic assurance that the owner really does own or have an interest in the security, which theoretically, should make it more cautious. 2. Should naked short selling be outlawed? A stronger argument can be made to ban short selling, since the “owner” does not own the security at all, and does not have any interest in it. Naked short-selling is highly regulated, but perhaps that is not enough. 3. How would you describe the ethical cultures at Goldman Sachs and Merrill Lynch with respect to failed trades? Both houses intentionally failed stock deliveries on short sales, for their own personal benefit This is appalling. 4. Short of wholesale firings, fines and jail terms, can you suggest ways that the ethical cultures at Goldman Sachs and Merrill Lynch could be corrected? See the answer to question 1 on the case above “Questionable Values.” 3. Lehman Brothers Repo 105 Manipulation What this case has to offer The bankruptcy of Lehman Brothers (LB) remains the largest bankruptcy filing in U.S. history. In 2008, the investment banking firm was holding over $600 billion in assets. This case constitutes an example of a company entering into a web of business transactions that might be legal, and could even be in accordance to accounting standards, but appear unethical given their negative consequences. LB’s bankruptcy played a major role in the U.S. financial crisis of 2008. LB borrowed money to fund its investing strategy, a strategy described in the case as leveraging. LB maintained approximately $700 billion of assets and had capital of approximately $25 billion, a leverage ratio of 28:1. In addition, a significant portion of LB’s portfolio was loaded with mortgage-backed securities (MBS) and related financial instruments, making the firm vulnerable to a downturn in the MBS market. While generating profits from rising prices in the MBS markets prior to 2008, LB’s high portfolio concentration, together with its high leverage, meant that just a small decline in the MBS market would entirely eliminate the firm’s book value or equity. Investment banks such as LB were not subject to the same regulations applied to depository banks to restrict their risktaking. This case focuses mainly on LB’s systematic pattern of manipulation done to reduce its total liabilities at the end of each reporting quarter. Ultimately, this case highlights how a combination of inefficient oversight, complex financial transactions, and a culture of “profits at any cost” and excessive risk-taking resulted in a severe liquidity crisis that led LB into bankruptcy. Teaching suggestions An interesting way to introduce this case is to talk briefly about the size and consequences of the financial crisis of 2008. Next, I start the discussion on the specific causes of LB’s problems, and ask students whether or not it was an avoidable problem. This is a complex case involving several financial, legal and accounting technical details; however, it is important to focus the discussion on how unethical financial reporting exacerbated LB’s problems by masking the firm’s liabilities and enabling the investment banking firm to take on excessive risk. Discussion of ethical issues 1. What was the most important reason for Lehman Brothers failure? There were several general reasons contributing to the failure of LB. The Examiner’s Report, prepared for the United States Bankruptcy Court of the Southern District of New York, explains that (p. 2): “There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate. Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.” However, the most important direct cause of the firm’s collapse was that LB overinvested in subprime mortgage securities (MBS). As explained by the Examiner’s Report (p. 4): “In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis, Lehman was slow to recognize the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to “double down,” hoping to profit from a counter‐cyclical strategy. As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.” The losses that the firm’s sustained as a result of its investment strategy became unsustainable in 2008, when the financial markets lost confidence in LB, and the firm was unable to borrow funds to continue with its daily operations. As explained in the Examiner’s Report (p. 3): “Lehman funded itself through the short-term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.” And further in (p. 16): “Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. Lehman was unable to maintain confidence because a series of business decisions had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate. Confidence was further eroded when it became public that attempts to form strategic partnerships to bolster its stability had failed.” 2. What is leverage and why is it so important? Leverage is the effect of borrowing to buy an asset, creating a liability but enabling the equity holders to benefit from the residual ownership in the asset. It is important because is the basis of a bank’s business model. As explained in the Case facts, banks generate revenue and profit principally by investing funds borrowed from other investors such as depositors or lenders. While some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds – an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit-generation investments beyond the capacity of the bank’s own limited resources. 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. Sell $1 million in financial assets before quarter-end: CASH 1,000,000 FINANCIAL INSTRUMENTS (Asset Account) 1,000,000 Pay $1 million in financial liabilities using the proceeds of the sale before quarter-end: COLLATERALIZED FINANCINGS (Liability Account) 1,000,000 CASH 1,000,000 Repurchase liabilities after quarter-end and pay financial expenses of 5 percent: COLLATERALIZED FINANCING (Liability Account) 1,000,000 FINANCIAL EXPENSES (Interest Expense Account) 5,000 CASH 1,005,000 4. In your opinion, how large should a Repo 105 transaction be to be considered material, and why? There are two auditing standards defining the concept of materiality, ISA 320 (IAASB) and AU 312 (AICPA). Under these standards, the exact definition of materiality is somehow vague; however, in general terms a material amount “could reasonably be expected to influence the economic decisions of users” taking the financial statements as a whole. The standards on materiality have refrained from explicitly stating a threshold percentage, but state that thresholds may be used. Moreover, specific thresholds depend on the audit risk for each client. As an example, the general thresholds recommended by the PwC Audit Guide (available at http://auditguide.0009.ws/PwCAuditGuide/2102.htm) are as follows: • For a profit-oriented entity, up to five percent (5%) of profit/loss before tax from continuing operations. • For a not-for-profit entity, up to one percent (1%) of total expenses or total revenues, or up to one-half of one percent (0.5%) of total assets. • For an entity in the mutual fund industry, up to one-half of one percent (0.5%) of net asset value. • For entities where total assets are used as the benchmark, up to 1% of total assets. Based on the benchmark recommended for clients in the mutual fund industry of 0.5% of total assets, and LB’s $691 billion in total assets as of the end of fiscal-year 2007, any amount over $3.46 billion would be considered material. Given the weak financial condition of LB, it is likely that the actual amounts of liabilities hidden by the Repo 105 transactions were material to the financial statement users. Using another approach, based on a threshold found in E&Y’s working papers for LB’s audit, the Examiner’s Report (p. 19) highlights that: “Lehman defined materiality, for purposes of reopening a closed balance sheet, as “Any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).” Lehman’s use of Repo 105 moved net leverage not by tenths but by whole points.” 5. Was LB’s interpretation of SFAS 140 – that Repo 105 transactions could be treated as sales – correct? Provide your reasons. Arguably, LB’s interpretation was incorrect because the substance of these transactions was not a final sale, given the intention of repurchasing those securities later on. Moreover, Lehman treated these transactions as sales when other investment banks treated them as financing. On the other side, these transactions were structured to meet the criteria of SFAS 140. For example, Paragraph 218 of SFAS 140 supports LB’s interpretation to treat Repo 105 and Repo 108 transactions as sales: “Judgment is needed to interpret the term substantially all and other aspects of the criterion that the terms of a repurchase agreement do not maintain effective control over the transferred asset. However, arrangements to repurchase or lend readily obtainable securities, typically with as much as 98 percent collateralization (for entities agreeing to repurchase) or as little as 102 percent overcollateralization (for securities lenders), valued daily and adjusted up or down frequently for changes in the market price of the securities transferred and with clear powers to use that collateral quickly in the event of default, typically fall clearly within that guideline. The Board believes that other collateral arrangements typically fall well outside that guideline.” Furthermore, an article published on the Wall Street journal on March 12, 2011, suggests that it would be difficult to question LB’s interpretation: “SEC officials generally have concluded that the transactions were consistent with accounting standards, according to people familiar with the situation. And agency officials aren't convinced that Lehman shareholders suffered material harm, since executives were trading one type of highly liquid asset for another, these people said. They said the SEC would face a far lower bar if Lehman had converted illiquid or damaged assets, such as Archstone's real-estate holdings, into cash using Repo 105.” Following LB’s bankruptcy, and other difficult cases dealing with securitization of assets, the FASB amended some deficiencies in SFAS 140 by issuing SFAS 166. The Summary of SFAS 166 states that: “This Statement clarifies that the objective of paragraph 9 of Statement 140 is to determine whether a transferor and all of the entities included in the transferor’s financial statements being presented have surrendered control over transferred financial assets. That determination must consider the transferor’s continuing involvements in the transferred financial asset, including all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. This Statement modifies the financial-components approach used in Statement 140 and limits the circumstances in which a financial asset, or portion of a financial asset, should be derecognized when the transferor has not transferred the entire original financial asset to an entity that is not consolidated with the transferor in the financial statements being presented and/or when the transferor has continuing involvement with the transferred financial asset. This Statement defines the term participating interest to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale. If the transfer does not meet those conditions, a transferor should account for the transfer as a sale only if it transfers an entire financial asset or a group of entire financial assets and surrenders control over the entire transferred asset(s) in accordance with the conditions in paragraph 9 of Statement 140, as amended by this Statement. Enhanced disclosures are required to provide financial statement users with greater transparency about transfers of financial assets and a transferor’s continuing involvement with transferred financial assets.” In conclusion, LB’s treatment of the Repo 105 and Repo 108 transactions as sales could have been correct in a narrow sense, but it was not necessarily correct if the intention of repurchase, a form of “continuing involvement”, was considered as an indicator that the Repo transactions were collateralized borrowing. 6. If, as the Examiner’s Report states, LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? This practice is explained in the Examiner’s Report (p. 771): “During the term of a Repo 105 transaction, as with a typical ordinary repo transaction, Lehman continued to receive the stream of income (the coupon payments) from the securities transferred in a Repo 105 transaction. As in an ordinary repo transaction, Lehman was charged interest on the cash borrowing in a Repo 105 transaction. Lehman paid the repo interest separately upon the completion of a Repo 105 transaction (i.e., when the term expired), just as Lehman would on all ordinary repo transactions. Accordingly, Lehman would debit an “interest expense” income statement item.” This was possible under a servicing agreement contained in the Repo sale contract; however, the fact that LB continued to collect revenue from the supposedly sold securities shows that the substance of the transaction was not a sale but collateralized borrowing. 7. An emerging issues Interpretation Bulletin accompanying SFAS 140, gives examples indicating Repo 102 transactions would not qualify as sales, but Repo 110 would. Why do you think this Bulletin was issued? There were several EITFs modifying and explaining SFAS 140, the main reason behind the extensive additional guidance is that it is inherently difficult to specify all cases where a transfer of assets constitutes a sale instead of collateralized financing. The timing of the release of SFAS 140 suggests that it was need to clarify issues in a timely fashion. 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? The Repo transactions were not carried directly by LB, but indirectly through a subsidiary in the U.K., Lehman Brothers International Europe (LBIE) because that jurisdiction was where a favorable legal opinion, which was not available in the U.S., could be obtained. In principle, it is acceptable to use the opinion of a U.K law firm. Determining the transfer of the ownership of an asset is not necessarily an accounting issue, but a legal issue, and under this view the auditor relied on the interpretation of LB’s U.K. law firm as evidence of legal transfer of the ownership of the assets. The Examiner’s Report explains the conditions of the opinion provided by the U.K. law firm (p. 784): “Lehman was able to get a true sale opinion from the Linklaters law firm in London, in several iterations, under the laws of the United Kingdom. The Linklaters letter was addressed to LBIE, and analyzes repo transactions executed under a 1995 or 2000 version of a Global Master Repurchase Agreement under English law, as applied by English courts. The Linklaters letter provides “[t]his opinion is addressed to you [LBIE] solely for your benefit” and that “[i]t is not to be transmitted to anyone else, nor is it to be relied upon by anyone else or for any other purpose. . . .” The letter stated, however, that “a copy of this opinion may be provided by Lehman Brothers to its auditors for the purpose of preparing the firm’s balance sheets.” The Linklaters letter did not contain any reference to United States GAAP or SFAS 140.” Nevertheless, even when obtaining the opinion of a U.K. law firm might have been appropriate for a U.K. transaction, there seems to be a myopic behavior around this issue involving lawyers and auditors. The lawyers did not care about the final use of their opinion to substantiate an accounting interpretation for the parent company of LBIE, while LB’s auditors were prepared to overlook the limited legal context used to generate the legal opinion applicable LB’s subsidiary. 9. Do the Repo 105 arrangements constitute fraud? Why and why not? It is difficult to determine whether or not these arrangements constitute fraud. Their accounting treatment was allowed under the applicable accounting standards at the time. Moreover, determining fraud hinges on proving wrong intentions by the perpetrator, as explained by the Auditing Standard ISA 240 (IAASB): “Misstatements in the financial statements can arise from either fraud or error. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.” Similarly, the U.S. Audit Standard AU 316 (AICPA) highlights that: “The primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. For purposes of the section, fraud is an intentional act that results in a material misstatement in financial statements that are the subject of an audit.” It would appear that this matter will be settled in a court of law. 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most important in such cases, and why? ISA 320 (IAASB) and AU 312 (AICPA) explain the auditor responsibility with respect to fraud. In general, the auditor’s responsibility is to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. However, if a fraud is discovered or suspected, it should be brought to the attention of an appropriate level of management, and if the auditor believes senior management may be involved, the matter has to be directly discussed with those charged with the company’s governance. 11. If you were the audit partner in charge in the U.S., what would you have required be done in regard to the Linklater “true sale” letter? The auditor could have done the following before accepting the lawyers’ letter at face value and as main piece of evidence supporting the sale treatment: 1) Ask whether the opinion could be verified by a U.S. firm using a U.S. context; and, 2) Evaluate the evidence from the lawyer’s opinion in combination with other audit evidence corroborating the sale (e.g., actual retention of risks, not part of the company business model, subsequent repurchase, etc.). In fact, verifying payments subsequent to the reporting date is a commonly used audit procedure to detect unrecorded liabilities. The evidence from the legal opinion cannot be taken in isolation when deciding whether the economic substance of the Repo transactions was actually a sale of assets. 12. Should consolidated financial statements of a U.S. parent company include (i.e. consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? Before consolidating foreign subsidiaries, their financial statements have to be prepared using the parent’s accounting standards. 13. Would the adoption of IFRS have prevented the Repo 105 misrepresentations? Arguably, the IFRS focus on the economic substance of transactions over their legal form should have helped to account for the Repo transactions; however, IFRS and U.S. GAAP had very similar standards on this matter. Under both SFAS 140 and IAS 39, the sale treatment depended on whether the transferor maintained a continuing involvement, for example by having residual interests or risks in the asset transferred, and continuing involvement was defined in similar terms. An exposure draft of changes in IAS 39, issued in March 2009, proposed modifications to IAS 39 aligning it to SFAS 166, refining the criteria to determine continuing involvement. With regard to transfers that do not qualify for the sale criteria, FAS 166 requires disclosures similar to those in IFRS 7. 14. What should the following have done upon learning of Matthew Lee’s whistleblower’s letter – LB’s management, board of directors, and the external auditors, E & Y? LB’s management, board of directors and E&Y should have taken the complaint more seriously. At least it should have triggered a comprehensive investigation into the matter. The auditors could have changed their position or could have demanded additional disclosures of potential off-balance sheet liabilities resulting from Repo 105 and Repo 108 transactions. 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E & Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced above, to their clients? Why and why not? By sending that letter to its clients, E&Y aimed to reinforce its clients confidence in the firm; however, it makes E&Y appear guilty and needing a public relations move to counteract the public reaction to LB’s bankruptcy and to the Examiner’s Report. Even when the firm may not be proven guilty of negligence in this case, it seems the firm failed to meet the public’s expectations by allowing LB to hide liabilities using a questionable accounting treatment. 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. It is going to be very difficult to prove that E&Y took the wrong decisions. Likely, the accounting firm examined very carefully its accounting interpretation, aided by experts in U.S. GAAP and its legal team, before sending the letter. On the other side, the firm’s reputation is ultimately based on the public’s perception that the firm exercised due care. There could be some repercussions for the firm even when its position was defensible. 17. If an auditor explains a problem to the Chair of an Audit Committee, is there any further obligation on the part of the auditor to ensure that the full board have been notified and why? The auditing standards do not explicitly separate the audit committee from the rest of the board when they request to communicate fraud to those charged with the company’s governance. The auditors should have requested the full board to be informed on this matter given its importance. 18. Organizations who use the Enterprise Risk Management (ERM) framework, should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? The 2004 Enterprise Risk Management Framework, provided by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), explains the general ideas behind enterprise risk management: “Enterprise risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.” The COSO framework proposes the following good principles of enterprise risk management: • “Aligning risk appetite and strategy – Management considers the entity’s risk appetite in evaluating strategic alternatives, setting related objectives, and developing mechanisms to manage related risks. • Enhancing risk response decisions – Enterprise risk management provides the rigor to identify and select among alternative risk responses – risk avoidance, reduction, sharing, and acceptance. • Reducing operational surprises and losses – Entities gain enhanced capability to identify potential events and establish responses, reducing surprises and associated costs or losses. • Identifying and managing multiple and cross-enterprise risks – Every enterprise faces a myriad of risks affecting different parts of the organization, and enterprise risk management facilitates effective response to the interrelated impacts, and integrated responses to multiple risks. • Seizing opportunities – By considering a full range of potential events, management is positioned to identify and proactively realize opportunities. • Improving deployment of capital – Obtaining robust risk information allows management to effectively assess overall capital needs and enhance capital allocation.” In addition, the COSO guidance on “Effective Enterprise Risk Management Oversight: The Role of the Board of Directors” (2009), highlights that the company’s board of directors has a preeminent role in the risk management process. The board of directors should: • “Understand the entity’s risk philosophy and concur with the entity’s risk appetite. Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of stakeholder value. Because boards represent the views and desires of the organization’s key stakeholders, management should have an active discussion with the board to establish a mutual understanding of the organization’s overall appetite for risks. • Know the extent to which management has established effective enterprise risk management of the organization. Boards should inquire of management about existing risk management processes and challenge management to demonstrate the effectiveness of those processes in identifying, assessing, and managing the organization’s most significant enterprise-wide risk exposures. • Review the entity’s portfolio of risk and consider it against the entity’s risk appetite. Effective board oversight of risks is contingent on the ability of the board to understand and assess an organization’s strategies with risk exposures. Board agenda time and information packets that integrate strategy and operational initiatives with enterprise-wide risk exposures strengthen the ability of boards to ensure risk exposures are consistent with overall appetite for risk. • Be apprised of the most significant risks and whether management is responding appropriately. Risks are constantly evolving and the need for robust information is of high demand. Regular updating by management to boards of key risk indicators is critical to effective board oversight of key risk exposures for preservation and enhancement of stakeholder value.” LB’s risk management process had severe deficiencies in risk assessment, risk mitigation and in risk oversight. • Problems with risk assessment: The risk assessment process is critical to take adequate actions to mitigate risks and LB failed to properly assess the risks of its over-levered position in combination with its large inventory of sub-prime mortgage securities. Moreover, LB ignored not only the inherent risks of its activities, but also the consequences of using a possibly questionable accounting treatment for the Repo transactions. Finally, LB ignored red flags raised by a whistleblower complaint. • Problems with risk mitigation: Once risks have been identified and assessed, a company can choose to take any of the following actions to deal with risk: avoidance, mitigation, sharing, or retention. LB failed to take several possible necessary actions to mitigate its risks, for example, use industry standards to account for the Repo transactions as collateralized transactions. • Problems with risk monitoring: LB’s management and board of directors failed to monitor risks and oversee the company’s risk taking behavior. 19. How should the U.S. Bankruptcy Examiner’s Report be regarded – as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? In several parts of the Examiner’s Report, the term “Colorable Claims” (i.e., potential claims) is used, highlighting one of the main objectives of the Report; however, the facts and conclusions contained in the Report are the result of a thorough and professional investigation. According to the Examiner’s Report, the Examiner’s mandate included the following (p. 28): “the Examiner is to “investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan [unless ordered otherwise.]” the Examiner must, inter alia, “file a statement of any investigation conducted . . . including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate[.]” In a strict sense, there is no explicit mandate to find potential claims. In addition, the report was prepared with due care and objectivity. In conducting the review of LB’s documents, containing more than five million documents, estimated to comprise more than 40,000,000 pages (p. 31) the Report explains that: “Documents were reviewed on at least two levels. First level review was conducted by lawyers trained to identify documents of possible interest and to code the substantive areas to which the documents pertained; those so identified were subjected to further and more careful review by lawyers or financial advisors especially immersed in the earmarked subjects.” Similarly, in planning the review, the Examiner sought advice from other experts (p. 35): “the Examiner spoke with examiners from other large bankruptcy proceedings, including WorldCom, SemCrude and Refco, and obtained their advice on best practices.” Also, interviews with former LB’s employees and other parties were conducted with objectivity (p. 36): “To assure accuracy, all interviews were conducted by at least two attorneys, one of whom was assigned to keep careful notes. Flash summaries were prepared as soon as possible, usually the day of the interview, and reviewed by all lawyers present while recollections remained sharp; and full summaries were made and reviewed as soon as practical after that. In the vast majority of cases, the interviewees were represented by counsel. Nevertheless, the Examiner advised each interviewee that he is a neutral fact‐finder and that he and his professionals should not be deemed to represent the witness nor any point of view.” 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why didn’t SOX prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure? SOX could not have prevented a situation where management, directors and auditors were aware and in agreement about an accounting interpretation. This case highlights some limitations of the SOX provisions. For example, a primary objective of the SOX 302 and 404 provisions (requiring attestation by management and an external audit of the company’s internal control system) is to prevent and detect accounting fraud committed by company insiders and make auditors and directors aware of the fraud. Nevertheless, if an accounting treatment is deemed appropriate by directors and auditors it will not be prevented by the internal control system. References: American Institute of Certified Public Accountants (AICPA).“AU 316 Consideration of Fraud in a Financial Statement Audit SAS No. 99.” 2002http://www.aicpa.org/Research/Standards/AuditAttest/Pages/SAS.aspx American Institute of Certified Public Accountants (AICPA).“AU 312 Audit Risk and Materiality in Conducting an Audit SAS No. 107.” 2006.http://www.aicpa.org/Research/Standards/AuditAttest/Pages/SAS.aspx Committee of Sponsoring Organizations of the Treadway Commission (COSO).“Effective Enterprise Risk Management Oversight: The Role of the Board of Directors” 2009.http://www.coso.org/guidance.htm Committee of Sponsoring Organizations of the Treadway Commission (COSO). “Enterprise Risk Management —Integrated Framework” 2004.http://www.coso.org/guidance.htm Eaglesham, John, and Rappaport, Liz. “Lehman Probe Stalls; Chance Of No Charges.” The Wall Street Journal. March 12, 2011.http://online.wsj.com/article/SB10001424052748703597804576194871565429108.html Financial Accounting Standards Board.“Summary of Statement No. 140. Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125” 2000.http://www.fasb.org/jsp/FASB/Page/PreCodSectionPage&cid=1218220137031#fas150 Financial Accounting Standards Board.“Summary of Statement No. 166. Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140.” 2009. http://www.fasb.org/jsp/FASB/Page/PreCodSectionPage&cid=1218220137031#fas150 International Auditing and Assurance Standards Board (IAASB). “ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements.” 2006.http://web.ifac.org/clarity-center/the-clarified-standards International Auditing and Assurance Standards Board (IAASB). “ISA 320 Materiality in Planning and Performing an Audit.” 2008.http://web.ifac.org/clarity-center/the-clarified-standards PwC Audit Guide. Materiality. 2011. http://auditguide.0009.ws/PwCAuditGuide/2102.htm) Report of Anton R. Valukas, Examiner, Lehman Brothers Holdings Inc., Chapter 11 Case No. 08-13555(JMP) (Jointly Administered), United States Bankruptcy Court, Southern District of New York, March 11, 2010.http://lehmanreport.jenner.com/ also in www.cengage.com/accounting/brooks 4. Goldman Sachs’ Conflicts: Guilty or Not? What this case has to offer This case exposes Goldman Sachs’ roles in regard to the ABACUS deal, where credit unworthy subprime mortgages were securitized and sold to poorly informed investors, insured by AIG, and bet against by Goldman Sachs’ traders. The investment banking firm appears to be involved in a conflict of interests by selling securities to investors while simultaneously taking a position in the derivatives markets that would generate a profit if the price of the same securities decreased afterwards. Moreover, Goldman Sachs failed to inform investors about the potentially very significant involvement of a hedge fund, Paulson & Co., that was known for dealing in highly questionable mortgage-backed securities. This case constitutes an example of a company entering into a series of financial transactions that might be legal, but not necessarily ethical. Goldman Sachs played a major role enabling several key players in the financial crises of 2008; however, unlike investors on securitized mortgages, home owners, and the large insurer AIG, Goldman Sachs actually profited from the crisis. This case is related to the Goldman Sachs and the Greek VeilCase (Chapter 1), that explains how the investment banking firm aided the government of Greece to enter into several financial transactions to mask the true extent of Greece’s national deficit. Teaching suggestions An interesting way to introduce this case is to talk about the size and consequences of the financial crisis of 2008. Next, I ask students what the potential causes of the financial crisis were and whether or not it was an avoidable problem. Ultimately, this case highlights how a combination of inefficient oversight, complex financial transactions, and a culture of “profits at any cost” resulted in a severe crisis that affected the global financial markets. It is not easy to determine whether or not Goldman Sachs was guilty of engaging in conflict of interests. I ask half of the class to defend the investment banking firm and the other half to argue against it. In addition to the material in Chapter 8, the documentary Inside Job and the Congressional Testimony of Goldman Sachs’ executives, available at www.youtube.com, constitute good materials to enrich the discussion of this case. Discussion of ethical issues 1. Based on the conflicts of interest raised in the case, has Goldman Sachs, in effect, shorted itself? Explain why and why not. Arguably, Goldman Sachs has no direct responsibility to protect its clients wishing to enter into a financial transaction, beyond providing them with sufficient disclosure. This is the position taken by Lloyd Blankfein, the investment banking firm’s CEO, in his testimony before a U.S Congress Subcommittee investigating the role of Goldman Sachs in the 2008 financial crisis. In its market-maker role, or selling securities as underwriter, the firm is only responsible for disclosing potential risks related to the transaction. The CEO of Goldman Sachs defended the three roles of the company as underwriter, market maker, and trader separately: • First, as explained in Chapter 8, buyers may rely on the underwriter, Goldman Sachs, and the rating agencies to do their due diligence and examine the structuring of each securitized mortgage portfolio. Some investors might examine the securitization prospectus (the actual contract specifying the details of the transaction) in detail, and/or the SEC filings. Others might want to go further and review the original documents or check out the mortgage/homeowner. Nevertheless, there was no easy access to these original documents, and it was impossible to know the names and other characteristics of the borrowers involved, so there was really no alternative but to rely on the underwriter and credit rating agencies. Investment banks have a fiduciary duty while issuing public securities to disclose all information about potential risks. Anticipating the investors’ reliance on Goldman Sachs’ disclosure, and to protect itself from liability, the firm extensively warned investors against virtually every possible risk. (However, they failed to disclose the involvement of Paulson & Co. and paid a huge fine for it. In addition, Goldman Sachs was not the only firm involved in these transactions. All large Wall Street investment banks participated in the securitization of mortgages. • Second, Goldman Sachs acted not only as an underwriter, but also as a market maker, serving as a counterparty selling CDOs to AIG, the largest mortgage insurer in the world. In its market maker role, Goldman Sachs was dealing with a highly specialized and knowledgeable financial institution that should have been aware of all the significant risks. • Third, Goldman Sachs engages routinely in proprietary trading activities, aiming to profit from devising trading strategies based on the firm’s financial expertise. The firm was just using public information and hedging other positions while setting up strategies that would profit if the MBS’ prices dropped. Separately, the arguments seem to make sense, and Goldman’s operations were within the applicable U.S. laws; however, the problem is that by combining the three roles, Goldman appears hypocritical and in possession of inside information about the true risks and rewards of the MBS. In so doing, Goldman Sachs may have undermined its image of trust and its credibility – thereby “shorting” its own future success. As explained in Chapter 5, a conflict of interests occurs when the independent judgment of a person is swayed, or might be swayed, from making decisions in the best interest of others who are relying on that judgment. It appears as the investment banking firm is engaging in a conflict of interests. The overall role of Goldman Sachs and its actions before and after the crisis constitute an ethical dilemma given that the investment bank indirectly contributed to the crisis and profited from the financial debacle. It would be hard to argue that these transactions were acceptable or ethical because of their highly negative social consequences. 2. How should Goldman Sachs have handled each conflict of interest? Chapter 2 (also Chapters 5 and 6) provides some guidance about the mechanisms to avoid a conflict of interest. To remedy the concerns over a conflict of interest, three general approaches should be considered: (1) avoidance, (2) disclosure to those stakeholders relying on the decision, and (3) management of the conflict of interest so that the benefits of the judgment made outweigh the costs. • Goldman could have avoided this conflict, although it seems unlikely. Avoidance is the preferred approach if the appearance of having a conflict of interests can be avoided as well as the reality. The appearance of having a conflict can often be as harmful to the decision maker’s reputation as having a real conflict because it is almost impossible to recover lost credibility and reputation without extreme effort and cost, and then only with luck. • Goldman could have disclosed its short-selling position in the MBS market, or could even have alerted regulators or AIG’s management about hidden risks in the MBS market that partially motivated the Goldman’s short-selling position. • Goldman could have managed its conflict of interest in a better way, making sure that controls and high ethical standards prevented the firm from “selling crap” to its clients as underwriter, while “betting against it” in its proprietary trading activities. Management of potential conflicts is a potentially useful approach if avoidance is not possible and the costbenefit trade-off of management measures is favorable. The probability that reputation will be lost, and the related cost, must be taken into account in the trade-off analysis. The first step in the process of managing to defend against these influences is to ensure that all employees are aware of their existence and consequences. This can be done through codes of conduct training. The second step is to create an understanding of the reasons: why the employer cannot afford unmanaged conflict of interests situations; and why guidelines have been developed to prevent their occurrence, their exploration though counseling if recognized, their reporting if they have occurred, as well as penalties for their occurrence and non-reporting. Annual written confirmations of ethical behavior and adherence to the employer’s code of conduct should include reference to conflicts of interest encountered by the signatory, and those identified involving others. 3. If Goldman Sachs really is innocent of all conflicts, why has the firm’s reputation suffered? The firm’s reputation likely suffered from the perceived presence of conflict of interests. Ultimately, investment banking is a business based not only on financial expertise, but also on reputation. It is difficult to prove without doubt that Goldman had a conflict of interests, but it is also difficult to argue that the firm played a naïve role during the crisis. During the Congressional Hearing investigating the involvement of Goldman Sachs in the 2008 crisis, the Chairman of the Congressional Subcommittee, Senator Carl Levin, notes that there is an “inherent conflict” and a “fundamental conflict of interests” in selling securities and betting against those securities. 4. Referring to the outrage over the apparent abuse of AIG, Farzad and Dwyer ask the question: If the firm could just write a multibillion-dollar check to erase the outrage – deserved or not – over the AIG payout and be done with the public agony, wouldn’t it just do it? What would your answer be? Provide your reasoning for and against. The answer to this question is partly related to role of the firm as per the answer to Question 1. In its market-maker role, the firm is only responsible for disclosing potential risks related to each transaction. By acting as counterparty for AIG’s positions, Goldman Sachs was dealing with a highly specialized and knowledgeable financial institution that should have been aware of all the significant risks. Nevertheless, there comes a point where doing business is not only about profits, Goldman Sachs could have warned AIG’s management, or U.S. financial regulators, about hidden risks in the MBS market. Goldman Sachs is partly responsible for not acting to mitigate or avoid the crisis and this brought highly negative social consequences. During the Congressional Hearing investigating the involvement of Goldman Sachs in the crisis, Senator Tom Coburn asks whether or not the firm warned regulators about potential problems, and Goldman’s CEO Lloyd Blankfein answers that he only had “very general and high level” conversations with senior people at the Department of Treasury, without touching on specific points about the crisis ahead. Regardless of its narrowly defined technical role, Goldman Sachs had an overriding fiduciary duty not to act without integrity with regard to its clients, the purchasers of its securities, and the markets in general. This fiduciary duty was not maintained, and it is difficult to see how a payment after-the-fact can repair the damage caused, but it would help. A fair question would be whether to include funds beyond the simple amounts lost in compensation for mental anguish or penalties. Making a payment for the firm’s contribution to the Greek debt crisis, and/or the general subprime lending fiasco would also be considered if an ex gratia payment were to be made to clients or abused investors. 5. Is it appropriate for Goldman Sachs to “bet against their clients” through their investment activities? It is certainly legal, but it appears as unethical. Goldman Sachs appears to have known that the MBS market was going to collapse. The firm switched from a long position in the ABX index (an index of MBS) and other instruments in 2006, to a net short position in CDOs and other instruments in 2007. Overall, the profits in the firm’s short positions netted a gain, even after the losses on other areas during the crisis months. Publicly, the firm kept asserting that it did not have a clear directional position, suggesting that Goldman did not specifically know of the imminent collapse of the MBS market, but its net short trading portfolio indicates the opposite. Disclosure of such bets should be made, but is something the firms can be expected to argue against because it would probably practically limit their hedging activities severely. 6. One of Goldman’s main arguments in their defense is that their intentions were good – they did what they did in response to client requests, thus facilitating markets and making the world a better place. a. Is the ‘good intention’ argument sufficient to claim actions following from it are ethical? Why and why not? Remember the saying: ‘The road to hell is paved with good intentions.’ No, particularly when the “true” intentions of the firm are exposed by the composition of its trading portfolio. b. Is there something in addition to good intentions that Goldman Sachs would have been wise to consider in its decision making? Arguably, Goldman Sachs executives did not foresee the extremely negative consequences of the financial crisis. Goldman Sachs should have considered the fundamental ethical principles noted above, and the potential impact of a global crisis in its decisions even though it would arguably be a “black swan” event. 7. How would you have advised Goldman Sachs’ executives to have handled this crisis better? Goldman could have taken the following steps to handle the crisis better: • The firm could have accepted some guilt and offer an apology, at least for the apparent conflict of interest; • The firm could have offered to work with financial regulators, given its proven expertise about the financial markets, to avoid systemic issues in the future; • The firm could have conducted a thorough ethical review before asserting that there were no problems, or that there we only a few “bad apples” such as “Fab” Tourre and settle minor disclosure issues in the sale of a particular MBS portfolio; and, • The firm could have used this opportunity to be seen as an ethical leader to be followed to reestablish the reputation of investment bankers. 8. What would an appropriate level of bonus payments be for Goldman Sachs as a whole? It is difficult to set an appropriate level of compensation for Goldman Sachs’ executives. Compensation packages have to be adequate to attract and retain talent, while motivating adequate risk-taking behavior. Often, the level of compensation is determined by the Board of Directors with the aid of one or several compensation consultants. The bonus scheme at Goldman was not much different than those at major investment banks in the U.S. and abroad. Nevertheless, bonuses at investment banking firms are generally paid based on financial performance, without reward for taking ethical actions. Moreover, it seems like a definite mistake to pay bonuses when investors are losing money or when banks received government funding from the TARP. The bonus levels before the crisis seemed to have motivated a culture of excessive risk-taking behavior. The ultimate bearers of the risk were not those who made the early returns or bonuses or stock gains—rather, it was the public, the taxpayer, those workers who lose their job, and so on, who had to pay to pick up the pieces and put them back together. It’s too bad that those who made money unethically cannot be made to pay restitution or give up their ill-gotten gains. 9. Would bonuses paid in Goldman Sachs stock be more appropriate than those paid in cash? The typical compensation package for executives includes a cash salary, cash bonuses, stock and stock option bonuses, pension, and other benefits. The composition of the compensation package should motivate a good mix of short and long term effort towards creating value for the company’s shareholders. Several companies pay bonuses in the form of stock options, stocks or restricted stocks (stocks that cannot be sold for a period of time). These stock-based incentives are better at aligning the shareholders’ incentives with the executives’ incentives than cash bonuses because the employees bear some risk. Nevertheless, these forms of compensation are not a perfect solution to the problem, as it has been shown in several other cases in the book (Enron, WorldCom, Adelphia, etc.). Moreover, backdating scandals had their origin in stock option compensation. The article “Undermining Staying Power: The Role of Unhelpful Management Theories” by Roger Martin (2009), highlights the pitfalls of rewarding executives with stock–related compensation, including excessive focus on the expectations-based stock market and not on creating value for the company’s shareholders. Ultimately, there is no substitution for personal ethics and a strong ethical culture in balancing financial performance and ethical behavior. References Martin, Roger. 2009. “Undermining Staying Power: The Role of Unhelpful Management Theories”. http://rogerlmartin.com/wp-content/themes/rm2009/pdfs/rotman_spring_09_staying_power.pdf 5. Mark-to-Market Accounting and the Demise of AIG What this case has to offer This case allows students to discuss the causal connections between financial reporting and economic consequences. Economic events impact firms, and financial accounting reports the effect of those economic forces on firms. Sometimes, however, it is claimed that the reporting of those economic events and their impacts aggravates their negative impact on the firm. Teaching suggestions This is a good opportunity to review the accounting rules associated with financial instruments and mark-to-market accounting. Consider having the students read the relevant sections of the accounting guidelines the night before class and be prepared to summarize them in class before the discussion begins. Discuss of ethical issues 1. Does accounting cause bankruptcy? The purpose of generally accepted accounting principles (GAAP) is to lay down a framework for the fair presentation of the financial affairs of a firm. The Canadian and International frameworks use principles rather than rules, so professional judgment is required when applying the standards to specific economic situations. Financial statements can never be precise measures of the firm’s economic activity. They contain numerous estimates on the probability of future cash inflows and outflows. As such, financial statements present a fairly stated financial position, not a precisely correct financial position of the firm. Financial statements are used by investors, creditors and others to help in their financial decision-making. In particular, they want to be able to estimate the future cash inflows and outflows of the firm. However, the presumption is that users are aware of the fact that there is ambiguity rather than precision in these estimates. The mark-to-market accounting rule requires firms to record various financial assets and liabilities at their exit value, i.e., the amount the firm could sell the asset for today, or the amount the firm would have to pay to discharge the liability today. When there is a ready market for these financial instruments, they can be easily measured. For example, it is easy to estimate the value of stocks and bonds that trade on highly liquid exchanges. When the market is not highly liquid, then the estimate becomes harder but not impossible to calculate. In such instances, accountants use a variety of other factors to estimate these exit values. When the market for these financial instruments is increasing, the items are revalued upwards, and when the market falls, the items are revalued downwards. This results in the firm recording unrealized gains or losses through the accounting period. These are unrealized because the firm continues to hold the asset or liability throughout the accounting period. They will not be realized until the asset is sold or the liability extinguished. The unrealized gain or loss reflects the economic consequences of holding the asset or liability over that period of time. It also gives the user of the financial statements a good estimate of what the firm would receive or pay if that asset or liability was sold or discharged. This is useful information for making investment and credit decisions, for estimating future cash flows. Firms that purchased financial instruments that fell in value through the Summer and Fall of 2008 made poor investment decisions. The financial reporting of these declines did not cause the fall in their value. The decrease in their value was the result of market forces and changes in the supply and demand for these instruments. The financial statements merely reported the consequences of those external market forces on the value of the assets and liabilities that the firm continued to hold. As such, the mark-to-market accounting rule did not cause the economic downturn; it merely reported the effect that the economic downturn was having on the financial position of those firms that continue to hold those financial instruments. Some observers argue that if the declines in value had been ignored, then companies, such as AIG, would not have been seen to be in precarious financial straits. They argue that, since the declines in market values were temporary (since housing prices are expected to rise in the future); ignoring these declines would be OK. However, it is impossible to know how long the decline in values will continue. So, failing to recognize these declines would be very unconservative and potentially misleading to investors. Moreover, the dominant investors – the ones who set the value of securities because they trade in large volumes – are not naïve. They know that mortgage-backed securities are worth less today than they were before the subprime lending crisis. Regulators aren’t naïve either. Consequently, if mark-to-market accounting were to be set aside, we would have a bizarre spectacle. The executives of some financial institutions would be claiming that their financial statements show that all was well, but the value of the institutions’ shares would be declining and regulators would be bailing out some institutions, as was the case. Ultimately the naïve investors would realize that the economy and many firms were in trouble, and they would wonder why financial statements were more fiction than truth. Moreover, they would wonder at the ethics of professional accountant and auditors who were involved with them. In the final analysis, AIG’s management made mistakes that caused its collapse, not the mark-tomarket accounting that provided a clear view of the problem. Some people, however, prefer the head-in-the-sand approach of the ostrich to dealing with their problems. 2. Should the federal government have bailed out AIG, especially when it had not rescued Lehman Brothers and had let Merrill Lynch be taken over by Bank of America? Those who oppose bailouts use the following arguments. • Private sector firms are inherently risky. Consumer tastes may change, interest rates may change, and government regulations may change. All of these factors, and many more, can and will have an effect on the firm’s financial position and continued variability. If the firm is managed well it can survive these exogenous shocks. If not it will fail. That is the nature of business, and those who enter the business world know this. Businesses are voluntary organizations and they run the risks of being successes or failures. • It would be unfair for the government to bailout firms. When the firm succeeds, the government does not usually share in the success of the firm. Therefore, when the business fails the government should not suffer. • It would be unfair for the government to bailout some industries and firms and not others. This would be treating equals unequally, which is a violation of the Kantian principle. Currently, for example, GM and Chrysler are being bailed out, but not Ford. There are arguments in favor of government bailouts. • Society is made up of a variety of stakeholders who have an interest in the firm beyond just the shareholders and creditors. In order to protect the interest of those other stakeholders, who may not have a voice, the government will often intercede on society’s behalf. In this case, society, as by the government, felt that it was best for all stakeholders that various firms to continue in business. So, the government provided financial assistance. • The government can and does share in both the successes and failures of firms. When a firm succeeds, the government shares in that success both directly and indirectly – directly through increased income taxes, and indirectly by having a variable economy with high employment. When the firm fails, the government suffers through decreased tax receipts, a souring economy and unemployment. As such, the government has an equal right, similar to shareholders, to protect its interest in the firm, and to ensure that the business does not fail. In the subprime lending fiasco, the government may buy mortgage-backed securities at depressed prices and hold them until the underlying housing prices rebound. Also, the government may invest in shares of financial institutions and hold the shares until profits return. • Some industries are more important than other industries to the economy of a nation. Therefore, it is not a violation of the Kantian principle of treating equals equally and unequals unequally for the government to only help selected firms and industries. The Kantian principle assumes that all are equal, and therefore it is incumbent on the government to explain why these firms are in fact different. Useful Videos, Films & Links Smalera, Paul (2010) “AIG settles longstanding fraud cases for $1 billion” Fortune, July 16thhttp://money.cnn.com/2010/07/16/news/companies/AIG_Ohio_billiondollar_settlement.fortune/index.htm “SEC Charges Hank Greenberg and Howard Smith for Roles in Alleged AIG Accounting Violations” Securities and Exchange Commission Press Release, Aug. 6th 2009 http://www.sec.gov/news/press/2009/2009-180.htm Satow, Julie (2009) “AIG’s Six Year Saga of Alleged Fraud” Huffington Post, Apr. 24thhttp://www.huffingtonpost.com/2009/03/24/aig-fraudhistory_n_178545.html?show_comment_id=22288349 “AIG Accused of Fraud” CBS News.com June 12th 2009 http://www.cbsnews.com/video/watch/?id=5085130n “AIG Exec. Avoids Criminal Charges” CBS News.com April 6th 2010 http://www.cbsnews.com/video/watch/?id=6369592n 6. Subprime Lending – Greed, Faith, & Disaster What this case has to offer This case allows students to discuss several different ethical issues including: • the difference between first-best and second-best employment contracts, and • the ethics of marketing to vulnerable members of society. Teaching suggestions Begin by differentiating between first-best contracts and second-best employment contracts. (A similar teaching suggestion is made for the ethics case “The Ethics of AIG Commission Sales”.) • A first-best employment contract occurs when there is a direct link between effort and outcome, such as commission sales and piecemeal work. If a worker is to be paid for completing an axle that requires twelve bolts, then the worker is paid for the achievement, rather than the number of minutes the worker spent. If a sales agent puts in no effort and no sale is made then no commission is paid. In both cases there is a direct link between effort and outcome. However, first-best employment contracts are difficult to arrange. • A second-best employment contract is where there is either an indirect relationship between effort and outcome, or the relationship cannot be accurately measured or observed. An example is a contract where a CEO receives a bonus based on net income. If net income goes up, is that because of the effort of the CEO or is it because of some exogenous factors? How do you determine and measure the amount of effort that was put in by a CEO? Discussion of ethical issues 1. Was this an ethically correct sales pitch? Were the lenders taking advantage of financially naive customers? Brenkert (1998) argues that the ethics of marketing becomes questionable when the target audience of the advertising campaign is the more vulnerable members of society. He notes that there are four types of vulnerability. • The physically vulnerable are those who have physical ailment or disability and may be more susceptible to buying products that they think may help them to overcome their limitation. • The emotionally vulnerable, such as the grieving and the gravely ill, may succumb to ordinary temptations or inducements that they would otherwise be able to resist. • There is intellectual vulnerability among the young and the senile that lack the cognitive capability to understand the true meaning of the advertising claims. • The socially vulnerable, including the poor, who may be seduced by the hyperbole of the claims of various advertisements. In the case of the sub-prime mortgages, financial institutions were marketing the mortgages to the socially vulnerable and the derivate instruments to the intellectually vulnerable. The poor were deluded into thinking that they could live in homes that they could not afford. The derivative instruments were sold to investors who demonstrated cognitive immaturity because they did not carefully assess the risks associated with the product. Instead, they thought that they could earn above average returns by investing in mortgage-backed securities without adequately considering the risk of the underlying asset, namely that the housing market bubble might burst. Of course, some of these investors would complain that the risks of the subprime mortgagebacked investments were not properly and fairly disclosed. 2. Should the investors now be upset that, as a result of the subprime mortgage meltdown, Merrill’s stock price fell by about 30 percent in 2007? Investors know that there is a risk in investing in the stock market but if they have sufficient information to correctly assess that risk and the ability to act upon their assessment, they cannot complain about the ethics involved. Stocks go up and down. When the stock rises, and the investor sells and benefits. The investor loses when the stock is sold for a capital loss. Investors who hold the stock and ride both the unrealized gains as the stock increases and the unrealized losses as the stock falls, are not out ofpocket any money. There have incurred an opportunity costs. But there is no cash flow associated with an opportunity costs, although there is an emotional aspect. The investor may regret failing to realize a capital gain while the stock was increasing. Opportunity costs measure what could have been; the emotional content is that it measures the advantages and disadvantages of having failed to make other investments. Investors who willingly bought a stock and realized either a capital gain or a capital loss have no ethical complaint. The only investors who have an ethical complaint are those who attempted appropriate due diligence but were deceived when they bought or sold the stock. The deception could be based on false claims by brokers, the managers of the company and/or inaccurate financial reports. When investors are not given accurate or complete information, then there is an ethical issue because they are unable to make fully-informed investment decisions. 3. Are these executive settlements unreasonably high, given the huge financial losses and writedowns that their companies recorded? Executive pay is a second-best contract in which the link between effort and outcome is not always clear. When net income increases, executives often take credit, but when income falls they often blame external factors or some rogue member on the top management team. Because the link between net income and managerial effort cannot be clearly measured, it is difficult to say whether or not managerial effort contributed to the outcome. In other words, did net income fall due to exogenous factors, and did managerial effort prevent net income from falling even further. If that is the case, then should the CEO be rewarded? How would you know and/or measure the amount that net income did not fall because of the manager’s effort? Arguments can be made in favor of large exit packages. The large payout is not usually because the current net income fell. Instead, it is a reward for the good performance of the executive in the years prior to the current year. • Since there may be no direct link between pay and performance, the large settlement is simply the salary the executive has earned throughout the period, regardless of whether the financial performance of the firm was positive or not. Arguments can also be made against large payouts. • The manager is ultimately responsible for the performance of the firm and so should be accountable in both good and bad times. Since the performance in this period is poor, the manager should not be rewarded and no large package should be awarded. • Giving a large pay package to a senior executive when the financial performance of the firm is poor has the appearance of rewarding bad behavior. This sends a negative signal to other employees. There is no motivation for them to work hard and demonstrate good behavior if both good and poor performance is rewarded. • When large payouts are made during periods of depressed profits, there is a significant risk of damage to the reputations of the company and its executives. Ultimately, some executives have voluntarily, or at the request of governments, returned their payouts in order to preserve their jobs or reputations. The problem with both arguments is that the link between pay and desired outcome is not clear and is often difficult to measure. Stakeholder reaction, however, is increasingly predictable, and governments providing bailout funds have done so with provisos that such payments not be made to those executives who are dismissed. The question remaining is what is a reasonable amount? Reference: Brenkert, G.G. 1998. Marketing and the vulnerable.Business Ethics Quarterly, Ruffin Series 1, 7-21. Useful Videos, Films & Links McLean, Bethany & Joe Nocera (2010) “Excerpt: The Blundering Herd” Vanity Fair, Nov. http://www.vanityfair.com/business/features/2010/11/financial-crisis-excerpt-201011 Comstock, Courtney (2010) “Why the Fall of Merrill Lynch Hurt Stan O’Neal More than John Thain” Business Insider, Nov. 12thhttp://www.businessinsider.com/greg-farrell-john-thain-stanoneal-2010-11 “E. Stanley O’Neal” Times Topics, New York Times Dec. 8th 2010 http://topics.nytimes.com/top/reference/timestopics/people/o/e_stanley_oneal/index.html 7. Moral Courage: Toronto-Dominion Bank CEO Refuses to Invest in High-Risk AssetBased Commercial Paper What this case has to offer This case tells the true story of a CEO who demonstrated moral courage by going against conventional wisdom and not investing in the highly profitable asset-backed commercial paper (ABCP). The case illustrates that it is incumbent on executives to carefully review and assess the risks and opportunities associated with all business ventures, and not to blindly go along with everyone else. Teaching suggestions Before getting into the facts of the case, I have the students think about how, as a CEO, you would say ‘no’ your board of directors. How would you convince the board that entering a popular new line of business is contrary to the values of the firm? It is important that students learn tact, politeness, and careful reasoning. Discussion of ethical issues 1. Did the bank have a moral responsibility to assist in the restructuring of the commercial paper market? Carroll (1991) argues that firms have four responsibilities towards society: • An economic responsibility to remain viable thereby providing the goods and services required by society. A legal responsibility to operate within the laws of the society in which they conduct their business. • An ethical responsibility to respect and adhere to the social norms and values of the society in which they operate. • A social responsibility to promote the common good. The TD Bank did not contribute to the economic problems associated with the asset-based commercial paper fiasco. The bank was neither a manufacturer nor distributor of the ABCP products. As such they probably had no economic or legal obligation to help in the restructuring or remediation of the commercial paper market. But, according to leading thinkers about corporate responsibility, corporations do have a social obligation to help society, to contribute to the common good. The commercial paper debacle was harming society in general, and, in particular, the financial industry in which the bank operates. The TD Bank had the financial resources to help. As such it had a social obligation to assist in the restructuring of the market for the good of society and the good of the financial industry. 2. How would you explain to the board of directors that you were having a bank exit a market in which your competitors were making a lot of money? Moral courage is the ability to face problems calmly and with fortitude. It means not compromising on personal or corporate values. It is demonstrated when a CEO will not sanction a bad decision on the basis that it may contribute to the short-term profits of the firm. Bad decisions cannot be rationalized away. It takes tremendous strength of character and moral sensitivity to stand up to the board of directors and insist that the bank should not enter the ABCP market. Although probably highly profitable in the short-term, the products were fraught with danger in the medium- and longerterm. These high-risk products were contrary to the values of the TD Bank. Integrity is demonstrated by adhering to the firm’s core values. Members of the board would be receptive to arguments related to the conservation of bank assets under conditions of severe risk, enhancement of reputation, and reinforcement of corporate values and the bank’s ethical corporate culture. 3. Should the federal government have forced the banks through legislation to providing $950 million financial support to help solve the ABCP liquidity crisis? The government has a responsibility to promote the public interest. The central bank is the government’s vehicle for helping to promote the common good with respect to financial matters. As such, the central bank had a responsibility to ensure that the financial markets remained economically viable and liquid. This required an infusion of $950 million into the ABCP market. As such, the central bank had an obligation to ensure that all the commercial banks helped in restructuring the market for the good of society. Even though the TD Bank did not contribute to the ABCP problem, they had a general responsibility to society. In addition, the TD Bank would certainly have benefited indirectly by a return to normalcy in the securities markets. Reference Carroll, A. 1991.“The pyramid of corporate social responsibility: Toward the moral management of organizational stakeholders,” Business Horizons 34, 39-48. 8. The Ethics of AIG’s Commission Sales What this case has to offer The excessive pay packages given to various employees at firms that subsequently went bankrupt raises ethical issues concerning fairness and equity. Why are some employees receiving rewards while other employees are not, and why are the rewards so excessive? This is a good case because, for many people, remuneration has both economic and emotional aspects. Teaching suggestions Begin by differentiating between first-best contracts and second-best employment contracts. (A similar teaching suggestion is made for the ethics case “Subprime Lending – Greed, Faith & Disaster”.) A first-best employment contract occurs when there is a direct link between effort and outcome, such as commission sales and piecemeal work. If a worker is to be paid for completing an axle that requires twelve bolts, then the worker is paid for the achievement, rather than the number of minutes the worker spent. If a sales agent puts in no effort and no sale is made then no commission is paid. In both cases there is a direct link between effort and outcome. However, first-best employment contracts are difficult to arrange. • A second-best employment contract is where there is either an indirect relationship between effort and outcome, or the relationship cannot be accurately measured or observed. An example is a contract where a CEO receives a bonus based on net income. If net income goes up, is that because of the effort of the CEO or is it because of some exogenous factors? How do you determine and measure the amount of effort that was put in by a CEO? Discussion of ethical issues 1. Ethics of commissions and commission caps Commissions on sales are first-best contracts. Firms are happy to have these contracts because revenue increases as sales are made, and a portion of that revenue is given to the sales agent. It is a win-win scenario. However, most firms prudently wait a period of time before paying commissions to protect against the customer returning the good and/or not paying for the item. It would be unfair for a sales agent to receive a commission on a sale that was reversed or not subsequently recorded by the firm. Sales drive most businesses. If the agent receives 10 percent of all sales, then the firm may be happy to pay a commission of $60 million because the firm has recorded sales of $600 million. These sales benefit everyone: customers, employees, shareholders, the government that receives taxes on the net income of the firm, and the agent receiving the sales commission all benefit from increased sales. Several arguments can be made in favor of no upper limit on sale commissions. If commissions are capped: • there is no incentive for the agent to put in more effort because it will not lead to more pay for the agent, and • the agent will only work until the agent receives the cap and then will stop working. This would not be to the benefit of the firm since the amount of sales to be derived from commissions would now be capped. On the other hand, an argument can be made for not remunerating sales agents only by commission. Commissions assume that the agent is only motivated by remuneration, but this is not always the case. Many employees work hard for both intrinsic and extrinsic rewards. In the final analysis, the Board of Directors of a company should consider their incentive systems in a context that includes effort and achievement, but also: • the impact the incentive schemes will have on the achievement or not of the company’s values, as well as • the impact they will have on the corporation’s reputation in the eyes of the public. 2. Perks to sales staff Companies need to guard against making two contradictory assumptions simultaneously. On the one hand it is assumed that sales agents are only motivated by extrinsic rewards such as commissions and paid vacations. Meanwhile it is assumed that all the other employees in the firm are motivated by both intrinsic and extrinsic rewards. The ethical question is why do firms make different behavioral assumptions about employees? Some may argue that to take away a benefit that previously had been given to executives and sales staff is unethical, on the basis that the benefit had initially been given in good faith as part of the employment contract. For management to later arbitrarily change the employment contract, without any input or agreement from the relevant employees, does not treat those employees with the respect and dignity they deserve as humans. It treats them as means rather than as ends in themselves. 3. Re-hiring managers Managers develop firm-specific knowledge and skills as a result of working for a firm. Often these skills are so unique that they are not transferable when an employee leaves and begins to work for another firm. Similarly, when a new employee joins a firm it may take a period of time to learn and master the firm-specific skills that are required by the new employer. The argument for re-hiring managers who caused problems is that those managers have firmspecific knowledge of the problems since they are the people who caused the problems. Because of their unique knowledge, they may be in the best position to be able to solve the problem. If new managers are hired, then it may take some time for the new managers to gain the firmspecific skills necessary to solve these problems. It may be costly for the firm to invest time, trouble and effort in training those new managers. On the other hand, it may be less costly to rehire the old managers and have them fix the problems they created. The opposing view is that managers should not be rewarded for poor performance. If they caused the problem, then they should be disciplined and if need be dismissed from the firm. To reward poor performance sends out a negative signal to other employees; there is no motivation for them to work hard at doing a good job, if both good and poor performance is rewarded. It also sends a negative signal to external parties about the values of the firm. If the firm is willing to tolerate, and even reward poor performance, then the quality of the firm’s products and services may be suspect in the eyes of both internal and external parties. Finally, managers who created the problem may not have the skill set to contribute effectively to the clean-up. Useful Videos, Films & Links “AIG set to repay $37 billion in bailout money” The Wall Street Journal Nov. 1st 2010 http://online.wsj.com/article/AP8988d983d6d646109cffb4cacfc762a7.html?KEYWORDS=aig+ bailout “News Hub: AIG, US Agree on Exit Plan” The Wall Street Journal, Sept. 30th 2010 http://online.wsj.com/video/news-hub-aig-us-agree-on-exit-plan/6A15A1AD-F840-44DC-AFE4F206C70084AC.html?KEYWORDS=aig+bailout Champ, Henry (2008) “Lawmakers fume at excess of failed firm’s execs” Washington File (available at cbc.ca) Oct. 8th http://www.cbc.ca/news/reportsfromabroad/champblog/2008/10/eyebrowraising_excess_at_the_t .html Chapter 9 – The Credibility Crisis – Enron, WorldCom and SOX Chapter Questions and Case Solutions Chapter Questions 1. What were the common aspects that were necessary for the Enron and WorldCom debacles to occur? In both cases, there was a dominant CEO who also controlled the Board of Directors. The Chair of the Board did not serve as an effective watchdog over the CEOs activities. In addition, senior financial officers were actively engaged in the manipulation of earnings and assets, and the siphoning off of funds for personal use, all to defraud the company. In each case, company policies and related internal controls of the company were suspended or over-ridden, and the Board was too trusting or too ignorant to ask the right questions. External auditors (Arthur Andersen in both cases) were willing to go along with manipulative entries and overstatements presumably to retain lucrative audit clients and consulting assignments. In so doing, they put aside the interests of the investing public and jeopardized pensions and employees’ interests. Finally, directors were apparently unaware of mounting problems because they were kept in the dark, and no whistle-blowers concerns were brought to them. 2. What actions by directors, executives and professional accountants could have prevented the Enron and WorldCom debacles? Directors should have reviewed policies for conflicts of interest and followed up on compliance with them using reports from internal audit and other sources. As a normal practice, they should have reviewed payments to employees and directors for stock options and other items for reasonability. Also they should have taken steps to create and ensure an ethical corporate culture, complete with a protected whistle-blowing mechanism. Executives could have spoken directly to Board members, or to the media, or used the False Claims Act – see Singer article. Professional accountants could have done the same, plus reported to the Audit Committee of the board, or to Arthur Andersen in writing. Arthur Andersen, of course, should have been more vigilant on SPE transactions, and should have refused to allow manipulative transactions without qualification of the audit opinion. They should have reported fully to the Audit Committee. In addition, they should have had more effective conflict of interest rules, and should not have permitted lure of revenue generation to overshadow their duty to the public interest. 3. Was the enactment of the Sarbanes-Oxley Act (SOX) necessary? Why or why not? I would say “yes” because the following patterns were too entrenched to be altered quickly without SOX, and the lack of credibility of and trust in the capital markets, and in turn in corporate accountability and governance, demanded a quick remedy: • Manipulation of financial reports to “smooth” earnings • Enormous remuneration for top executives, particularly with stock options • Lack of effective governance by Boards of Directors, due to: • Lack of understanding • Failure to accept responsibility • Lack of competence • Lack of effective legal penalties for executive and director malfeasance • Rampant conflicts of interest in the public accounting profession • Failure of public accounting profession to serve the public interest The negative side could be argued – that the market should be allowed to selfcorrect, but the correction would be slow, and the players would be reluctant to give up their positions of advantage. In the end, self-regulation produced the debacle, so far-reaching, quick readjustments would be an unlikely possibility. 4. What are the three most important improvements in the governance structure that could result from the SOX? It will take some time to know for sure, but the following are likely to be high on the list: • Requiring directors on key committees (audit and nominating) to be independent and competent • Establishing direct criminal liability on the part of the CEO and CFO for manipulations and/or failure to have appropriate control systems in place who must sign the quarterly financial reports asserting to both • Enhanced independence of external auditors • Ensuring that the Audit Committee has unfettered access to auditors and their discussions with management • Ensuring that whistleblowers have a path to the Audit Committee 5. What were the common elements in Arthur Andersen’s approach that appeared to allow the disasters at Enron, WorldCom, Waste management, and Sunbeam? Within Arthur Andersen, the audit partner responsible for each audit had the power to veto or ignore the recommendations of the quality control partner. Consequently, the ongoing pressure for more audit and consulting revenue (and take-home remuneration particularly for the audit partner) appears to have caused the audit partner in charge at each client cited to ignore warnings that could have prevented manipulations and the disasters. Pressure to retain and enhance revenue was also exerted by those managing the practice. 6. What is wrong with Enron’s banks financing transactions they knew were without economic substance? With hindsight, Enron’s banks should have realized that they were becoming accessories to the crime of misleading investors. If there was no legitimate financial purpose, then they were facilitating something else. In the future, they will be more careful in assessing their mandates and why they are in some business deals. As articulated in the chapter, the banks have paid huge fines for aiding and abetting in the Enron fraud, and will be stiffening up their due diligence protocols in the future. 7. How should Boards of Directors change incentive remuneration schemes for executives to lessen the risk of motivating executives to risk manipulations to enrich themselves? There should be less emphasis on short-term performance and on stock options where their value depends upon stock price rather than fundamental indicators of performance that are less susceptible to manipulation. Deferred payouts, concentration on cash payouts, remuneration schemes that have negative provisions for poor performance, and constant review and readjustment are all good ideas for a board to consider. Finally, the Compensation Committee of the Board should be independent of management so that decisions can be free of bias. 8. What lessons should be learned from reviewing the events described in this chapter? See the above list of learning points and false assumptions for Chapter 2. Case Solutions 1. Waste Management, Inc. What this case has to offer The Sunbeam and Waste Management cases were early, high profile evidence of Arthur Andersen’s flawed decision making process, and approach to dealing with clients and “working out” of audit adjustments rather than forcing large negative changes to financial statements or qualifying their audit report. Both cases proved to damage AA’s reputation, and were instrumental in generating sanctions from the SEC as well as triggering the SEC’s “take out” response when AA failed a third time with Enron to rectify the same audit and decision making deficiencies. In effect, the SEC was fed up with AA and decided to suspend the firm’s ability to give opinions on SEC registrant clients rather than apply a monetary sanction that could readily be paid and require another undertaking that could be ignored by AA. Teaching suggestions I ask a student in the class be asked to recap the main issues of the case, and then ask his/her colleagues to add their comments. I make sure that the class understands the manipulation methods revealed in the case, and the motivation for them. I would then discuss the questions listed at the end of the case and answered below Discussion of ethical issues 1. Why didn’t Arthur Andersen stand up to WMI management? Arthur Andersen didn’t stand up to the management of Waste Management, Inc. (WMI) because the firm wanted not to aggravate the management (Buntrock et al) an raise the risk of losing a lucrative audit and consulting client. The penalty for not demanding immediate corrections or an audit opinion qualification was quite low at the time relative to the revenue being generated, and the risk that WMI would not make a profit must have seemed low. A long-term work out of errors (slow correction over future years) may have seemed to be reasonable solution at the time. Of course, the overall financial picture changed, and AA was caught. 2. What aspects of their risk management model did the Arthur Andersen partners incorrectly consider? AA’s partners failed to accurately consider the cumulative damage to AA’s reputation, particularly with the SEC. As mentioned in the opening comment on this case, the SEC ultimately became fed up and AA lost its franchise to operate. Ultimately AA did not correctly compute its franchise risk and the cumulative change therein. 3. To whom should Arthur Andersen have complained if WMI management was acting improperly? To the WMI Audit Committee and Board, particularly to the independent directors. 4. Did the WMI Board and Audit Committee do their jobs? I would say that the WMI Board and Audit Committee did not do their jobs as fiduciaries of the public interest, and particularly they did not protect the interests of some shareholders who acquired shares under false pretenses as well as others like banks and governments. 5. Were the fines levied high enough? With hindsight, I would say that the fines were not high enough to change AA’s behavior or signal other executives that this kind of manipulation should stop. 6. Should you use the same “dog” to discover the “bones” in an accounting scandal? Using an agent that has made mistakes, does not guaranty the mistakes will be rectified or that the “dog” will offer the best service available. The statement is ridiculous. AA was probably retained so that they would not embarrass management or perhaps the major shareholder, Mr. Buntrock. Useful Videos, Films & Links “Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud” US Securities and Exchange Commission, March 22, 2002 http://www.sec.gov/news/headlines/wastemgmt6.htm “Waste Management settles” CNNMoney Nov. 7, 2001 http://money.cnn.com/2001/11/07/news/waste_mgt/index.htm 2. Sunbeam Corporation What this case has to offer The Sunbeam and Waste Management cases were early, high profile evidence of Arthur Andersen’s flawed decision making process, and approach to dealing with clients and “working out” of audit adjustments rather than forcing large negative changes to financial statements or qualifying their audit report. Both cases proved to damage AA’s reputation, and were instrumental in generating sanctions from the SEC as well as triggering the SEC’s “take out” response when AA failed a third time with Enron to rectify the same audit and decision making deficiencies. In effect, the SEC was fed up with AA and decided to suspend the firm’s ability to give opinions on SEC registrant clients rather than apply a monetary sanction that could readily be paid and require another undertaking that could be ignored by AA. Teaching suggestions I would suggest that a student in the class be asked to recap the case, and then ask his/her colleagues to add their comments. I would want to ask whether the class thought that Chainsaw Al’s overbearing style represented a common or uncommon stereotype. This discussion usually reveals that his dominating approach is not common, but by no means unique. It is a common thread through most of the AA cases discussed in Chapter 2. I would then discuss the questions listed at the end of the case and answered below. Discussion of ethical issues 1. Explain how Chainsaw Al used “cookie jar” reserves to inflate Sunbeam’s profit? In principle, “cookie jar” reserves are created when an opportunity presents (i.e. to overstate costs of reorganization) itself to overstate expenses in one reporting period and carry forward the credit as a “reserve” to be used to understate future expenses. This shifts profit forward to the future period when management decides extra profit is needed (i.e. the cookies are needed). 2. Can “bill and hold” practices ever be considered sales that should be recorded in the period in which the goods are initially “held”? Not unless there is an explicit (written) agreement that the goods are being held at the request of the customer who accepts the risks of storage at the seller’s premises without condition. This means that the seller cannot take the goods back for a credit. Also, the buyer should pay for the goods. 3. Why didn’t Sunbeam’s Board of Directors catch on to the manipulations? The Board was not informed until one of the internal auditors, Deidra DenDanto, resigned because no one would listen on April 3, 1998, and sent a letter to the Board. A stock analyst, Andrew Shore, had raised the alarm earlier but the Board was apparently not on guard. The unethical culture that Chainsaw Al and his associate, Russell Kersh, had created made sure that earlier concerns did not reach the Board. A culture of loyalty and silence was created by a system of stock options to 250 of the company’s top 300 executives. 4. How should a Board make sure that it gets the information it needs to monitor management actions and accounting policies? The Board should have introduced a whistle-blowing mechanism with reports to it at an earlier date, and should have been aware of the culture that was being created within the company as well as the style of management being practiced. They should make the opportunity to make contact with and get to know executives so these executives will contact them if need be, and to assess their competency when projects are being evaluated. Surveys of personnel attitudes can also be taken by outside services. 5. If you are a professional accountant who reports an ethical problem to your superior who does nothing, what more should you do? I would continue to report ‘up the line’ until I got reasonable answer, or to the ombudsman or ethics officer, or finally to the Audit Committee, or the Chair of the Board. 6. What problems can you identify with Arthur Andersen’s work as auditor of Sunbeam? The problems that could reflect poor audit work by AA might include: • Failure to verify reasonability of reserves such as by estimates of restructuring charges after the restructuring, and the ultimate use of the “cookie jar” credits thus created, • Failure to detect channel stuffing through normal cutoff tests, reviews of inventory amounts, unusual sales and discount practices • Failure to review large or unusual inventory and sales transactions, and large changes in reserves • Poor cutoff tests that did not detect the extension of a reporting period. • See also the section on AA’s Role 7. How should a Board assess the performance of their company’s auditors? A Board can assess the performance of the company’s auditors by: • Questioning them on their audit approach, findings and discussions with management • Assessing them on their knowledge of the company and its industry by posing questions about alternatives likely to be under consideration • Assuring that auditors understand that they are to report specific problems to the Board and are independent of management influence • Discuss the external auditors’ performance with management and separately with the head of internal audit. • Compare the auditor’s performance with that of other auditors that board members have encountered • Periodically ask for bids from other firms and the incumbent auditors 8. While it is attractive to have a CEO that is a strong person with a high profile, how should a board manage or keep track of such a person without demotivating them? CEOs must be expected to report regularly to the Board on standard matters and for any significant matters, particularly those requiring policy advice. The Board has a right to be kept up to date, to consult other executives, make policy recommendations and operate their portion of the governance system. Boards should not be a rubber stamp. They should set or approve strategy and policy, provide advice, evaluate performance and ensure compliance with policy and the law. If a Board member believes that s/he is not getting enough information, s/he should raise the matter and should consider resignation if the matter is not resolved. The Board also should have the right to meet without management present. See further discussions in Chapters 2 and 3. 9. Can a Board effectively monitor a CEO who is also the Chair of the Board? Not unless there is a “Lead Director” who acts as a quasi-chair and runs that portion of every Board meeting wherein the CEO and Chair is invited to leave the room for open discussion by the rest of the Board, or when matters pertaining to the CEO and Chair are being discussed. Useful Videos, Films & Links Byrne, John (1998) “How Al Dunlap Self-Destructed: The inside story of what drove Sunbeam’s board to act” Business Week, July 6th http://www.businessweek.com/1998/27/b3585090.htm Chainsaw: The Notorious Career of Al Dunlap in the Era of Profit-at-Any-Price, written by Business Week Senior Writer John A. Byrne. Book excerpt available at http://www.businessweek.com/1999/99_42/b3651099.htm Byrne, John (2002) “Chainsaw Al Dunlap Cuts His Last Deal” Business Week Sept. 5 http://www.businessweek.com/bwdaily/dnflash/sep2002/nf2002095_2847.htm Solution Manual for Business and Professional Ethics for Directors, Executives and Accountants Leonard J. Brooks, Paul Dunn 9781285182223
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