Business and Professional Ethics 9th Edition Brooks Dunn Test Bank and Solution Manual by Ace Test Banks

Business and Professional Ethics 9th Edition Brooks Dunn Test Bank

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Ch01 1. The difference between what the public thinks it is getting in audited financial statements and what the public

is actually getting is known as: a. the credibility gap. b. the expectations gap. c. the audit gap. d. the stewardship gap. e. None of the above ANSWER: b 2. Which of the following is not a trend described in Chapter 1 as having an impact on the ethics of business? a. Directors’ legal liability b. Management’s stated intention to protect reputation c. Auditors’ legal liability d. Management’s assertions to shareholders on the adequacy of internal controls e. Management’s stated intention to manage risk ANSWER: c 3. Which corporate report discusses subjects that include environmental, health and safety, philanthropic, and

other social impacts? a. A corporate annual report b. A corporate social responsibility report c. A corporate quarterly report d. A corporate stakeholder report e. A corporate ethics committee report ANSWER: b 4. Professional accountants, in their fiduciary role, owe their primary loyalty to: a. the accounting profession. b. the client. c. the general public. d. government regulations. e. All of the above ANSWER: c 5. Ethical corporate behavior is expected to lead to: a. higher profitability in the short term. b. higher profitability in both the short term and the long term. c. lower profitability in the long term. d. higher profitability in the long term. e. lower profitability in both the short term and the long term. ANSWER: d Copyright Cengage Learning. Powered by Cognero.

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Ch01 6. Examining the interests of stakeholders is probably required for: a. high short-term profits. b. optimal medium- and longer-term profits. c. continuing support from stakeholder groups. d. effective risk management. e. All of the above ANSWER: a 7. A value that is almost universally respected by stakeholder groups is: a. a super norm. b. an alfa norm. c. a value norm. d. a hypernorm. e. a general norm. ANSWER: d 8. Since the mid-1990s, both management and auditors have become increasingly: a. profit management oriented. b. ethics oriented. c. value management oriented. d. risk management oriented. e. marketing oriented. ANSWER: b, d 9. The following are determinants of reputation. a. Trustworthiness and responsibility b. Credibility, responsibility, and relevance c. Responsibility and impartiality d. Relevance and impartiality e. Relevance, credibility, and responsibility ANSWER: a 10. The following would be a key control function of a board of directors. a. Set guidance and boundaries b. Appoint the CEO c. Approve the sale of the company’s assets d. Decide on the company’s auditor e. All of the above ANSWER: e 11. Companies attempt to manage the risk of something happening that will have a negative or positive impact Copyright Cengage Learning. Powered by Cognero.

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Ch01

on the company’s objectives, such as: a. credit risks. b. litigation risks. c. reputation risks. d. ethics risks. e. All of the above ANSWER: e 12. Most large corporations do not consider these risks in a broad and comprehensive way. a. Operational risks b. Reputational risks c. Credit risks d. Market risks e. Ethics risks ANSWER: e 13. The following are examples of ethics risks faced by employees. a. Honesty and integrity b. Fairness and compassion c. Integrity and responsibility d. Fairness and integrity e. Responsibility and honesty ANSWER: b 14. Not reporting environmental issues is an example of: a. a lack of transparency. b. a lack of integrity. c. a lack of accuracy. d. All of the above e. None of the above ANSWER: b 15. Incomplete disclosure of a company’s revenue recognition policy is an example of: a. a lack of transparency. b. a lack of integrity. c. a lack of accuracy. d. All of the above e. None of the above ANSWER: a 16. This philosophical approach requires that an ethical decision depend upon the duty, rights, and justice Copyright Cengage Learning. Powered by Cognero.

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Ch01

involved. a. Consequentialism b. Virtue ethics c. Duty ethics d. Righteousness e. Deontology ANSWER: a 17. The Modified Moral Standards Approach focuses on the following dimensions of the impact of a proposed

action. a. Whether it provides a net benefit to society, is fair to all stakeholders, is right, and demonstrates the virtues expected b. Whether it provides a net benefit to society and whether it is legal c. Whether it provides a net benefit to society, is fair to all stakeholders, and is legal d. Whether it is fair to most stakeholders and is right e. Whether it provides a net benefit to society, is fair to most stakeholders, and is right ANSWER: a 18. This organization is developing an international code of conduct for professional accountants. a. The International Accounting Standards Board b. The European Federation of Accountants c. The Financial Accounting Standards Board d. The Public Accounting Oversight Board e. The International Federation of Accountants ANSWER: e 19. The following is a fundamental factor for having an effective ethical corporate culture. a. Tone at the top (Ethical leadership) b. Efficient oversight by the company’s board of directors c. Workplace ethics d. Code of conduct e. An ethics risk management program ANSWER: a, c 20. How do we know that the #MeToo movement has been successful? a. Sexual violence against women has stopped. b. Police forces are taking women’s complaints of bullying seriously. c. Court cases against high-ranking executives and celebrities are becoming successful. d. Major companies are investigating and firing executives accused of sexual misbehavior with

employees. e. None of the above Copyright Cengage Learning. Powered by Cognero.

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Ch01 ANSWER: c, d 21. The August 2019 Business Roundtable Statement on the Purpose of a Corporation is important because: a. It confirms that profit maximization is the appropriate sole goal of corporations. b. It confirms that corporations are accountable only to shareholders. c. It confirms that corporations are to benefit all stakeholders. d. It changes what most executives have thought. e. None of the above ANSWER: c, d 22. NOCLAR rules or standards are important because they: a. will cause business to observe No Carbon Required practices. b. will cause executives to be less aggressive. c. will cause professional accountants to violate employer confidences. d. will cause professional accountants to report nonsustainable practices of clients. e. None of the above ANSWER: c 23. Nonfinancial measures of performance have become increasingly popular because they: a. are better measures of performance than traditional financial measures. b. are easier to understand than traditional financial measures. c. are easier to compute than traditional financial measures. d. are less susceptible to manipulation than traditional financial measures. e. All of the above ANSWER: e 24. The International Federation of Accountants (IFAC): a. is not relevant to professional accountants in most industrialized countries. b. is not relevant to professional accountants working in industry. c. was created to develop global accounting, auditing, and ethics standards for professional accountants. d. has the authority to discipline professional accountants. e. has an impact on professional accounting practices in less than 20 countries around the world. ANSWER: c 25. Effective crisis management could represent: a. an opportunity to avoid costs. b. an opportunity to change employees’ perspectives on risk. c. an opportunity to enhance a company’s reputation. d. All of the above e. None of the above ANSWER: c Copyright Cengage Learning. Powered by Cognero.

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Ch01

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Ch02 1. As a result of the spectacular stock market crash in 1929, the government enacted the Securities Act of 1933,

the Securities Act of 1934, and: a. The Glass-Steagall Act. b. The Investment Advisers Act. c. The Gramm-Leach-Bliley Act. d. All of the above e. Only a and b ANSWER: e 2. In 1984, Edward Freeman published an article on stakeholder theory. Which of the following is not true? a. A firm needs the support of its stakeholders to enhance the firm’s reputation. b. Stakeholder theory took years to mature. c. Stakeholder theory is not a useful framework for those interested in governance. d. Firms need stakeholders to achieve their corporate objectives. e. Stakeholder theory occurred at the same time as the rise in social and corporate activism. ANSWER: c 3. Which of the following is not covered under the Sarbanes-Oxley Act of 2002 (SOX)? a. The responsibilities of shareholders b. The responsibilities of the board of directors c. The responsibilities of management d. The responsibilities of auditors e. Conflicts of interest ANSWER: a 4. The overall requirement of the Internal Revenue Service Circular 230 is to ensure that tax professionals: a. know their clients. b. always develop tax plans for their clients. c. make tax planning suggestions that, even if they don’t have a chance of success, will save the client

some money in the short term. d. never develop tax shelters. e. only be professional accountants. ANSWER: a 5. A collateralized debt obligation (CDO): a. is an insurance policy that any investor can purchase. b. is a bond that is secured by a portfolio of mortgages. c. protects an investor in the event that the issuer of the mortgage defaults on the contract. d. acts as a hedge against changes in interest rates. e. was outlawed with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Ch02 6. Which of the following is not a sign of an ethical collapse within an organization, according to Marianne

Jennings, author of The Seven Signs of Ethical Collapse: How to Spot Moral Meltdowns in Companies? a. Pressure to meet financial goals b. Hubris c. Nepotism, favoritism, and hiring sycophants d. An open and candid organizational culture e. A weak board of directors ANSWER: d 7. The U.S. Federal Sentencing Guidelines were introduced in 1991 to: a. help judges formulate sentences. b. avoid sentences that were too light. c. signal potential sentences to executives and directors. d. encourage executives and directors to avoid environmental damage. e. All of the above ANSWER: e 8. Due diligence programs developed to reduce penalties levied under the U.S. Federal Sentencing Guidelines

for environmental harm did not include: a. awareness programs for employees. b. guidelines for employees. c. compliance oversight by corporate officials. d. rewards for noncompliance. e. encouragement for whistleblowers. ANSWER: d 9. Which of the following financial crises or fiascos were not related to the subprime lending crisis? a. Bear Stearns b. Lehman Brothers c. Bernie Madoff d. AIG e. Galleon Group ANSWER: c, e 10. Which was the largest fraud or bankruptcy leading to the crisis of investor confidence in 2002? a. Enron b. Global Crossing c. WorldCom d. HIH Insurance e. Xerox ANSWER: c Copyright Cengage Learning. Powered by Cognero.

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Ch02 11. The crisis in investor confidence in 2002 was caused by: a. a lack of integrity of business leaders. b. the manipulation of financial results. c. the boards of directors that did not provide proper oversight. d. the findings of alert auditors. e. All of the above ANSWER: a, b, c 12. SOX contained sections with regard to the auditors and/or audit committee that were designed to: a. increase the independence of management. b. increase the financial literacy of audit committee members. c. limit the conflicts of interest related to the services an auditor can perform. d. restrict the ability of auditors to serve on the audit committee. e. All of the above ANSWER: b, c 13. The U.S. Internal Revenue Service (IRS) implemented Circular 230 to remedy problems found with regard

to the marketing of tax shelters thought to: a. have no other purpose than reducing taxes. b. have lower than 50% chance of success if challenged by the IRS. c. not be in accordance with the client’s needs. d. create fictitious losses. e. All of the above ANSWER: e 14. Why didn’t investors caught in the subprime lending crisis take earlier note of the risks inherent in

investments known as collateralized debt obligations (CDOs)? a. Investors were driven by greed and the desire for high returns. b. Banks were selling and buying them. c. The risks were buried in complex, jargon-oriented documents. d. The risks were diversified over many mortgages. e. Only three of the above ANSWER: a, b, c, d 15. The U.S. government created the Troubled Asset Relief Program (TARP) to: a. bail out investors in U.S. financial firms and institutions. b. avoid a worldwide financial crisis. c. stimulate the U.S. economy. d. resolve the financial crisis in Iceland. e. make a profit on the ultimate sale assets bought at a low value. ANSWER: a, b, c Copyright Cengage Learning. Powered by Cognero.

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Ch02 16. The Dodd-Frank Wall Street Reform and Consumer Protection Act was created after the subprime lending

fiasco to protect consumers from deceptive practices related to: a. mortgages. b. credit cards. c. cars. d. financial derivatives. e. All of the above ANSWER: a, b, d 17. A Ponzi scheme, such as the one Bernie Madoff ran, is:

hard to hide forever. a. a card game. b. a sound investment scheme. c. a scheme to improve the environment. d. hard to hide forever. e. None of the above ANSWER: d 18. Ralph Nader contributed to the lack of credibility of corporations by exposing: a. their excessive bonus schemes. b. their greed. c. their poor car safety. d. their poor environmental record. e. the “seller beware” attitude of toy manufacturers. ANSWER: c, d 19. Freddie Mac and Fannie Mae: a. were created to support the U.S. housing market. b. stimulated the U.S. housing bubble. c. provided bailout funds to the U.S. government. d. acted in the best interests of consumers. e. acted in the best interests of lenders. ANSWER: a, b 20. Who among the following demonstrated extraordinary hubris (the arrogant belief that rules are for other

people but not for us)? a. Kenneth Lay b. Bernie Ebbers c. Arthur Andersen d. Scott Sullivan e. All of the above Copyright Cengage Learning. Powered by Cognero.

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Ch02 ANSWER: a, b 21. The Carillion plc bankruptcy was important because: a. it had major infrastructure construction and operations projects all over the world. b. it left tens of thousands of active and pensioned workers without financial support. c. it attracted the largest number of short sellers on the London Stock Exchange. d. it went bankrupt within six months of receiving a clean audit report. e. All of the above ANSWER: e 22. The QuadrigaCX cryptocurrency exchange went bankrupt because: a. the founder and operator died. b. the founder fired all professional accounting and control personnel. c. Canada had no regulatory framework to oversee such exchanges. d. the founder dissipated most of the exchange’s funds. e. cryptocurrency is a very risky investment. ANSWER: d 23. Deutsche Bank closed down a business segment producing roughly 20% of its business because: a. it was an unprofitable business segment for banks in general. b. the leader of that business segment was disgraced. c. there were damning reports from the German regulator. d. there was negligent strategic thinking. e. the culture in that business segment was beyond remediation. ANSWER: e 24. Large drug and chemical manufacturers have been fined huge sums for harmful products that they marketed

aggressively and that: a. were seriously harmful to humans. b. were priced at absurdly high margins of profit. c. involved a very high risk of addiction. d. have generated over 2,000 lawsuits. e. All of the above ANSWER: e 25. At least two major accounting bodies have begun to reimage the accounting profession because of the

following. a. A lack of basic accounting knowledge b. Faulty basic auditing practices c. Poor risk assessment practices d. A lack of competency with modern tools Copyright Cengage Learning. Powered by Cognero.

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Ch02 e. Three of the above ANSWER: e

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Ch03 1. Ethical dilemmas arise when: a. norms and values are in conflict. b. there is only one alternative course of action available. c. norms and values are not in conflict. d. there are several theories of ethical decision making. e. All of the above ANSWER: a 2. Individuals may be ethical because of: a. religious concerns. b. emotional attachments to other people. c. emotional attachments to other people. d. enlightened self-interest. e. None of the above ANSWER: e 3. This philosopher argued that self-interest motivates people to form peaceful civil societies. a. Adam Smith b. John Locke c. Thomas Hobbes d. Jeremy Bentham e. John Rawls ANSWER: c 4. This theory argues that the best ethical alternative is the one that will produce the greatest amount of happiness to the largest number of stakeholders. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: c 5. This theory focuses on the moral character of the decision maker. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: e 6. This approach focuses on coming up with an innovative solution to an ethical dilemma a. Deontology b. Distributive justice Copyright Cengage Learning. Powered by Cognero.

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Ch03 c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: d 7. This theory argues that equals should be treated equally in relation to their relevant equalities and differences. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: b 8. This theory is concerned with the motivation of the decision maker rather than the consequences of the decision. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: a 9. Two weaknesses of the following approach are that (1) it is difficult to determine who demonstrates integrity in the workplace and (2) it is difficult to choose between compassion and not betraying somebody’s trust. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: e 10. A problem with this theory is that the categorical imperative does not provide clear guidelines for deciding what is right and wrong when two or more moral laws conflict and only one can be chosen. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: a 11. Minority rights may be violated under this approach. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination Copyright Cengage Learning. Powered by Cognero.

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Ch03 e. Virtue ethics ANSWER: c 12. This approach presupposes that happiness, utility, pleasure, pain, and anguish can be quantified. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: c 13. This approach, a variant of utilitarianism, considers an action to be ethically good if it will probably produce a greater balance of good over evil. a. Act utilitarianism b. Active utilitarianism c. Sub-utilitarianism d. Consequentialism e. Virtue ethics ANSWER: d 14. Under this approach, what is important is that the decision was made for the right reasons. a. Deontology b. Distributive justice c. Utilitarianism d. Moral imagination e. Virtue ethics ANSWER: a 15. This philosopher argued that self-interest leads to economic cooperation. a. Adam Smith b. John Locke c. Thomas Hobbes d. Jeremy Bentham e. John Rawls ANSWER: a 16. There are two aspects of justice, but under this aspect there should be a consistent application of law. a. Distributive justice b. Procedural justice c. Balance of justice d. Deontology e. Teleology ANSWER: b Copyright Cengage Learning. Powered by Cognero.

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Ch03 17. If managers use moral imagination to determine ethical alternatives, the decisions need to be good for: a. the individual. b. the firm. c. society. d. a and b only e. All of the above ANSWER: e 18. A difficulty in applying this approach is identifying all possible stakeholders impacted by the decision. a. Deontology b. Distributive justice c. Utilitarianism d. Procedural justice/consequentialism e. Virtue ethics ANSWER: a 19. This philosopher argued that social and economic inequalities are just if these inequalities are to everyone’s benefit. a. Adam Smith b. John Locke c. Thomas Hobbes d. Jeremy Bentham e. John Rawls ANSWER: e 20. According to distributive justice theory, there are three main criteria for determining the just distribution. a. Need, fairness, and merit b. Need, arithmetic equality, and merit c. Opportunity, fairness, and merit d. Opportunity, fairness, and arithmetic equality e. Need, arithmetic equality, and equivalence ANSWER: b

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Ch04 1. The first resource for guidance when a businessperson or a professional accountant faces an ethical problem should be: a. commonly accepted social norms. b. corporate and professional codes of conduct. c. ethical decision-making frameworks. d. commonly accepted philosophical approaches. e. All of the above ANSWER: b 2. The AACSB Ethics Education Task Force has called for business students to be familiar with the following approaches to ethical decision making. a. Consequentialism, deontology, and virtue ethics b. Consequentialism, deontology, and moral imagination c. Distributive justice, deontology, and virtue ethics d. Distributive justice, deontology, and moral imagination e. Consequentialism, deontology, and distributive justice ANSWER: a 3. These are character traits that dispose a person to act ethically and thereby make that person a morally good human being. a. Norms b. Moral judgments c. Virtues d. Values e. Ethical judgments ANSWER: c 4. From a stakeholder point of view, which of the following must be satisfied for a decision to be considered ethical? a. The decision should demonstrate virtues reasonably expected. b. The decision should result in more benefits than costs. c. The decision should not offend the rights of any other stakeholders. d. The distribution of benefits and burdens should be fair. e. All of the above must be satisfied for a decision to be considered ethical. ANSWER: e 5. The costs of environmental cleanups absorbed by downstream individuals, companies, or municipalities are referred to as: a. surrogates. b. externalities. c. future impacts. d. collateral damages. e. ethical costs. ANSWER: b 6. These costs can be measured indirectly by using costs incurred in similar circumstances or mirror-image alternatives. Copyright Cengage Learning. Powered by Cognero.

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Ch04 a. Surrogates b. Externalities c. Future impacts d. Collateral damages e. Ethical costs ANSWER: b 7. What is the most common measure of shareholder well-being? a. Profit or loss b. Profit or loss plus externalities c. Profit or loss plus cost–benefit analysis d. Profit or loss plus risk–benefit analysis e. All of the above ANSWER: a 8. Which of the following is not a stakeholder right? a. Life, health, and safety b. A reasonable return on an investment c. Freedom of speech d. Fair treatment before the law e. All of the above ANSWER: b 9. This approach incorporates the expected future impacts of a decision into the analysis. a. Virtue ethics b. Consequentialism c. Cost–benefit analysis d. Risk–benefit analysis e. All of the above ANSWER: c 10. These values are the combinations of a value and the probability of its occurrence. a. Probable values b. Common values c. Present values d. Expected values e. Risk-adjusted values ANSWER: d 11. Which of the following is not one of the 5 questions in Graham Tucker’s original approach to ethical decision making? a. Is it profitable? b. Is it right? c. Is it fair? Copyright Cengage Learning. Powered by Cognero.

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Ch04 d. Is it legal? e. Does it demonstrate the virtues expected? ANSWER: e 12. The following four standards make up the modified moral standards approach. a. Utilitarian, individual rights, justice, and virtues b. Utilitarian, individual rights, fairness, and virtues c. Legal, individual rights, justice, and virtues d. Utilitarian, moral rights, justice, and virtues e. Legal, moral rights, justice, and virtues ANSWER: a 13. The modified Pastin approach adds the following concepts to stakeholder impact analysis. a. Rule ethics b. End-point ethics c. Social contract ethics d. Virtue ethics e. All of the above ANSWER: e 14. The following approach does not specifically incorporate a thorough review of the motivation for the decisions involved, or the virtues or character traits expected: a. The modified 5-question approach b. The modified moral standards approach c. The modified Pastin approach d. All of the above e. a and b only ANSWER: d 15. A lack of awareness of the following problem results in executives not attributing enough value to the use of an environmental resource. a. A commons problem b. An ethics problem c. A value problem d. A risk-assessment problem e. A moral problem ANSWER: a 16. If a decision is expected to be unfair to a particular stakeholder group, the decision may be improved by: a. using stakeholder analysis. b. using a decision-making approach. c. increasing the compensation to that stakeholder group. d. increasing the compensation to all stakeholder groups. e. All of the above Copyright Cengage Learning. Powered by Cognero.

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Ch04 ANSWER: c 17. Which of the following is not an example of a common ethical decision-making pitfall? a. Conforming to an unethical corporate culture b. Focusing only on legalities c. Conflict of interest d. Failure to identify all stakeholder groups e. None of the above ANSWER: e 18. Failure to identify all relevant stakeholder groups for a proper stakeholder impact analysis may be the result of: a. bias. b. conforming to an unethical corporate culture. c. conflicts of interests. d. failure to consider the motivation for the decision. e. All of the above ANSWER: e 19. Completing steps in the following order provides a sound basis for challenging a proposed decision. a. Identify facts and stakeholders, rank stakeholders and their interests, and assess the impact of the proposed action. b. Identify a proper ethical decision framework, rank stakeholders and their interests, and assess the impact of the proposed action. c. Rank stakeholders and their interests, identify facts and stakeholders, and assess the impact of the proposed action. d. Identify a proper ethical decision framework, identify facts and stakeholders, and assess the impact of the proposed action. e. Rank stakeholders and their interests, identify a proper ethical decision framework, and assess the impact of the proposed action. ANSWER: a 20. Frequently, decision makers are subject to unreasonable expectations and unrealistic deadlines; this is an example of: a. conforming to an unethical corporate culture. b. focusing only on legalities. c. conflicts of interests. d. failure to identify all stakeholder groups. e. failure to rank stakeholder interests. ANSWER: a

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Ch05 1. Corporations are now increasingly realizing that they are accountable: a. legally to shareholders. b. legally to all stakeholders. c. strategically to additional stakeholders. d. a and b e. a and c ANSWER: e 2. A company’s internal auditors and the ethics officer should report: a. on a day-to-day basis to the CEO. b. on a day-to-day basis to the Audit Committee of the board of directors. c. regularly to the Audit Committee of the board of directors without management being present. d. a and c e. a and b ANSWER: d 3. Which of the following is not true? a. Principles are more useful than rules because principles can be interpreted as required in new circumstances. b. Rules are more useful than principles because rules can be interpreted as required in new circumstances. c. A blend of principles and rules is often optimal. d. All of the above e. a and c only ANSWER: b 4. Experience has revealed that, to be effective, a code must be reinforced by: a. the tone at the top. b. ethics officer and internal auditors. c. a comprehensive ethical culture. d. principles, rules, and examples. e. All of the above ANSWER: e 5. Which of the following is not an ethics risk management principle? a. Normal definitions of risk are too narrow for stakeholder accountability. b. Assign responsibility, develop follow-up processes, and conduct board review. c. Discovery and remediation are essential. d. The code of ethics must be reviewed by independent parties. e. An ethics risk exists when the expectations of stakeholders may not be met. ANSWER: d 6. A conflict of interest potentially exists when a given decision maker (D) and another person (P) are in the following situation. a. D has to exercise judgment on P’s behalf. b. P has to exercise judgment on D’s behalf. Copyright Cengage Learning. Powered by Cognero.

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Ch05 c. D has a special interest that interferes with proper judgment. d. a and b e. a and c ANSWER: e 7. This is the preferred approach to dealing with conflicts of interest. a. Management b. Disclosure c. Remediation d. Avoidance e. Awareness ANSWER: d 8. A fundamental problem examined by agency theory is how it is possible to align: a. shareholders’ and stakeholders’ goals. b. managers’ and stakeholders’ goals. c. shareholders’ and managers’ goals. d. principals’ and shareholders’ goals. e. agents’ and stakeholders’ goals. ANSWER: c 9. The 20/60/20 rule states that the total percentage of employees who could commit a fraudulent act is: a. 20. b. 60. c. 80. d. 100. e. None of the above ANSWER: b 10. Which of the following is not a characteristic identified by forensic experts in prospective fraud situations? a. High intelligence b. Greed c. Need for whatever is taken d. Opportunity to take advantage e. Low probability of being caught ANSWER: a 11. The primary focus of a compliance-based ethics program is to: a. prevent, detect, and punish violations of the law. b. define organizational values and encourage employee commitment. c. improve image and relationship with stakeholders. d. protect management from blame. e. All of the above Copyright Cengage Learning. Powered by Cognero.

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Ch05 ANSWER: a 12. The primary focus of an integrity-based ethics program is to: a. prevent, detect, and punish violations of the law. b. define organizational values and encourage employee commitment. c. improve image and relationship with stakeholders. d. protect management from blame. e. All of the above ANSWER: b 13. The most important factor in encouraging employee observance of an ethics program is that employees perceive it as: a. compliance based. b. values based. c. achievement oriented. d. stakeholder based. e. externally oriented. ANSWER: b 14. Building trust within an organization can have a favorable impact on employees’ willingness to share information and ideas in a process called: a. ethical awareness. b. ethical awakening. c. ethical renewal. d. ethical wave. e. None of the above ANSWER: c 15. A Conference Board survey identified the following rationale for developing codes of ethics. a. Make employees aware that adherence is critical to bottom-line success b. Provide a statement of do’s and don’ts c. Discuss what is expected in stakeholder relationships d. Establish values and mission e. All of the above ANSWER: e 16. This code deals with ethics principles plus additional examples. a. Credo b. Code of ethics c. Code of conduct d. Code of practice e. All of the above ANSWER: c 17. Which of the following is not a mechanism for monitoring a code of ethics? Copyright Cengage Learning. Powered by Cognero.

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Ch05 a. Ethics audit or internal audit procedures b. Reviews by legal department c. Awards and bonuses d. Annual sign-off by employees e. Employee surveys ANSWER: c 18. SOX imposed the following new penalties for executives. a. Fines b. Suspension c. Criminal prosecution for executives d. Return of ill-gotten gains e. All of the above ANSWER: c 19. Which of the following industries are corporate psychopaths likely to be attracted to? a. Automotive b. Construction c. Real estate d. Transportation e. Investment banking ANSWER: e 20. Which of the following corporate adventures depended on a corporate culture of integrity? a. Wells Fargo’s unethical incentives b. Siemen’s bribery scandal c. Merck and river blindness d. Enron’s financial manipulations e. None of the above ANSWER: c

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Ch06 1. The following elements are essential features of a profession. a. Extensive training, license or certification, and provision of important services to society b. Extensive training, primarily intellectual skills, and representation by professional organizations c. Extensive training, provision of important services to society, and primarily intellectual skills d. License or certification, representation by professional organizations, and autonomy e. License or certification, autonomy, and provision of important services to society ANSWER: c 2. The following value is not necessary for an accounting professional. a. Honesty b. Integrity c. Objectivity d. A primary commitment to self-interest e. Trustworthiness ANSWER: d 3. The following duties are essential to maintaining a fiduciary relationship in the accounting profession. a. Development and maintenance of required knowledge and skills b. Maintenance of trust c. Maintenance of an acceptable personal reputation d. All of the above e. a and b only ANSWER: d 4. Professional accountants, in their fiduciary role, owe primary loyalty to: a. the accounting profession. b. the client. c. the general public. d. government regulations. e. All of the above ANSWER: c 5. According to Kohlberg, at this stage of moral reasoning, fear of punishment and authorities is a motive for doing right. a. Obedience b. Egotism c. Interpersonal concordance d. Law and duty e. General rights and standards agreed upon by society f. Self-chosen principles ANSWER: a 6. According to Kohlberg's stages of moral reasoning, which of the following is the first stage at which a professional accountant should be motivated? a. Obedience Copyright Cengage Learning. Powered by Cognero.

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Ch06 b. Egotism c. Interpersonal concordance d. Law and duty e. General rights and standards agreed upon by society f. Self-chosen principles ANSWER: d 7. Which of the following is not a fundamental principle of codes of conduct for professional accountants? a. Act in the client’s best interest b. Maintain objectivity and independence c. Maintain the good reputation of the profession d. Maintain confidentiality e. Do not associate with misleading information ANSWER: a 8. If a professional accountant is billing an audit client for more hours than those actually worked, he or she will be violating the following fundamental principle. a. Objectivity b. Professional due care c. Integrity d. Confidentiality e. All of the above ANSWER: c 9. If a professional accountant is auditing a public company and she receives company shares as payment for her audit services, she will be violating the following fundamental principle. a. Integrity b. Objectivity c. Professional due care d. Confidentiality e. All of the above ANSWER: b 10. A professional accountant is auditing client A and providing consulting services to client B. Both clients are in the same industry. If the professional accountant uses specific information from client A’s audit to prepare a business plan for client B, he will be violating the following fundamental principle. a. Integrity b. Objectivity c. Professional due care d. Confidentiality e. All of the above ANSWER: d 11. Adopting the following measures would reduce the expectations gap and lessen public misunderstanding of the Copyright Cengage Learning. Powered by Cognero.

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Ch06 auditor’s role. a. Publishing a statement of management responsibility b. The auditor reporting annually to the audit committee c. Expanding the audit report to clarify the auditor’s role and the level of assurance d. a and b e. a and c ANSWER: e 12. The recommendation of the appointment and review of external auditors by the audit committee is an example of: a. safeguards reducing the risk of conflict of interest created by the profession, legislation, or regulation. b. safeguards reducing the risk of conflict of interest between an auditor and management. c. safeguards reducing the risk of conflict of interest within a professional accounting firm’s own systems and procedures. d. All of the above e. a and c only ANSWER: b 13. Using partners who do not report to audit partners for the provision of nonassuranc services to an assurance client would be an example of: a. safeguards reducing the risk of conflict of interest created by the profession, legislation, or regulation. b. safeguards reducing the risk of conflict of interest within a client. c. safeguards reducing the risk of conflict of interest within a professional accounting firm. d. All of the above e. a and c only ANSWER: c 14. The external review of an audit firm’s quality control system is an example of: a. safeguards reducing the risk of conflict of interest within the audit profession. b. safeguards reducing the risk of conflict of interest within a client. c. safeguards reducing the risk of conflict of interest within a professional accounting firm. d. All of the above e. a and c only ANSWER: c 15. This organization is developing an international code of conduct for professional accountants. a. The International Accounting Standards Board b. The European Federation of Accountants c. The Financial Accounting Standards Board d. The Public Accounting Oversight Board e. The International Federation of Accountants ANSWER: e 16. This organization issues auditing standards, carries out inspections of public accounting firms auditing U.S. public clients, and imposes sanctions when applicable. Copyright Cengage Learning. Powered by Cognero.

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Ch06 a. CPAB b. PCAOB c. SEC d. FASB e. AICPA ANSWER: b 17. This organization can set auditing standards in the U.S. a. AICPA b. FASB c. SEC d. PCAOB e. All of the above ANSWER: e 18. A professional accounting firm has several audit and tax clients; however, a single client represents 40% of the firm’s revenue. This situation could result in the following threat to professional independence. a. Self-review b. Intimidation c. Advocacy d. Familiarity e. Self-interest ANSWER: b, e 19. A professional accountant has been the partner in charge of a particular audit client for the past eight years. This situation could result in the following threat to professional independence. a. Self-review b. Intimidation c. Advocacy d. Familiarity e. None of the above ANSWER: d 20. A new audit client has been taken on by a professional accountant’s firm. The fee for this client’s audit engagement is significantly lower than that charged by the previous accountants. This situation could result in the following threat to professional independence. a. Self-review b. Intimidation c. Advocacy d. Familiarity e. None of the above ANSWER: e 21. The most recent International Code of Ethics for Professional Accountants mandates that professional accountants Copyright Cengage Learning. Powered by Cognero.

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Ch06 must protect the public interest because professionals serving the public: a. must be trusted by the public. b. must serve only the best interests of their client. c. must do what their boss says. d. must do only what is in their self-interest. ANSWER: a 22. Maintaining the confidentiality of client or employer matters is considered essential for a professional accountant (PA) in order that clients and employers: a. will continue to discuss all matters with the PA. b. will not fire the PA. c. will be protected from prosecution. d. will be able to maximize profits. e. will not find their competitive position to be jeopardized. ANSWER: a 23. New NOCLAR standards have been introduced in some jurisdictions requiring professional accountants (PAs) to report internally if a client or employer is not in compliance with laws or regulations on a significant matter, and if the matter is not remediated, to report externally because some PAs were witnessing noncompliance but not speaking up because: a. they thought confidentiality prohibited it. b. they weren’t sure if confidentiality prohibited it. c. they didn’t have the moral courage to do so. d. they did not understand that speaking up was in the public interest. e. they did not want to be identified as whistleblowers. ANSWER: a, b, c, d, e 24. If you are a professional accountant who is considering reporting noncompliance as contemplated under the NOCLAR standards, you would decide if the matter was significant enough to require reporting if it: a. was larger than the company’s materiality standards for financial disclosure. b. would have increased bonuses. c. was self-correcting in the next quarter year and resulted in no distortion. d. understated taxes payable. e. avoided the exercise of legal covenants from lenders. ANSWER: a, b, d, e 25. Professionalism is essential for professional accountants to protect the public interest. Which of the following are the most important aspects of professionalism? a. Technical competence b. Ethical behavior c. Awareness and consideration of the public interest d. Professional skepticism e. Moral courage ANSWER: a, b, c, d, e Copyright Cengage Learning. Powered by Cognero.

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Ch06

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Ch07 1. The new enterprise risk management (ERM) focuses on how risks and opportunities might impact the achievement of strategic goals as well as the creation, preservation, realization, or erosion of value. ERM involves the assessment of an organization’s: a. culture. b. capabilities. c. practices. d. strategies. e. All but one of the above ANSWER: a, b, c, d 2. It important that enterprise risk management (ERM) and strategy setting are integrated because: a. strategies should not be developed if the inherent risks are too high. b. strategies should align with an organization’s mission, vision, and operational risk profiles. c. ethics risks should be considered before strategies are activated. d. mindset risks need to be minimized. e. All of the above ANSWER: e 3. Ethics and ethical corporate culture should play a vital role in setting: a. the control environment. b. risk assessment. c. information and communication. d. monitoring. e. control activities. ANSWER: a, b, d, e 4. Which of the following is a source of risk identified by both the AICPA/CICA/CPA Canada and the Institute of Internal Auditors? a. Environmental b. Informational c. Financial d. Operational e. All of the above ANSWER: d 5. What is the recommended strategy when stakeholders’ potential for threat is high and the stakeholders’ potential for cooperation is high? a. Monitor b. Involve c. Discuss d. Defend e. None of the above ANSWER: e Copyright Cengage Learning. Powered by Cognero.

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Ch07 6. What is the recommended strategy when stakeholders’ potential for threat is low and the stakeholders’ potential for cooperation is high? a. Monitor b. Involve c. Discuss d. Defend e. None of the above ANSWER: b 7. The disclosure of the following three performance categories is recommended by the Global Reporting Initiative. a. Economic, environmental, and organizational b. Environmental, financial, and social c. Economic, organizational, and social d. Environmental, financial, and organizational e. Economic, environmental, and social ANSWER: e 8. The following performance component recommended by the Global Reporting Initiative relates to customer health and safety, marketing communications, and customer privacy. a. Labor practices b. Human rights c. Product responsibility d. Society e. Customer rights ANSWER: c 9. What are the two most difficult practical aspects of sustainability reporting? a. Identifying corporate impacts b. Measuring corporate impacts c. Deciding on the disclosure format d. Identifying boundaries for the report (i.e., number of years, countries, activities, etc.) e. Avoiding legal liability for misdeeds ANSWER: a, b 10. Auditors are mandated to assess the client’s risk of financial reporting fraud. Auditing standard the following a mandatory tool in fraud assessment. a. Discussion and brainstorming b. The fraud triangle c. Interviews with management d. The development of fraud training programs e. All of the above ANSWER: a

SAS 99 considers

11. Which of the following would be the least useful report of ethics risks and opportunities? Copyright Cengage Learning. Powered by Cognero.

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Ch07 a. By hypernorm value b. By shareholder group c. By product or service d. By corporate objective e. By reputation driver ANSWER: b 12. Which of the following best describes harassment? a. Improper behavior that is considered offensive by the victim and that the perpetrator knows is offensive b. Improper behavior that is considered offensive by society in general and that the perpetrator knows is offensive c. Improper behavior that is not considered offensive by the victim but that the perpetrator knows is offensive d. Improper behavior that is considered offensive by the victim but that the perpetrator does not know is offensive e. Improper behavior that is not considered offensive by the victim and that the perpetrator does not know is offensive ANSWER: a, d 13. What is the most important reason sexual harassment has recently become much more important for businesspeople? a. The #MeToo movement has gained more public support. b. Senior executives have been fired after investigations at McDonald’s and Fox News. c. Presidential behavior has been questioned. d. Courts have allowed harassment lawsuits to proceed. e. High-profile cases have changed public opinion and tolerance. ANSWER: e 14. An employee in charge of counting and depositing cash holdings at the end of the day urgently needs some extra cash to pay her son’s medical bills. According to the fraud triangle, this situation likely constitutes: a. motive/need. b. rationalization. c. opportunity. d. a and b e. a and c ANSWER: e 15. An employee in charge of the customer service helpline urgently needs some extra cash for paying his son’s hospital bills. According to the fraud triangle, this situation likely constitutes: a. motive. b. rationalization. c. opportunity. d. a and b e. a and c ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Ch07 16. An employee who thinks he is being treated unfairly because he is regularly working unpaid overtime urgently needs some extra cash. According to the fraud triangle, this situation likely constitutes: a. motive. b. rationalization. c. opportunity. d. a and b e. a and c ANSWER: d 17. An employee in charge of the cash register at a busy restaurant steals small sums of money at the end of the day whenever the cash in the register exceeds the sum of the day’s bills. He thinks it is fine to do so because every day there are two or three customers that pay more than they should. This type of rationalization is categorized as: a. everyone else is doing it. b. denial of the victim. c. condemnation of the condemners. d. an appeal to higher loyalties. e. entitlement. ANSWER: b 18. An employee in charge of writing checks to suppliers in a manufacturing firm steals small sums of money every month by writing himself a check for the total of the discounts he negotiates with the company’s suppliers. This type of rationalization is categorized as: a. denial of responsibility. b. denial of the victim. c. condemnation of the condemners. d. everyone else is doing it. e. entitlement. ANSWER: b, e 19. An employee in charge of collecting tickets at the entrance of a movie theater lets her friends enter the theater without paying for tickets. She thinks it is fine to do so because the employees at the popcorn bar give free popcorn to their friends. This type of rationalization is categorized as: a. denial of responsibility. b. denial of the victim. c. everyone else is doing it. d. an appeal to higher loyalties. e. entitlement. ANSWER: c 20. The following need is at the top of Maslow’s Hierarchy of Needs. a. Esteem b. Respect c. Fulfillment d. Safety e. Affinity Copyright Cengage Learning. Powered by Cognero.

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Ch07 ANSWER: c 21. Forensic accountants require knowledge and skills beyond the levels expected of regular professional accountants in the following areas. a. Professional skepticism b. Ethics c. Cybercrime d. Loss quantification e. Money laundering ANSWER: a, c, d, e 22. If you are a professional accountant employed in a firearms manufacturing corporation and your boss tells you to open a corporate bank account in the Cayman Islands where secrecy is guaranteed, what are the likely purposes of that account? a. Payment of accounts payable b. Tax evasion c. Money laundering d. Deposits of funds from banned purchasers e. Payment of dividends ANSWER: b, c, d 23. Crises can result in significant financial losses, but they can also result in other losses. Which of the following losses can have the worst long-run impact on a company? a. Short-term financial loss b. Loss of credibility with the media c. Loss of employee morale d. Loss of reputation e. Loss of executive concentration. ANSWER: c, d 24. An important difference between anticipated and unanticipated crises is that: a. unanticipated crises are easier to control than anticipated crises. b. unanticipated crises have a less negative reputational impact than anticipated crises. c. anticipated crises start much earlier than unanticipated crises. d. anticipated crises are less costly than unanticipated crises. e. anticipated crises have a longer uncontrolled period than unanticipated crises. ANSWER: d 25. Most of the damage is usually done in this phase of a crisis. a. Pre-crisis b. Reputation restoration c. Controlled d. Uncontrolled e. Post-crisis ANSWER: d Copyright Cengage Learning. Powered by Cognero.

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Ch07

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Ch08 1. Some observers claim that the U.S. Federal Reserve Board encouraged the housing and credit bubbles by: a. not regulating subprime mortgages. b. cutting interest rates. c. enforcing mark-to-market accounting. d. a and b e. a and c ANSWER: d 2. According to former Federal Reserve chairman Alan Greenspan, the Fed became concerned about subprime lending in 2000; however: a. the global demand for mortgage-backed security ended in 2005. b. the quality of mortgage products began to deteriorate in 2005. c. the global demand for mortgage-backed security started in 2003. d. the quality of mortgage products began to deteriorate in 2003. e. the global demand for mortgage-backed security ended in 2008. ANSWER: b 3. The 1933 Glass-Steagall Act precluded banks from: a. practicing subprime lending. b. selling insurance. c. underwriting insurance generating more than 10% of total bank income. d. underwriting securities generating more than 10% of total bank income. e. underwriting any securities. ANSWER: d 4. Which of the following is not an example of aggressive lending practices that contributed to the subprime crisis? a. Mortgagors were not required to make any down payment at the inception of the loan. b. Loans were given to people with poor credit histories. c. Loans were given to people with no income. d. A borrower could get a second mortgage and use it as down payment. e. None of the above ANSWER: a 5. In simple terms, a mortgage-backed security is: a. a portfolio of mortgages sold to investors through publicly issued bonds. b. a contract that transfers the ownership of a lender’s mortgages receivable. c. a contract that transfers the risk of noncollection from mortgage originators to other investors. d. All of the above e. a and c only ANSWER: d 6. In simple terms, the securitization process is: a. a way to sell structured investment vehicles (SIVs). b. a way for mortgage lenders to sell accounts receivable to public investors. Copyright Cengage Learning. Powered by Cognero.

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Ch08 c. a way to create high-yield investments with little risk. d. All of the above e. a and c only ANSWER: b 7. Mortgage-backed securities lost their value when: a. the underlying assets lost their value. b. borrowers (the mortgagees) walked away without a real obligation to repay. c. mortgage originators went bankrupt. d. a and b e. b and c ANSWER: d 8. These entities worked as second-party consolidators by purchasing loans and reselling them to investors. a. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) b. Structured investment vehicles (SIVs) c. Credit rating agencies d. Investment banks e. All of the above ANSWER: a 9. Rating agencies were exposed to a conflict of interest because: a. credit rating agencies were rating securities and investing in those securities. b. credit rating agencies used ratings to sell securities. c. the clients of credit rating agencies used ratings to sell securities. d. investors did not want rating downgrades. e. credit rating agencies were paid by the firms who created the securities being rated. ANSWER: e 10. These regulators were aware of the problem of “predatory real estate financing” and tried to blow the whistle in 2003. a. The Security and Exchange Commission and the Federal Reserve Board b. Iowa and North Carolina state attorneys c. The Office of the Comptroller of the Currency and the Office of Thrift Supervision d. Federal banking regulators e. None of the above ANSWER: b 11. A fundamental problem with Goldman Sachs’ GSAMP Trust was that: a. loans were given to people with poor credit histories. b. homeowners’ equity in the securitized mortgages was less than 1%, on average. c. loans were given to people with no income. d. a sizeable portion of the securitized loans had little or no documentation. e. All of the above Copyright Cengage Learning. Powered by Cognero.

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Ch08 ANSWER: e 12. Goldman Sachs’ GSAMP Trust was able to create AAA-rated securities by: a. separating the mortgage portfolio into tranches and assigning the tranches to share risks of default equally. b. not disclosing the risks clearly. c. guaranteeing or protecting some tranches. d. separating the mortgage portfolio into tranches and assigning the A-1, A-2, and A-3 tranches last in order, after the M-1 to M-7 and B-1 to B-3 tranches, to suffer losses if a default occurred. e. All of the above ANSWER: d 13. The movie The Big Short is the story of a few clever investors who realized that security markets were about to crash, and they: a. invested in CDOs. b. invested in CDSs. c. invested in NCDSs. d. sold stocks short. e. bought gold. ANSWER: c 14. Investors relied on the judgment of credit rating agencies because: a. credit rating agencies were supposed to be experts in evaluating credit risk. b. the information directly available to investors on mortgage pools was insufficient c. credit rating agencies were supposed to do their due diligence and do a thorough review before rating a given security. d. All of the above e. a and c ANSWER: d 15. Early in 2008, mark-to-market accounting provisions caused the banks to: a. revalue their portfolio downwards. b. be in jeopardy of falling below the regulatory capital requirements. c. restrict new loans. d. All of the above e. a and c only ANSWER: d 16. Late in 2008, the International Accounting Standards Board allowed firms to: a. reclassify devaluated financial assets, delaying the recognition of losses. b. estimate the value of the portfolio if there was no ready market for a derivative portfolio. c. reduce their capital requirements. d. accelerate the recognition of losses through mark-to-market accounting. e. None of the above ANSWER: a Copyright Cengage Learning. Powered by Cognero.

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Ch08 17. The 1999 Gramm-Leach-Bliley Act allowed banks to: a. engage in subprime lending. b. sell insurance. c. become more involved in investment bank activities. d. underwrite government bonds. e. choose between commercial and investment bank activities. ANSWER: c 18. Mark-to-market accounting is usually related to all of the following items, except: a. derivatives and financial instruments. b. the long-term cash flows of a firm. c. the short-term taxes payable of a firm. d. the short-term cash flows of a firm. e. the immediate recognition of unrealized gains and losses. ANSWER: d 19. Mark-to-market accounting is incorrectly characterized as being: a. relevant for management compensation purposes. b. relevant for valuation purposes. c. relevant to investors. d. sometimes misleading. e. responsible for the subprime lending fiasco. ANSWER: e

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Business and Professional Ethics 9th Edition Brooks Dunn Solution Manual

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Chapter 1—Ethics Expectations Chapter Questions and Case Solutions

Chapter Questions..................................................................2 Case Solutions.........................................................................8

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Chapter Questions 1. Why have concerns over pollution become so important for management and directors? Because the public perceive that our environment is finite and that our wellbeing is threatened. In turn they have influenced politicians to enact tougher laws and heavier penalties...up to $2 million/day, with the prospect of personal liability and jail. In addition, U.S. courts have agreed to hear lawsuits brought by foreigners for pollution on foreign soil (see ethics case “Texaco: The Ecuador Issue” in Chapter 1). Finally, pollution can erode the trust necessary to preserve stakeholder support, and this will be seen by stakeholders with resultant negative consequences in consumer and capital markets. 2. Why are we more concerned now than our parents were about fair treatment of employees? Our social consciousness is higher due to the reasons listed in Chapter 1. 3. What could professional accountants have done to prevent the development of the credibility gap and the expectations gap? See the discussion on the Treadway, Metcalf and Macdonald Commissions. Also see case “Arthur Andersen’s Troubles,” in Chapter 2. 4. Why might ethical corporate behavior lead to higher profitability? Because attention to ethical concerns can keep corporations out of costly problems such as clean-up of pollution, fines, low morale, and loss of reputation and stakeholder support; and it can open up profitable opportunities such as developing green product lines. 5. Why is it important for the clients of professional accountants to be ethical? Because auditors don't check 100% of all transactions and, even if they did, there would be conflicts of interest and other hidden issues which would be found only by chance. Making sure that clients are ethical provides assurance that they will not be hiding things from the auditors or engaging in unethical activities. The value of the auditor's opinion depends upon it. 6. How can corporations ensure that their employees behave ethically? By developing ethical corporate cultures based on codes of conduct to provide guidance; training to provide awareness and understanding; monitoring to assure compliance; and rewards or sanctions to reinforce the desired behavior. Also, the top executives should set the best example possible. 7. Why didn’t some corporations protect women employees from sexual abuse before 2017– 2019? Many factors have contributed to changes in workplaces and attitudes toward sexual abuse over the last decade, including the following reasons. Sexual abuse was once a taboo subject, but when media reported on sometimes decades-old abuses associated with pedophile priests, residential schools, and sports coaches, etc., taboos were eroded, particularly because abuses had been directed

Page |4 toward boys and men. Public outrage, media appetite, and victims realizing that they were not alone, increased coverage of the topic. At the same time, cultural norms concerning the roles and treatment of women were changing. The advent of desktop computers even played a role, because corporate employees were expected to type their own documents and not rely on “traditional” secretarial work by women. In professions and workplaces, more and more women were moving into non-traditional jobs. In still male-dominated workplace and professions, women in new roles feared reprisal if they complained of sexual abuse—if, indeed, they could find anyone to complain to. Complaints in male-dominated workplaces— particularly against a high-power or high-profile abuser–may have fallen on deaf ears. As more women gained roles of influence, recognition of workplace discrimination led to employment equity and pay equity programs. As workplace norms changed, so did cultural ones. Through continued media coverage, people learned more about the pervasiveness of abuse and its recipe: abusers were usually in positions of power and worked to isolate insecure or vulnerable victims and pressure them into secrecy through shame or threats of reprisal. Old attitudes of victim blaming—that women were responsible for or complicit in abuse, and that “No!” did not mean “no”–were being dispelled. Social media, used as a vehicle by the #MeToo movement in 2017, rocketed the awareness of abuses against women to new heights. The movement spread a feeling of strength-in-numbers and an attitude of “We’re not going to take it anymore.” Emboldened by widespread support, changing attitudes among women and men, and more women in roles of influence, corporations were forced to appear proactive and intolerant of abuse. Prior to 2017, there were relatively few instances were powerful men were successfully prosecuted in court with serious fines or prison as outcomes. That all changed with cases involving Bill Cosby (convicted in 2018) and Harry Weinstein (convicted in 2020).12 Corporations took note, and they took action against executives they formerly excused. See also the answer to question 13, Chapter 7, page 590: “The #MeToo Movement has finally succeeded in getting women’s allegations of sexual abuse to be taken seriously by management and boards of directors. Why did it take so long for this tipping point to be reached?” 8. Should executives and directors be sent to jail for the acts of their corporation's employees? Yes, they should, if the executives and directors act negligently or without engaging in due diligence procedures, which are designed to ensure that reasonable and proper actions are taken.

Eric Levenson, “Harvey Weinstein's trial is closely tracking Bill Cosby's. But there's 1 major difference,” CNN.com, January 28, 2020, https://www.cnn.com/2020/01/28/us/harvey-weinstein-bill-cosby-trial/index.html. 2 Mike Hayes and Meg Wagner, “Harvey Weinstein found guilty,” CNN.com, February 24, 2020, https://www.cnn.com/us/live-news/harvey-weinstein-verdict/index.html. 1

Page |5 9. Why are the expectations of a corporation’s stakeholders important to the reputation of the corporation and to its profitability? Without the support of key or primary stakeholders such as customers and employees, sustained profitability is not possible. A corporation’s reputation is based on the elements that such stakeholders find relevant to their support, including credibility, reliability, trustworthiness and accepting responsibility. 10. How can a corporation show respect for its stakeholders? By taking their interests into account (respecting them) when making decisions. 11. How can conflicts between the interests of stakeholders be resolved by a corporation’s management? By displaying sensitivity to each side, ranking the interests involved, and using this ranking to favor the most important, as discussed in the Text, Chapter 4. Stakeholders should be made aware of the ranking and decision process where possible. In the end, tough trade-off decisions may be involved, but stakeholders should have confidence in the process. 12. Why are philosophical approaches to ethical decision making relevant to modern corporations and professional accountants? The philosophical approaches to ethical decision making (utilitarianism, deontology, and virtue ethics—see Text, Chapters 3 & 4) are relevant because of stakeholders’ greater and growing ethical awareness, sensitivity, and power. Stakeholders can make a difference to the reputations and fortunes of companies and of professional accountants. Their support is needed now more than ever. 13. What are the common elements of the three practical approaches to ethical decision making that are briefly outlined in the chapter? The common elements are measures of well-offness, fairness, right(ness), and virtues expected. 14. Is a professional accountant a businessperson pursuing profit or a fiduciary that is to act in the public interest? Both, but when there is a conflict between these roles, the professional accountant must place fiduciary duty above personal profit. Otherwise, the public interest will not be protected (which is the primary goal of a professional—see later chapters in the Text, particularly Chapter 6, for discussion).

Page |6 15. Will the NOCLAR standards assist or hurt the accounting profession? For the most part, the NOCLAR standards will assist the accounting profession by bolstering its reputation for serving the public interest. They will: •

Help the profession recover from recent scandals by demonstrating that professional accountants have uniform ethical behavior (Text, pages 10, 15) and stress “…that the primary purpose of professional accountants is to serve the public interest…” (Text, page 15.)

•

Help PAs serve the public interest by requiring PAs to internally disclose (and potentially externally disclose) violations or potential violations of law or regulation, by a client or employer, that are not in the public interest.

•

Allow them/oblige them to report malfeasance and be pardoned for breaking client confidentiality

•

“[W]ill require professional accountants in assurance or in business as employees to report when they discover when their client or employer is not complying with laws or regulations. This will significantly change the role of professional accountants depending on how and when these rules are adopted by the professional body in each jurisdiction. These changes should help reduce the serious expectations gaps that have become apparent between the expectations of public for corporations and the accounting profession.” (Text, page 13.)

•

“…[W]ill require a professional accountant who discovers or suspects that his or her employer or client is not complying with laws or regulations to report this internally and then externally if no or insufficient action is taken.” (Text, page 15.)

•

Be included in the 2018 IESBA International Code of Ethics for Professional Accountants (see Text, Chapter 6) to which over 170 professional accounting bodies worldwide including the AICPA, CPA Canada, and ICAEW—as members of the International Federation of Accountants (IFAC), have pledged to harmonize their local codes in the near future. (Text, page 15.)

•

May make tax practice less aggressive.

On the negative side: •

Some worry that PAs must know and comply with more and more rules. However, wide acceptance of the NOCLAR standards and harmonization of codes will help reduce this concern.

•

Others worry that to avoid being reported upon, companies might hire non-PAs who have no professional obligations. In Canada, the majority of CFO roles are filled by CPAs. In the United States, however, an increasing number of CFO Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

Page |7 positions are being filled by MBAs.3 16. Why is it important for a professional accountant to understand the ethical trends discussed in this chapter? So that the expectations for business can be understood and so that advice can be given or actions can be screened according to what might be acceptable and desirable, now and in the future, with regard to operations as well as financial matters. Also, the accounting profession is subject to the same set of expectations—and is expected to rise to higher standards of performance–than business. 17. Why should a professional accountant be aware of the Ethics Code of the International Federation of Accountants (IFAC)? Because the IFAC Code is the newly defined standard to which all IFAC member organizations, including the AICPA, PA (formerly CICA) and ICAEW, IMA and SMAC have pledged to harmonize their Codes. The IFAC Code contains the common elements to which all professional accountants will adhere worldwide. (See also Text, Chapter 6.) 18. Why is an ethical corporate culture important? An ethical corporate culture—also called a culture of integrity–is one in which ethical behavior is considered normal and expected. This behavior is supported by codes, policies, and compliance that can be passed on to employees and agents. Developing and maintaining an ethical corporate culture are now expected aspects of good governance and are, therefore, part of what directors and senior executives must ensure are included in their responsibilities and duties. 19. What three ethics risks must a company guard against, and why? From Text, Table 1.7 (Ethics Risks), page 23: •

Organizational culture risks exist when an organization’s culture fails to provide sufficient support and guidance to ensure a culture of integrity.

•

Mindset risks exist when decision makers, employees, and agents are:

•

improperly motivated, or

use ethically unsound rationales for their decisions.

Systemic risks often originate outside an organization and affect an entire system of activity.

Each of these ethics risks can result in failure to meet the ethical expectations of

Jamal, Karim. “Developments in the U.S. CPA Profession: Will they be replicated in Canada?” (keynote speech, University of Toronto at Mississauga, September 14, 2018), PAC Annual Conference on Professional Accounting Futures, https://www.utm.utoronto.ca/pac/pac-events/pac-annual-conference-professionalaccounting-futures-september-14-2018. 3

Page |8 stakeholders. The consequences can be the loss of reputation, loss of stakeholder support, and prevention of full and/or efficient achievement of strategic objectives. Several topics associated with the management of ethics risks and opportunities, such as developing a culture of integrity, are discussed in the Text, Chapters 4 to 7.

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Case Solutions Cases Involving Improper Behavior 1. Selling Only Sugary Drinks (Chapter 1, page 36) What this case has to offer This case looks at actions that might be legal, but not ethical; individual rights versus the common good; and companies that dare to ignore key stakeholders. The case can be examined at a more general level by examining, for example, increases in diabetes and obesity levels; attempts by governments to influence companies to reduce sugar, salt, and fat in their offerings; and companies’ willingness—or not—to be influenced. Teaching suggestions I find it useful to start off by asking if the class members were surprised to learn how much sugar is in normally consumed sizes of sugary drinks. That raises awareness, and I go on to explore the relationship of sugar to diabetes and obesity problems, and the growing concern for each. I then ask what the ethical issues are in the case, which leads to discussion of the following issues. The case introduces the conflict between business freedom (the right of the doughnut chain to choose to sell profitable sugary drinks) versus the harm sugary drinks can cause to health and health habits. The company shows a lack of responsibility for the possible health consequences of its products, but it may be satisfying shareholders’ demand for profits. In the context of this particular university, the case also suggests that the company ignores customer feedback and refuses to change its offering despite consumer demand for healthy alternatives. Over the last decade or more, pressure has increased on food companies and fast-food chains to improve the health of their product offerings in order to fight a nearly global increase in diabetes and obesity rates—from New York mayor Michael Bloomberg’s 2012 attempt to reduce sugary soda size, to the United Kingdom’s 2010 “Public Health Responsibility Deal,” to a 2016 Canadian Senate report on taxing sugar. This case offers the opportunity to examine many stakeholders associated with the issue and their often conflicting desires, and the attempts made by governments (e.g., through taxation) and companies (through voluntary measures or all-out opposition, for example, by the American Beverage Association to Bloomberg’s proposal) that may or may not have expected or desired outcomes. For example, governments (healthcare systems) see rising costs with adverse health outcomes, and reduced productivity. Shareholders want profits, and sugary drinks offer good margins. Some consumers want sugary offerings; others (for example, health-care-associated individuals and associations) see the dangers of those offerings. Discussion of ethical issues 1. Why do you think that the doughnut chain continued to sell only sugary soft drinks even though it was under pressure to sell diet soft drinks as well?

P a g e | 10 The profit margin on sugary drinks increases with the size of the beverage, because drinks are made by adding water to syrup. The marginal cost of a larger sugary drink is small, so the profit is greater for the larger drink, and the business’s owners and/or shareholders need profitability. The profit margin on diet drinks may be smaller if, for example, they are sold as units, rather than on tap. Or, the chain may have made a deal with one drink supplier over another whose offerings include predominantly sugary beverages. Henry Ford said about the Model-T produced at the turn of the 20th century that consumers could have any color they wished, as long as it was black. In the fast-food industry, limiting choice can speed up customer flow-through and simplify supply ordering, order filling, storage, employee training, etc., but it is a company-centric decision. Given this particular doughnut chain’s customers’ reluctance to shop at more than one place when time is limited, the strategy might have been a profitable one in the short term, particularly if the chain had little competition. In the long term, however, especially if product substitution is possible, customers can vote with their feet if they feel their needs are not being met by the doughnut chain. Henry Ford’s strategy, for example, was ultimately used against him by a rival company that was more than willing to offer cars in other colors. 2. Was selling only sugary soft drinks ethical? Consider the questions of self-interest (the doughnut chain’s) versus the common interest (its consumers’ health; health problems and societal costs associated with excessive sugar consumption) and consumer feedback (desire for other beverages). It seems that the chain doesn’t demonstrate the hypernorm values of compassion or fairness, and lacks responsibility, so its decisions appear to be unethical. In the short term, ignoring changing consumer tastes and preferences could be a viable strategy, particularly if consumers have no substitute offerings if the chain has no competition, but over the long term, particularly as more health effects of sugar are exposed, consumer trust in the chain is eroded when it is clear that company interest is greater than consumer interest. Turning its back on a major stakeholder as a long-term strategy will very likely backfire on the company. As noted in the Text, Chapter 1, without the support of key or primary stakeholders such as customers and employees, sustained profitability is not possible. A corporation’s reputation is based on the elements that such stakeholders find relevant to their support, including: credibility, reliability, trustworthiness and the taking of responsibility. Not taking their interests into account shows a lack of respect for customers. And where product substitution is possible, consumers can walk away.

P a g e | 11 3. Should the university campus officials have forced the doughnut chain to carry diet soft drinks? Yes, if they want to take an ethical stance and protect their students. However, the university’s power to force the doughnut chain to change its product offerings may be limited unless the contract with the chain permits it or is up for renewal. However, if the university really wants to follow some elementary schools, hospitals, and other establishments in developing a healthy food product policy, campus officials may want to try to persuade the chain to offer non-sugar-sweetened drinks. Consumers/students may also provide powerful support by boycotting the chain or, at least, drawing attention to the unhealthy offerings and the chain’s denial to offer healthier choices. Useful Articles, Links, and Videos “Pepsi gets aggressive on cutting sugar,” Alanna Petroff (October 17, 2016), CNN Money, http://money.cnn.com/2016/10/17/news/pepsi-sugar-drinks-soda/index.html [Petroff writes that “…two-thirds of [Pepsi’s] single serving drinks will have 100 or fewer calories by 2025 as it cuts back on sugar. Currently [2016], less than 40% of its drinks have 100 calories or fewer.” In addition, the company says it will reduce saturated fat and sodium in its snack products.] “Food for thought: Food companies play an ambivalent part in the fight against flab.” (December 15, 2012). Economist, http://www.economist.com/news/special%2dreport/21568064%2dfood%2dcompanies %2dplay%2dambivalent%2dpart%2dfight%2dagainst%2dflab%2dfood%2dthought . [While a few years old, this article provides graphics and information on voluntary programs by food companies and fast-food chains to improve their offerings while still satisfying shareholders. Given their intentions, how have those companies performed?] “Introduce sugar tax, ban food and drink ads for kids: Senate obesity report: Number of obese children has tripled, adults has doubled across Canada since 1980,” Peter Zimonjic (March 1, 2016), CBC News, http://www.cbc.ca/news/politics/senate-obesity-sugar-tax1.3471469 [Introduces the Canadian senate’s obesity report and its recommendations, and counters with failed examples of taxation in other countries.] World Health Organization, “Global Health Observatory (GHO) data,” (2014), http://www.who.int/gho/ncd/risk_factors/overweight/en/ [Interactive website with 2014 data on global overweight, obesity, and body mass index (BMI) data.] “New York’s Ban on Big Sodas Is Rejected by Final Court,” Michael M. Grynbaum (June 26, 2014), New York Times, http://www.nytimes.com/2014/06/27/nyregion/city-loses-finalappeal-on-limiting-sales-of-large-sodas.html?_r=0 “The Extraordinary Science of Addictive Junk Food,” Michael Moss (February 20, 2013), New York Times Magazine, http://www.nytimes.com/2013/02/24/magazine/theextraordinary-science-of-junk-food.html [Although somewhat dated, this article documents a meeting in which many of the world’s largest food companies, in 1999, admitted culpability in their contribution to growing obesity levels, and what they did— or did not do—in response.]

P a g e | 12 “What is the single best drink for your health?” [DocMikeEvans video], 4:09, Mike Evans (October 18, 2014), Evans Health Lab: Whiteboard Health Videos, accessed at http://www.evanshealthlab.com/category/whiteboard-health-videos/ and https://www.youtube.com/watch?v=YjutUrbIM3I. [Education may be the most important ingredient in the battle against sugary drinks. This video compares drinks and highlights the benefits of one, in particular.] “What's the Best Diet? Healthy Eating 101,” [DocMikeEvans video], 15:13, Mike Evans (September 24, 2015), Evans Health Lab: Whiteboard Health Videos, accessed at http://www.evanshealthlab.com/category/whiteboard-health-videos/ and https://www.youtube.com/watch?v=fqhYBTg73fw [Education may be the most important ingredient in the battle against junk food consumption. This video compares examines changes in health, lifestyles, foods, and diets, scientific evidence, and recommends changes.] United Kingdom, Department of Health. “Public Health Responsibility Deal,” 2010-2015, https://responsibilitydeal.dh.gov.uk/ [This website provides links to videos and articles that include the food industry’s efforts to reduce salt and sugar under its voluntary “Responsibility Deal.” The information was “published under the 2010 to 2015 coalition government.”]

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2. Buying and Selling Blood (Chapter 1, page 37) What this case has to offer This case examines whether is it ethical to buy and sell blood and, by extension, other body parts that are essential to life. The case invites a comparison of these products to commodities and a discussion of why the sale of human organs is illegal and/or considered abhorrent in many countries. Teaching suggestions This is the first case I use each semester, because it clearly illustrates that a good analysis must include both social and economic factors. I begin by asking students to explain why this is a good business idea, and then why this is not a good business idea. Normally, the arguments in favour are economic: it provides money to the poor and homeless; it creates employment; and presumably, it will generate a profit for the owner. Normally, the arguments against are social: it exploits the poor and homeless; it is a violation of the ethos of having blood freely available to everyone (as in Canada); and it commodifies blood, an essential part of human existence. I then remind the students that their responses to all of the cases that we will be taking up must include both economic and social aspects, not just one or the other. This case can be used to look at questions of altruism versus financial gain; volunteerism versus exploitation; demand for blood, tissue and organs versus their limited supply or the need to increase their supply. A discussion of Maslow’s Needs Hierarchy (Text, Chapter 7) can be useful in discussing how ethical values can be shaped by environment and need, and how the disadvantaged might be exploited. Stakeholders in this issue include, but are not limited to, for-profit company collecting blood products; non-profits collecting blood products; company producing pharma products from blood products; donors; recipients of blood products or pharma products derived from blood products; healthcare organizations and regulators. Consider the points of view of, and the effects on, each stakeholder group when forprofit companies are involved in collection and sale of blood products and derivatives. Discussion of ethical issues 1. Is it unethical to pay donors for making blood donations? The practice of paying for blood differs depending on the jurisdiction. In the U.S., blood is paid for, but in Canada, it is not, generally speaking. Whether the practice is unethical depends upon the potential impacts on the stakeholders, particularly on donors who might be harmed, and on whether adding a profit component to the process of health care is ethical when the right to life or health is considered a fundamental right in a society. This latter issue is influenced by whether one believes that government or not-for-profit entities can deliver healthcare as efficiently, effectively, and humanely/fairly as for-profit entities. In Canada, access to health care is considered a right of all Canadians, regardless of ability to pay. The Canadian Health Care Coalition, for example, says, “Rooted in our health care system are the values of equity and fairness but these values lie in opposition to the goals of the free market. There is a profit to be made in health care and therefore the protection of public health care will require strong and vigilant Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 14 allies. We [The Coalition] believe in protecting and improving our public health care system; a system that puts patients before profits.”4 If we look at the 5-question Approach for evaluating decisions, we’re stopped at fairness and the impact on stakeholder rights with this issue. Exploiting the disadvantaged offends the rights of that stakeholder group. In addition, the company’s profit at the expense of others, or by capitalizing on altruism, is not fair, so paying donors for blood “donations” seems unethical. Paying for donations is a slippery slope, because there is a risk that coercion or harm could come to people in order to attain their blood products or body parts. In 19th century London, for example, the demand for cadavers was so great that grave robbers and body snatchers/murderers supplied corpses for medical research, and, today, the demand is so high for organs and cadavers that a for-profit industry of “cadaver service firms” or “body-brokers” has arisen, with more than 30 in the United States. The body brokers act as middle persons between cadavers and donors, “…charg[ing] for things like transport, storage and preservation.”5 It is arguable that organizations paying for blood could offset possible harmful consequences by ensuring that a strict screening mechanism and selection criteria are enforced. Unfortunately, the best intentions and internal controls are often breached. 2. Is blood a commodity that can be bought and sold like any other commodity? A World Health Organization (WHO) report says that “Blood and blood products are a unique and precious national resource because they are obtainable only from individuals who donate blood or its components.”6 At question is whether one person should benefit at the expense of the health of another person. Accepting harm or injury to another, through allowing the donation of body parts or fluids, is one thing, but paying for those parts or fluids means assigning a price to these essentials of life. While blood is replenishable, most organs cannot be regenerated, and the fear is that the most economically vulnerable are the most likely to accept money for body parts or fluids, to the detriment of their health.

“Pro-Public Healthcare [Position paper],” Amélie Baillargeon, September 8, 2016. Canadian Health Care Coalition [website], http://www.healthcoalition.ca/pro-public-health-care/, [p1] . 5 “The cadaver market. Death, where is thy bling? A growing industry tries to meet the demand for corpses,” Economist, February 1, 2014, accessed at http://www.economist.com/news/unitedstates/21595433-growing-industry-tries-meet-demand-corpses-death-where-thy-bling 4

World Health Organization and International Federation of Red Cross and Red Crescent Societies. 2010. Towards 100% Voluntary Blood Donation: A Global Framework for Action. http://www.who.int/bloodsafety/publications/9789241599696_eng.pdf, p. 14. 6

P a g e | 15 3. Is there a difference between selling blood that can be used in transfusions and selling blood that will be used to make pharmaceutical products? While transfusion blood is transferred from donor to recipient and may have an associated cost to the medical facility, pharmaceutical products are sold for much higher profits that benefit the company, rather than the donor. If considered in terms of fairness—an equal distribution of benefits and harm–to the stakeholders involved, selling pharmaceutical products made from donated materials is not fair unless the increased value is passed on to the donor. 4. Do companies, such as Canadian Plasma Resources, contribute to drug addiction and alcoholism by locating their clinics in poorer neighborhoods? The concern is that while $20 to $30 may not represent a lot of money to those who are not in need, and would not be considered adequate compensation for the time required to donate plasma for those earning more than that in hourly compensation, it may be considered a lot of money to those who are in need. A WHO report says, “Paid donors often lead lifestyles that expose them to the risk of HIV and other infections that could be transmitted through their blood. The highest prevalence of transfusion-transmissible infections is generally found among paid or commercial donors. People who accept payment for their blood are primarily motivated by the prospect of monetary gain rather than a desire to help save lives. The need to protect their income from blood “donation” compromises issues of honesty in the donor interview and they are highly unlikely to reveal reasons why they may be unsuitable to donate blood. Further, they are often undernourished and in poor health and may give blood more frequently than is recommended, resulting in harmful effects on their own health…Paid donors are vulnerable to exploitation and commercialization of the human body as they usually come from the poorer sectors of society and become paid blood donors due to economic difficulties. Any form of exploitation of blood donors, including payment for blood, coercion and the collection of blood from institutionalized or marginalized communities such as prisoners diminishes the true value of blood donation. A blood donation is a “gift of life” that cannot be valued in monetary terms. The commercialization of blood donation is in breach of the fundamental principle of altruism which voluntary blood donation enshrines.”7 Useful Articles, Links, and Videos “Pay for plasma: Calls for and against it from those affected,” Julia Wong, Global News, May 1, 2016, http://globalnews.ca/news/2652180/pay-for-plasma-calls-for-and-against-itfrom-those-affected/ Plasma Protein Therapeutics Association (PPTA). “Becoming a Plasma Donor,” Video, 10:00, posted by Canadian Plasma Resources [website], 2016. http://giveplasma.ca/becomea-donor/becoming-a-plasma-donor/

P a g e | 16 World Health Organization [WHO] and International Federation of Red Cross and Red Crescent Societies. 2010. Towards 100% Voluntary Blood Donation: A Global Framework for Action. http://www.who.int/bloodsafety/publications/9789241599696_eng.pdf Chapter 7: Organ Donation, in The Canadian Bioethics Companion: An online textbook for Canadian ethicists and health care workers. David Unger, 2016. http://canadianbioethicscompanion.ca/the-canadian-bioethics-companion/chapter-7organ-donation/ “Death, where is thy bling? The cadaver market.” (February 1, 2014) The Economist, http://www.economist.com/news/united-states/21595433-growing-industry-triesmeet-demand-corpses-death-where-thy-bling

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3. Pedophile Priests in the Catholic Church (Chapter 1, page 38) What this case has to offer This is a good case to begin a discussion of whistleblowing, and to reflect on the problems of an unethical corporate culture. If an employee is aware of wrongdoing within an organization, what should the employee do? This case can also be used when discussing whistleblowing programs in the Text, Chapter 7 (page 566ff). Teaching suggestions Have a class member provide a summary of the Singer article, “The Whistle Blower: Patriot or Bounty Hunter?” located at the end of Chapter 1. This will set the stage for discussing the problems a whistleblower faces, and why whistleblowing is essential to good corporate governance. Whistleblowing enables directors to ensure that appropriate action is taken on problems reported. Ask the following questions before discussing the ethical issues raised below: •

Do the students remember the pedophile priests’ scandal and their reaction at the time?

•

Do students think that the scandal resulted in a loss of reputation for the Catholic Church?

•

If the students were on a parish council, what would they have done if it were revealed there was a pedophile priest in their parish? Discussion of ethical issues

1. What are the responsibilities of employees who become aware of unethical behavior by their superiors? Often, employees are afraid to report wrongdoing because of the stigma of being labelled a snitch. Consequently, employers must create an environment of trust, so that employees will report wrongdoing. Employees must realize that the consequences of wrongdoing can be extremely damaging to the organization and often to society. As such, employees have an obligation to report wrongdoing to their superiors for the longterm benefit of the firm and society. 2. What actions should be taken by corporate leaders when they receive reports of sexual abuse? Why? Corporate leaders must conduct a thorough and private investigation into any reports of wrongdoing. The investigator must be mindful that the whistleblower may be falsely accusing a coworker for personal reasons. Also, the whistleblower may have only limited information that makes the situation incorrectly appear to be an instance of wrongdoing. Consequently, the investigation and its results must incorporate both procedural justice (that the investigative process was fair (and prompt)), as well as distributive justice (that the punishment was commensurate with the crime).

P a g e | 18 3. If unethical or illegal behavior occurs within a business enterprise, how can employees bring about change when initial reports are ignored? Ultimate responsibility for the activities of the firm rests with the board of directors. If initial reports to superiors are ignored, then employees have a responsibility to report wrongdoings to the board of directors. If no action is taken, then whistleblowing through the media should be considered. 4. Why do you think that senior managers want to cover-up scandals that occur within their organizations? Managers want to protect their personal reputation as well as the reputation of the firm. A loss of personal reputation can end a manager’s career, and a damaged reputation can harm the perceived organizational legitimacy of the firm. Good reputation is important for the long-term success of the firm. Consequently, directors, executives, and managers engage in scandal cover-ups, falsely believing that if the scandal is hidden, the wrongdoing does not exist. What these managers fail to remember is that eventually most cover-ups are unearthed. And the combination of a wrongdoing and a botched cover-up can be much more damaging to a firm’s reputation than the initial wrongdoing. 5. What actions can senior managers take to repair the damaged reputations of their organizations after scandals become publicly known? Do you think that apologies are worthwhile? The organization must create an ethical corporate culture by correcting its operational routines and internal controls in order to ensure that the wrongdoing does not reoccur. Then, the organization must invest in goodwill in order to re-establish trust with its stakeholders (Brown, Buchholtz and Dunn 2014). An apology is the first step on the road to repairing a damaged reputation. But, if employees do not believe that the CEO is trustworthy and caring, the apology will not be perceived as sincere (Basford, Offermann & Behrend 2014). Useful Articles, Links, and Videos Basford, T.E., Offermann, L.R., and Behrend, T.S. 2014. Please Accept My Sincerest Apologies: Examining Follower Reactions to Leader Apology. Journal of Business Ethics 119 (1), 99117. Brown, J., Buchholtz, A. and Dunn, P. 2014. The Role of Moral Salience in Firm-Stakeholder Trust Repair. Working paper. Koehn, Daryl. 2013. Why Saying “I’m Sorry” Isn’t Good Enough: The Ethics of Corporate Apologies. Business Ethics Quarterly 23 (2), 239-268. Haberman, Clyde. “The Fight to Reveal Abuses by Catholic Priests” [Video and article], The New York Times: Retro Report, March 30, 2014, accessed at http://www.nytimes.com/2014/03/31/us/the-fight-to-reveal-abuses-by-catholicpriests.html on September 23, 2014.

P a g e | 19 This video uses a medley of television news reports from the 1980s onwards to provide a history of repeated abuses by Catholic priests and repeated promises to end the abuse. The video caption asks the question, “Sexual abuse in the Catholic Church has been making headlines for years. Some priests have been punished, but what about the bishops who shielded them?”

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4. Sexual Abuse by a Penn State Football Coach (Chapter 1, page 39) What this case has to offer The case describes an important scandal and cover-up. It highlights how an organization’s departments and activities can take on a mythical aura such that they become exempt from criticism, and they fail to deal with problems quickly and effectively. Teaching suggestions Ask students who have been on sports teams to describe the culture of solidarity. 1. Discuss how team members are expected to contribute “110%.” 2. Explain how and why one team member might “take one for the team.” 3. Discuss how a team member should deal with other team members who are “not pulling their weight.” After a discussion of the organizational culture of team sports, have a class member provide an overview of the case facts of the Penn State football scandal. Discussion of ethical issues 1. Football is big business, raising millions and millions of dollars for American universities. Numerous administrators and officials at Pennsylvania State University put a higher value on college football than on the welfare of children. How would an organization develop such a misguided culture? Penn State focused on profits to fund university activities, and the football program was extremely profitable. What Penn State overlooked is that profits should not be the sole objective of an organization (particularly a university); profits should not get in the way of operating in an efficient, effective and responsible manner. An organization develops a misguided culture when it puts profits ahead of how those profits are generated. 2. Louis French discovered that a janitor saw Jerry Sandusky abusing a boy in the showers in 2000, but said nothing because he was afraid to “take on the football program.” Why do you think that certain organizational departments and programs develop a mystique such that their activities and behaviors cannot be challenged nor questioned? What can organizations do to prevent this from happening? Meyer and Rowan (1977) argue that many activities and departments within an organization become so institutionalized that they are accepted in an unquestioning fashion. Their practices and structures become ritualistic, because they reflect socially accepted beliefs and rules about how the organization should be structured and behave. As such, they become rule-like and are accepted in an unquestioning fashion. These myths can become incredibly powerful beliefs that determine the actions and activities of the organization. At Penn State, the football program was so institutionalized, so powerful, and so respected, that no one would dare to question its actions or conduct for fear of not being taken seriously or losing a job or promotions. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 21 Myths are very difficult to overcome. It requires senior managers to constantly question why certain activities are sanctioned and approved. Managers must be diligent in challenging accepted beliefs about “this is the way we’ve always done it.” Uncritical acceptance of organizational routines can lead to unacceptable and unethical activities being glibly accepted as normal operating procedures. Useful Articles, Links, and Videos Meyer, J., and Rowan, B. 1977. Institutionalized Organizations: Formal Structure as Myth and Ceremony. American Journal of Sociology 83, 340-363. “Sundance Film Review: ‘Happy Valley’: Amir Bar-Lev offers a typically gripping and thoughtful take on the Penn State scandal,” Justin Chang, Variety, January 21, 2014, accessed at http://variety.com/2014/film/reviews/sundance-film-review-happy-valley-1201066057/ on September 23, 2014. This author reviews the film, “Happy Valley,” saying it is “a gripping inquiry into the revelations of sexual abuse that shocked the U.S. and devastated Penn State’s storied football program. Rather than focusing primarily on Jerry Sandusky’s crimes, the film broadens in scope and complexity to examine the assumptions of an entire community, as well as the football-first culture that allowed evil to flourish in its midst.” Jerry Sandusky’s Son Discusses Alleged Sexual Abuse, Associated Press, WOCHit, July 17, 2014, accessed at http://www.youtube.com/watch?v=c1q-fXzLOiY on September 23, 2014. [Link active in 2020 at https://www.youtube.com/watch?v=TTGLnIal1WA.] The video describes an interview with Oprah Winfrey says that an adopted son of Jerry Sandusky provides details of the alleged sexual abuse he suffered at the hands of his father. Videos of parts of the interview are available at https://www.youtube.com/watch?v=3JZOTE61bIw.

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Advertising & Sales Promotion Cases 5. Tiger Woods: “Winning Takes Care of Everything” (Chapter 1, pages 39-40) What this case has to offer Whether success—celebrity, wealth, profitability, and prowess–replace the hypernorm values of responsibility, integrity, honesty are key discussion points in this case. Many students and businesspeople have the view that they can ignore values because success is all that counts. They often fail to realize that the ends-justify-the-means approach often does not produce medium- or long-term success. Analyzing stakeholder impacts through this case can be very helpful in exploring whether winning really takes care of everything. Companies, like Nike, need to understand their stakeholders and their stakeholders’ values. If stakeholders value an ethical corporate culture or strategy, support of an unethical brand or product undermines stakeholder trust in the organization. The same is true for individuals. Teaching suggestions I have found it helpful to start by asking how many students play golf or are familiar with Tiger Woods. Then I show the YouTube video noted in the case that tells the story, and then we deal with the questions listed. Considering the celebrity as a brand or corporation can be helpful here: if achieving an ethical corporate culture (culture of integrity) means understanding issues and their stakeholder impact, how far away from that ideal is Tiger Woods or other celebrities like Ray Rice—the football player whose punching of his fiancée went viral on YouTube in 2014? Discussion of ethical issues 1. Does winning take care of everything? In golf? In life? In business? No, it should not—but it often does cause blind eyes, particularly in the short run. Consider a performance evaluation: it is based on many performance measures, not a single one. Also, short-term success can be undermined if values required for longer term success are ignored, and/or performance or reputation wanes. As future managers, accountants, leaders developing an ethical corporate culture, you will want desirable behaviors throughout your organizations, and you want will employees to have an ethical mindset no matter what they are doing. Just winning is not in keeping with these objectives, and winning alone will not engender trust of stakeholders. Consider how the winning football legacy at Penn State was destroyed by child abuse by an assistant coach, Jerry Sandusky, and the unethical decisions by a legendary coach, Joe Paterno, and university officials to cover it up (See Chapter 1 case “Sexual Abuse by a Penn State Football Coach”).

P a g e | 23 2. Does how you play the game or run your business ever matter? If you learned that your investment banker lied and cheated on his wife and cheated in your last week’s tennis game, do you suppose that you would wonder how s/he conducts business? Most of us would lose trust in that person and be inclined to seek another investment banker. When we see people acting with integrity, responsibility, fairness, honesty and compassion in one facet of their lives, we are naturally inclined to respect and trust that person, believing that their behavior is predictable and respectable, given the evidence we have seen, in other aspects of their lives. A significant error of judgement in one aspect of a person’s activity will raise questions about their ability to perform in a reliable and trustworthy manner in others. 3. Is the reputational impact of unethical behavior different for a sports star than for a business, or for yourself? Tiger Woods along with many other sports stars are phenomena: we are so in awe of their feats—and don’t want to miss the thrill of their next appearance—that we are often blinded to their weaknesses or failings. But when their bad behavior becomes public, we recognize that their high profile may not buffer their reputation. Often, such behavior presents companies using stars for marketing with risks they want to avoid, and marketing contracts are terminated using built-in “morals” clause provisions. Businesses find that fallen stars are poor role models for adults or children, and many people realize that their behavior is not what they want others to emulate or endorse by buying. In the business world, scrutiny of high-level people is less intense if they lack celebrity appeal, but negative reaction can be as significant, and questions can be raised about suitability for promotion or termination. While Tiger Wood’s celebrity may protect him from fallout from some misbehavior, it is unlikely that a business person or professional would be similarly protected. For individuals wanting to work in positions of trust—such as professional accountants–the negative fallout could be career-ending. It may be helpful to consider other instances where unethical behavior has been negatively received. Many corporations have suffered significantly because the public has realized that the enterprise has been doing something unethical. Examples would include VW for cheating on emissions tests, or Wells Fargo for creating two million fake accounts. Also instructive is the public reaction in October 2016 to what presidential candidate billionaire Donald Trump dismissed as his “locker room talk”—a candid video and tape of lewd, denigrating comments about women. First Lady Michelle Obama eloquently described why his behavior and attitudes are unacceptable today, but also why fear of retribution makes it difficult to speak against people in power. Without celebrity stardom, many people might find that our stakeholders are quite unforgiving. In the future, there will be increasing scrutiny of how we do something, or how business earns a profit, not just of what we achieve. Focusing on the quality of how we do something, and the values we observe, will protect lasting reputation much more than spectacular short-run success. Useful Articles, Links, and Videos

P a g e | 24 “For Tiger, winning does take care of everything,” Roxanne Jones (March 27, 2013), CNN, http://www.cnn.com/2013/03/27/opinion/jones-tiger-woods/index.html [An editorial explaining why winners do get away with more than non-celebrities, and an assertion that celebrities don’t have the job of teaching children; parents do.] “Donald Trump, ‘Locker-Room Talk’ and Sexual Assault,” (Numerous authors, October 10, 2016). The Opinion Pages, New York Times, http://www.nytimes.com/2016/10/11/opinion/donald-trump-locker-room-talk-andsexual-assault.html?_r=0. [Opinions expressed about the release of a tape of Donald Trump speaking crudely about women and boasting of his sexual exploits.] “Donald Trump Apology Caps Day of Outrage Over Lewd Tape,” Alexander Burns, Maggie Haberman, and Jonathan Martin. (October 7, 2016) New York Times, http://www.nytimes.com/2016/10/08/us/politics/donald-trump-women.html “Watch: Michelle Obama’s powerful speech on the Trump sexual assault allegations [article with embedded video],” (October 13, 2016). Vox, http://www.vox.com/2016/10/13/13271166/michelle-obama-trump-speech [An eloquent speech on the denigration of women by U.S presidential candidate Donald Trump, why we should expect high standards of behavior, especially from leaders.] “We Shouldn’t Have Needed Photos to Understand Greg Hardy’s Violence: Stephen A. Smith didn’t change his tune on Hardy until Deadspin’s report. That’s wrong,” Justin Block (September 11, 2016), Huffington Post, http://www.huffingtonpost.com/entry/ray-ricegreg-hardy-domestic-violence_us_5640a2c4e4b0307f2cadf8e5 “Ray Rice terminated by team, suspended by NFL after new violent video [article and embedded video],” Jill Martin and Steve Almasy (September 16, 2014). CNN, http://www.cnn.com/2014/09/08/us/ray-rice-new-video/index.html

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Pepsi iPhone App Stereotypes Women (Chapter 1, pages 40-41) What this case has to offer

This case is an example of divergent beliefs among various stakeholders. Pepsi launched an iPhone application, as part of an advertising campaign targeting young males, which received a wave of criticisms since it was perceived to degrade and objectify women. There are several interesting aspects of this case, such as the reasons why this app was launched in first place and the company’s response to social criticisms. Teaching suggestions A good way to start the class discussion is to ask what a company should do before launching a public media campaign. Following that, I ask the students their opinions about the AMP iPhone application and whether it should be considered harmless and funny or a serious public relations issue. Finally, I ask the students what a company should do if a media campaign becomes the center of criticisms and what they think about Pepsi’s response. Discussion of ethical issues 1. Do you find it interesting that most of the critics were women and the media, but those who considered the app to be funny were young men? From a marketing perspective, this iPhone application was appealing to some target consumers. Clearly, what could be considered acceptable to some target consumers is not necessarily acceptable for all people. Male-centered marketing is a feature of AMP, promoting itself through male dominated extreme sports. The iPhone application may have appeared as a harmless way for guys trying to pick up women; however, its features stereotyped women and were offensive. This case is an example of the topic of moral sensitivity discussed in the Text, Chapter 1. 2. The target market of AMP is males between the ages of 18 and 24. If this group of consumers found the iPhone app to be funny and acceptable, then why did Pepsi withdraw the app? Pepsi’s intention was probably to attract some attention, but this campaign ended up becoming a social media fiasco. An interesting aspect of this case is how divergent opinions spread very rapidly beyond the company’s control through blogs, Twitter and other social media. Ultimately, the company responded to the interests of a large set of stakeholders. The potential costs of keeping this campaign in terms of damaged reputation and loss of business outweighed the financial benefits of the campaign. 3. Are advertising campaigns that are in bad taste also unethical? A number of factors might affect people’s reaction to an advertising campaign, for example, how relevant the advertising is to the product and its target market, the campaign’s style and presentation, and where the advertisements appear. Although disrespectful references to gender, race, religion, or culture should never be allowed, drawing a line between bad taste and unethical advertisement is sometimes difficult. Companies may use surveys or focus groups before launching a mass media campaign to make sure it is considered acceptable for a wide audience. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

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7. 41-42)

Should Porn Be Sold by Cell Phone Companies? (Chapter 1, pages

What this case has to offer This case permits students to discuss the trade-offs between activities that increase profits and activities that are socially responsible. It allows them to see that sometimes firms will forego profitable ventures if the ethics of the venture are questionable. Teaching suggestions This is a good case for discussing ethical relativism. Many students find ethical relativism appealing because it does not force them to say that anything is wrong. The theory is often used by students to eschew taking responsibility. So, a general discussion of ethical relativism should be conducted prior to discussing the facts of this case. Discussion of Ethical Issues 1. If selling pornography is legal, profitable, and readily available elsewhere, should Telus shut down its adult service? Why or why not? The argument in favor of permitting adult content on cell phones is “freedom of expression.” Some students will try to use an ethical relativism approach; that is, they will argue that whatever is in the individual’s interest is ethically acceptable—in other words, that ethics is simply a matter of personal choice. This is a good opportunity to point out the flaws in ethical relativism. •

This position would allow any practice to be ethically correct (such as slavery, torture, or genocide) if a number of people within that society thought that the practice was acceptable.

•

It does not admit that there is an absolute standard of right and wrong. There are many similarities in the ethical and moral codes of societies over time and through different cultures. Prohibitions about murder and other forms of violence are universal standards that would be abandoned under an ethical relativist approach.

•

Relativism admits of too many exceptions. “The ethical standard may apply to you, but not to me, because it would be inconvenient to me.”

•

It is very difficult to define a culture or a social group such that clear standards can be established for that group or sect.

The implication of ethical relativism is that values become a function of, or are causally dependent upon, an individual’s culture. The implication is that ethical truth would be “relative” to a specific culture and a specific time. Such a position essentially denies that there is any ethical truth.8

See The Encyclopaedia of Philosophy, 1967, Paul Edwards (ed.), v. 3, pp. 75-78.

P a g e | 28 Many people forget that having a right also entails having a responsibility. Adults may have a right to view and read anything that they want. But they also have responsibilities. •

Pornography can be harmful to children and so we have a responsibility to not allow them to see such material until they are old enough to understand what the material represents.

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Pornography tends to exploit women and the vulnerable. As such, we have a responsibility to not encourage their exploitation.

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We have a responsibility to be sensitive to the values of others who may be offended by seeing pornography on their cell phones.

2. Telus said that it wanted to be Canada’s premier corporate citizen. Should companies such as Telus feel obligated to give back to society? Some will argue for a false dichotomy, that a firm can either be socially responsible or it can be profitable, but it cannot be both. However, there is no strong empirical evidence to show that firms that are socially responsible are any less profitable than those firms that are not socially responsible. In fact, there are strong reasons for firms to engage in socially responsible activities, many of which have an indirect economic impact. •

Investments in socially responsible activities can increase the firm’s reputation, thereby creating an intangible asset for the firm.

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Many young adults who are beginning their careers prefer to work for firms that are socially responsible.

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Community stakeholders adversely impacted by firms that are not socially responsible could lobby regulators to deny licensing permits.

Ultimately, Telus, the mobile phone provider in the case, decided that the values signalled by the porn content service were incompatible with their desire to be “Canada’s premier corporate citizen” and withdrew the service. Useful Articles, Links and Videos McLean, Catherine (2007) “Why Telus ditched its plans to profit from porn” Globe and Mail, February 22. https://www.theglobeandmail.com/news/national/why-telus-ditched-itsplans-to-profit-from-porn/article17991588/ Fournier, Chris (2007) “Telus Stops Selling Porn After Protests From Catholic Church” Bloomberg, February 21. https://web.archive.org/web/20070930073833/http://www.bloomberg.com/apps/news? pid=20601082&sid=aqeEJ53nbyp0&refer=canada Austen, Ian (2007) “Canadian Company Offers Nude Photos via Cellphone” New York Times, February 19 http://www.nytimes.com/2007/02/19/business/worldbusiness/19cell.html?_r=1&ref=te lus-corporation

P a g e | 29 Carew, Sinead (2008) “Porn to spice up cell phones” Reuters, January 30th http://www.reuters.com/article/idUSN3030000720080130

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Virgin Mobile’s Strip2Clothe Campaign: Exploitive, Risqué, and Worthwhile (Chapter 1, pages 42-43) What this case has to offer This case allows students to discuss the issue of freedom of expression, freedom of choice as well as pornography. More importantly, it provides an opportunity to illustrate that having a right also entails having an obligation. Teaching suggestions The class should begin with a general discuss of the pervasiveness of pornography. It is readily available to almost everyone at any time. Does the fact that it is readily available make it socially acceptable? The students should also discuss the exploitive and dehumanizing aspects of pornography (See the discussion of the Ethics Case Should Porn be Sold by Cell Phone Companies? above). Discussion of ethical issues 1. The Strip2Clothe campaign may have been in questionable taste, but it did raise tens of thousands of pieces of clothing for the homeless. Does the end justify the means? The theory that the end justifies the means is a political theory, often attributed to Nicole Machiavelli. However, it is not an ethical theory. Ethics involves treating people as ends in themselves, and not treating them simply as a means to an end. Providing clothes to homeless people is a very worthwhile end. However, in this case, the end is accomplished by exploiting people. Having vulnerable teenagers perform a striptease for the titillation of others is a form of exploitation. Exploitation (dehumanizing people) is not treating people with the respect and dignity they deserve by virtue of their humanity. As such, the end (clothing) does not justify the means (exploitation). 2. Virgin Mobile has a history of using cutting-edge advertisements. It poked fun at religion in its 2004 holiday commercial Christmas-hanukwanzakah,” and it had the company’s founder, Sir Richard Branson, stand in a nude suit in New York’s Times Square as part of a “Nothing to Hide” campaign. Are marketing tactics that are tasteless and risqué also unethical? One of the purposes of marketing is to make a company or product known to potential consumers. Marketing that is in poor taste offends some stakeholders’ preferences or values. Tasteless advertising is justified on the basis that the consumer does not remember the advertisement, but does remember the product name. Tasteless advertisements are simply a means of communicating brand name information. But something that is in poor taste is not necessarily unethical. It becomes unethical when the advertisement uses people as a means to an end, or when the advertisement is designed to exploit vulnerable consumers. 3. Social awareness advertisements—Some years before, the Benetton Group S.p.A. developed the United Colors of Benetton Campaign, originally to draw attention to prejudice against black people. The campaign broadened over time to include other prejudices and consisted of a series of shocking pictures published in unexpected venues. For example, there were pictures of a nun kissing a priest, a bombed car in a street, a white dog kissing a black lamb, an AIDS activist on his Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 31 death bed in front of a picture of a crucified Christ, and a white girl portrayed with an angelic halo and a black boy with hair like horns. Is the Virgin campaign substantively different that the Benetton campaign of 1992? Some advertisements not only market products, but they also remind all of us of our ethnic diversity. The United Colors of Benetton drew attention to ethnic and cultural differences. There were not exploitive; they were not marketing to the vulnerable; and they were not ethically questionable. The Virgin Mobile advertising campaign, on the other hand, was exploitive of teenagers. They were encouraging teenagers to conduct a striptease for the voyeuristic gratification of others. A striptease tends to dehumanize the participant and injures the dignity of the stripper. Virgin was also marketing to the vulnerable. The young are cognitively vulnerable because they have not yet reached their moral maturity. Exploitive advertisements that are marketed to the cognitively vulnerable are considered just as unethical as advertisements that are marketed to the physically vulnerable (e.g., medical remedies to those with allergies) or to the mentally vulnerable (e.g., children, or those grieving or seriously ill). 4. What rule would you put forward that would differentiate ethical from unethical advertising campaigns? The two rules that most advertisers follow are: 1. Do not market to the vulnerable, and 2. Do not use people in an exploitive manner. Useful Articles, Links, and Videos LaVallee, Andrew (2008) “Virgin Mobile Pulls Back Racy Campaign” The Wall Street Journal, July 21 http://online.wsj.com/article/SB121660673649869421.html?mod=djemPJ

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Cases Involving Financial Transactions 9.

Goldman Sachs and the Greek Veil (Chapter 1, pages 43-44) What this case has to offer

This case constitutes an example of a company aiding a client to enter into a business transaction that appears legal, but is not necessarily ethical. Goldman Sachs helped the Greek government to set up structured finance transactions that reduced the book value of Greece’s national debt and resulted in an immediate cash windfall from the securitization of future cash inflows from airport landing fees and lottery revenue. These transactions enabled the Greek government to mask the true extent of its deficit and to legally comply with European Union rules for its member countries. Teaching suggestions An interesting way to introduce this case is to talk about the size and potential consequences of Greece’s bail-out. In May 2010, the European Union members and the IMF agreed on a €110 billion ($147 billion) three-year bail-out package to rescue Greece's embattled economy. Next, I ask students what the potential causes of Greece’s crisis were and whether or not it was an avoidable problem. Ultimately, this case highlights how a combination of inefficient oversight, ambiguous accounting rules, and complex financial transactions allowed the Greek government to borrow and spend beyond its means. Discussion of ethical issues 1. Did Goldman Sachs do anything wrong legally or ethically? Explain your answer. Structured finance transactions are part of normal government treasury operations. European governments obtain funds from investors around the world by issuing bonds in yen, dollars or Swiss francs; however, each government needs euros to pay salaries and other expenses. Years later, the bonds are repaid in the original foreign denominations. Investment banks help their government clients to hedge currencyrelated and other financial risks, Goldman Sachs acted on behalf of the Greek government in a series of legitimate financial transactions. Goldman Sachs was only one of several investment banks that worked with the Greek government. Moreover, in their own defense, the firm claimed that these transactions had a "minimal effect on the country's overall fiscal situation." However, the intention of these transactions could have been to deceive the European Union rules. It seems somehow unethical to profit by aiding a client to circumvent rules that are in place to ensure the monetary stability of the European Union countries. Finally, Goldman Sachs did not only profit from these transactions, but also from helping the Greek government to restructure its debt in 2010, as well as from proprietary trades that essentially bet against the country's ability to manage its problems. This may also constitute an ethical dilemma given that the investment bank indirectly contributed Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 33 to the Greek crisis and later on profited from this country’s financial debacle. It would be hard to argue that these transactions were acceptable or ethical because of their highly negative social consequences. It would appear that Goldman Sachs’ best guess was that their services to Greece would prove unsuccessful in changing the fundamental financial situation in Greece. Perhaps investment advisers/banks etc. should be required to disclose when they are betting against a product/client. 2. Would it make a difference if other investment bankers were also providing such services? Arguably, if Goldman Sachs had not aided Greece’s government to set up these transactions, some other bank would have done it. Most large investment banks offer these services to public and private clients. A recent article by the New York Times highlights that “Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.”9 It is very poor ethical reasoning to argue that “someone else will do it if we don’t”, or that “everyone is doing it,” because either approach can justify virtually any action. These rationales do not refer to any fundamental ethical principles. Ultimately, a corporation that is interested in its ethical reputation should base its actions on ethical principles, not on what their competitors are doing. 3. What subsequent impacts could the transactions described above have on Goldman Sachs? Because these deals were not recorded as government loans, they may have misled investors and regulators about the depth of Greece’s liabilities. The credit swap enabled Greece to improve its budget and meet a target needed to remain within the region’s single currency. Knowledge of Greece’s true financial position may have changed investors’ perception of the risk associated with this country and the price they may have been willing to pay for the country’s securities. Investment banks have a fiduciary duty while issuing public securities. If Goldman Sachs was aware of Greece’s potential financial risks and failed to disclose them while issuing securities, the investment bank may be subject to legal actions. At the very least, clients should begin to question Goldman Sachs’ loyalty and whether the firm can be trusted. In addition, there could be more reputational and legal costs for the investment bank. The U.S. Federal Reserve and Securities and Exchange Commission are currently examining financial deals that Goldman Sachs and other banking companies made with Greece before the country's debt crisis. This examination has the potential to create more public relations troubles for Wall Street firms, already troubled by their role in the U.S. financial crisis of 2008. Useful Articles, Links, and Videos

Story, Louise, Thomas Jr., Landon, and Schwartz, Nelson D. (February 13, 2010). “Wall St. Helped to Mask Debt Fueling Europe’s Crisis” New York Times, http://www.nytimes.com/2010/02/14/business/global/14debt.html?pagewanted=1&_r=1 9

P a g e | 34 For additional information on the “Goldman Sachs and the Greek Veil” case, see the interview: “Is Goldman responsible for Greek crisis?,” YouTube video, 4:47, posted by RT Moscow, February 11, 2010, at https://www.youtube.com/watch?v=tCe80hsx-ig

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10. Martha Stewart’s Lost Reputation (Chapter 1, pages 44-48) What this case has to offer Martha Stewart is an icon. She represents successful women who are smart, astute, and hard-driving in a male-dominated industry. Although she was once a stock broker and became a director of the New York Stock Exchange, she is best known for creating a billion dollar empire (Martha Stewart Living Omnimedia Inc.) based on the style, good taste and frugality she delivered daily on television, through her magazines, and through her line of housewares. These characteristics are all integrated into her reputation, and are a major reason why people are willing to watch her on TV, buy her goods, and subscribe to her magazines (see the website, martha stewart at http://www.marthastewart.com/ ). In 2004, what a shock it was to find the she would to go to jail for obstructing justice during the investigation of an alleged financially trivial insider trade of ImClone stock in 2002. It showed that anyone can lose his/her reputation and face great cost. It showed that we all need to be on guard for ethical malfeasance. The case of Martha Stewart Living Omnimedia Inc. (which traded as MSO)10 shows how reputation is vulnerable. MSO was subsumed as a subsidiary of Sequential Brands Group in 2015, which trades on NASDAQ as SQBG. MSO offers an opportunity to discuss the link between ethics and reputation, the link between reputation drivers and models, how trust underpins reputation, the cost of losing reputation, the relationship of reputation to brand recognition in marketing, insider trading, and ethical issues in general. Teaching suggestions Martha was as revered as she was reviled. Too perfect to be true, she was often the target of mocking comedy, only because she set unattainable standards for perfection in whatever she set her talents to—yet her huge following tried, and her companies were very successful. So while Martha was innocent until proven guilty in court, debates about her innocence or guilt were lively, tainted by some wishing her to fail. So through court, could her reputation escape intact? In class, I begin by drawing attention to Martha’s current television show and persona to set the stage, and after calling for a recap of the case, I deal with the questions asked at the end of the case, answered below. I use a set of PowerPoint slides (PPT)to frame my discussion. They are available on the instructor companion website through Cengage as Session 2 of my Ethics & Governance course (PPT 63 to 66 for this case). Discussion of ethical issues 1. What was the basis of Martha Stewart’s reputation? See the first section above. 2. Why did MSO’s stock price decline due to Martha Stewart’s loss of reputation? Martha was the dominant individual in the formation and delivery of value in the MSO business model – there was really no one else who could fill her role, so revenue and profits were sure to decline. Investors are far-sighted in that the announcement of 10

MSO traded from 1999 to 2015.

P a g e | 36 investigation and charges against Martha created a dark cloud over her image and therefore her reputation. They reasoned that fewer people would want to sleep on Martha Stewart bed sheets if she became a felon, and the profit of MSO would fall. Also, if Martha really was a one-person dynamo whose ideas and savvy made MSO successful, then prospects for continued dynamism would be reduced if Martha was in jail. Reduced profits meant that investors would be prepared to pay less for shares of MSO. 3. Who is Martha Stewart’s target market? Martha’s target market is made up of women (and men) who are respected and are interested in the characteristics that gained her reputation because they would like to identify with those characteristics. I believe that this encompasses a wide age range of homemakers who are interested in good, wholesome value(s). 4. What qualities were associated with the Martha Stewart brand before the controversy? Which of these were affected by the accusations of insider trading, and how? How would you find out for sure? Refer to the list of characteristics listed above, and to PowerPoint (PPT) slide 66 for a framework and qualities to start the discussion. Obviously, the trust in Martha and her products was weakened by the accusations and some customers might wonder if they really knew the real Martha and what she stood for. They might opt for a brand in which they had trust. Also some retail chains might choose not to carry Marta’s brands for fear they would be seen to be dealing with an undesirable person. Attitude surveys could reveal a potential shift, as could cross-sectional focus groups. Observed behavior in the short run could also provide helpful information. 5. What level of sales and profits would MSO have reached if Martha’s reputation had not been harmed? Refer to the SEC or MSO websites for information on financial trends. The answer is a matter of projection based upon observed trends for MSO and for the industry. Websites with historical price information (such as Historical Stock Price.com) could be useful. The intent is for the students to explore the factors involved, including MSO, competitor and industry trends, economic assumptions that could bear upon revenues and costs, and so on. 6. What range would the stock price have been in at the end of 2002 based on your estimates? This follows from the analysis in question 5, and from projecting the price/earnings multiple that shareholders might be willing to pay for those earnings. Based on the MSO 2001 Annual Report, earnings per share were $0.45 in 2001 and $0.44 or $0.43 in 2000. According to a search of historical stock prices at Historical Stock Price.com, MSO stock traded during 2001 from $17.50 to $22, approx. Therefore, an estimate of EPS would be 40/1 approx. 7. Stewart’s overall net worth was huge relative to her investment in ImClone. Assuming she did not have inside information, was there any way she could have avoided the appearance of having it?

P a g e | 37 Yes. She could have responded to the charges quickly and fully, and have been helpful to the investigation. All of this would have indicated that she thought that she was innocent. 8. How could Martha have handled this crisis better? In addition to the answer to question 7, Martha could have donated the modest saving of $45,673 to charity. This would have shown that the amount of money involved was not enough to motivate her to break the law and damage her reputation. Other suggestions of this nature are also relevant. 9. Why is insider trading considered harmful? Should insider trading be banned if it assists in moving a stock price to a new equilibrium quickly, so that noninsiders are trading at appropriate prices sooner? Insider trading is harmful because it is evidence that privileged insiders with access to information before the rest of the market hears can make an unfair from unknowing investors. It shows investment markets to be unfair and not to be trusted, thus weakening the desire of other investors to participate thereby lowering the pool of funds available and raising the cost of capital. Insider trading may speed up market price transitions, but some investors are losing unfairly in the process so there are victims. Why should insiders be allowed to make unfair profits – once the info becomes known, the market will react and the equilibrium will be real, not want some speculator believes is in his/her interest. 10. If you wished to sell an investment in a company where one of your friends is an insider or even a significant employee, should you call your friend to advise him that you are about to sell? Why, or why not? No, you should not. There would be at least an appearance of a conflict of interest and of insider trading that you should avoid. You do not really owe him any such information, and your call could get you and him into trouble. Subsequent Events Check for further information: •

U.S Securities and Exchange Commission (SEC) website, at https://www.sec.gov/

•

“Martha Stewart.” Wikipedia. Retrieved from http://en.wikipedia.org/wiki/Martha_Stewart

•

For historical stock performance information for MSO, see the website, Historical Stock Price.com, at https://www.historicalstockprice.com/mso-historical-stockprices/

•

For the latest from Martha Stewart, see her website, martha stewart, at http://www.marthastewart.com/

In August 2006, in a settlement of the related civil case brought by the SEC, Stewart agreed to a five-year ban on serving as a director or officer of any public company. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 38 The stock price of MSO fluctuated since Martha’s problems surfaced in 2002, and traded below $5 in 2009. MSO was subsumed as a subsidiary of Sequential Brands Group in 2015, which trades on NASDAQ as SQBG. Useful Articles, Links, and Videos McFadden, Cynthia and Steven Baker (November 18, 2009) “Martha Stewart Looks to Complete Comeback” ABC News/Nightline. Retrieved from http://abcnews.go.com/Nightline/martha-stewart-dishes-empire-prison-rachel-rayexclusive/story?id=9106551 Naughton, Keith (March 14, 2004). “Martha’s Fall,” Newsweek. Retrieved from http://www.newsweek.com/marthas-fall-124093 Toobin, Jeffrey (February 3, 2003). “Lunch at Martha’s: Interview with Martha Stewart” The New Yorker. Retrieved from https://www.newyorker.com/magazine/2003/02/03/lunch-atmarthas Toobin, Jeffrey (March 15, 2004). “A Bad Thing: Why did Martha Stewart Lose?” The New Yorker. Retrieved from http://www.newyorker.com/magazine/2004/03/22/a-bad-thing Reputation Institute (October 22, 2008). “Reputation Institute Announces 2008 Most Admired U.S. CEOs.” Retrieved from http://www.prweb.com/releases/2008/10/prweb1498944.htm Hancock, David (March 7, 2005). “Martha Back In Business” CBS News. Retrieved from http://www.cbsnews.com/stories/2005/03/07/national/main678478.shtml Martha Stewart Living Omnimedia 2001 Annual Report. 2002. Retrieved from http://media.corporate-ir.net/media_files/nys/mso/reports/mso2001ar.pdf

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Cases Involving the Control of Information 11. Google versus China (Chapter 1, pages 49-50) What this case has to offer This case is an example of conflicting interests between Google’s operating philosophy and its for-profit objective. It also shows how business done in a foreign country may cause a dilemma between what is legal and what is ethically acceptable. Google is committed to give users the information they are looking for, company cofounder Larry Page states, “The perfect search engine would understand exactly what you mean and give back exactly what you want.” Furthermore, one of the company’s principles is that "you can make money without doing evil.” Nevertheless, these principles have to be compromised in order to do business in China, where the government requires Internet engines to censor politically sensitive information, or must allow the government to censor it. Moreover, this case encourages discussion about how Internet businesses should operate in a country with a questionable record of protecting the online privacy and freedom of expression by its citizens. Teaching suggestions A good way to introduce this case is to ask whether acting legally is the same as acting ethically for a company doing business in a foreign country. I ask the students to discuss the various ethical dilemmas that Google confronted when it first started operating in China and later on when the company was a victim of a hacker attack allegedly traced back to China. Discussion of ethical issues 1. When it began operations in China in 2006, Google had agreed to have the search engine Google.cn censor information. Did Google have an ethical right to renege on its agreement in 2010 by directing its Chinese users to the uncensored search engine Google.com.hk? When Google took its search engine into China, it was criticized by human rights groups for allowing the censoring of search results. In response, Google argued that it was better for the Chinese to have a censored Google than no Google at all. The firm could play a useful role for the cause of free speech by participating in China's IT industry instead of refusing to comply and being denied admission to the mainland Chinese market. Four years later, Google threatened to leave the Chinese market completely after a series of hacker attacks were traced back to China. Although Google did not explicitly accuse the Chinese government of the breach, Google announced that it was no longer willing to continue censoring results on Google.cn, following a breach of Gmail accounts of Chinese human rights activists. The company found that the hackers had breached two Gmail accounts but were only able to access 'from' and 'to' information

P a g e | 40 and subject headers of emails in these accounts. The company's investigation into the attack showed that at least 34 other companies had been similarly targeted. Chinese government officials stated that Google's move to stop censoring search results was totally wrong and accused it of breaking a promise made when it launched in China. In a way, Google’s decision could be seen as an ethical one, as explained in a 2010 editorial (New York Times 2010): “Google’s decision to stop censoring its search service in China on Monday was a principled and brave move, a belated acknowledgment that Internet companies cannot enable a government’s censorship without becoming a de facto accomplice to repression.” However, Google’s move to stop censoring search results was questionable because it involved breaking an initial corporate decision to conform with the local laws and regulations. 2. Google derives its revenue by selling advertising. Should Google be concerned about the type of information that users access through the various Google search engines? Google is concerned about the contents delivered by its search engine, particularly regarding advertising contents. The company’s policies (2010) state: “Google is a business. The revenue we generate is derived from offering search technology to companies and from the sale of advertising displayed on our site and on other sites across the web. Hundreds of thousands of advertisers worldwide use AdWords to promote their products; hundreds of thousands of publishers take advantage of our AdSense program to deliver ads relevant to their site content. To ensure that we’re ultimately serving all our users (whether they are advertisers or not), we have a set of guiding principles for our advertising programs and practices: “We don’t allow ads to be displayed on our results pages unless they are relevant where they are shown. And we firmly believe that ads can provide useful information if, and only if, they are relevant to what you wish to find–so it‘s possible that certain searches won’t lead to any ads at all. “We believe that advertising can be effective without being flashy. We don‘t accept pop–up advertising, which interferes with your ability to see the content you’ve requested. We’ve found that text ads that are relevant to the person reading them draw much higher click through rates than ads appearing randomly. Any advertiser, whether small or large, can take advantage of this highly targeted medium. “Advertising on Google is always clearly identified as a “Sponsored Link,” so it does not compromise the integrity of our search results. We never manipulate rankings to put our partners higher in our search results and no one can buy better PageRank. Our users trust our objectivity and no short-term gain could ever justify breaching that trust.”

P a g e | 41 On the other side, the information within individual sites retrieved by the search engine is not controlled by Google. The company is not directly concerned with whether or not the retrieved sites contain ethically questionable information, such as sexually explicit or violent content. 3. Do for-profit businesses, such as Google, have an ethical responsibility to lobby for human rights and against censorship in the various countries in which they have commercial operations? Google’s ethical responsibility may be conflicting with the views on censorship and human rights in several countries. By actively stopping the censorship and potentially leaving the Chinese market, the company exposed itself to a loss of business. Google had to balance its ethical principles, its reputation, and its business objectives before deciding to stop the censorship. It was not clear whether or not leaving the Chinese market would seriously hurt Google. Google was not the biggest search provider in China, and its mainland Chinese operation accounted for just a fraction of the firm's total sales. However, Google risked losing market share, revenue, and staff to rivals such as market leader Baidu, up-andcomer Tencent, and U.S. Microsoft. Moreover, Google had trouble growing in China. Google’s YouTube service, like the social networks Facebook and Twitter, is blocked. Nevertheless, the move to challenge the Chinese Communist Party may not come without a cost. The Chinese Internet search market is growing fast. Also, China Mobile, the biggest cellular company in the country, was expected to cancel a deal to use Google’s search engine on its home page, while China Unicom was thought to have canceled plans to create a telephone based on Google’s Android system. 4. After the December 2009 attack, Google enhanced the security for all its users. Does Google have any additional ethical responsibility to human rights activists to provide them with even more sophisticated architectural and infrastructure improvements so that their specific Gmail accounts cannot be compromised? As part of the company’s privacy policy (2010), Google states that: “A greater challenge is to make sure that Google demonstrates respect for users’ right to control their own data. Google is transparent about how it uses information and how that information is shared with others (if at all), so that users can make informed choices. Our products warn users about such dangers as insecure connections, actions that may make users vulnerable to spam, or the possibility that data shared outside Google may be stored elsewhere. The larger Google becomes, the more essential it is to live up to our ‘Don‘t be evil’ motto.” All users’ personal information should be kept private in general; however, in some cases revealing or leaking information shared through email may expose activists in certain countries and even compromise their personal freedom or their lives. Google does not explicitly mention special security issues in their privacy policy. This issue may be important for the firm’s reputation if future privacy breaches involve information from activists. Other Issues

P a g e | 42 Baidu.com, Google’s primary search engine competition in China, is not noted for its ethical scruples as is illustrated in the case: China’s Tainted Baby Milk Powder in the Text, Chapter 1. Students should be encouraged to follow later developments about how Google conducts its business in China. Is it possible for Google to claim its information integrity is important to maintain the trust of its customers, if the company compromises on its activities in China? Useful Articles, Links, and Videos BBC News. (March 23, 2010). “Google stops censoring search results in China,” BBC News. Retrieved from http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/8581393.stm Google. Our Philosophy. 2010. Retrieved from http://www.google.com/about/corporate/company/tenthings.html [Link not active in 2020.] Google Privacy Policy. 2010. http://www.google.com/intl/en/privacy/privacy-policy.html Helft, Miguel, and Barboza, David (March 22 2010). “Google shuts China site in dispute over censorship,” The New York Times. Retrieved from http://www.nytimes.com/2010/03/23/technology/23google.html New York Times. 2010. “Google and China [editorial],” The New York Times (March 24). http://www.nytimes.com/2010/03/24/opinion/24wed2.html

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12. China’s Tainted Baby Milk Powder: Rumored Control of Online News (Chapter 1, pages 50-52) What this case has to offer This case offers the opportunity to review many of the main issues in the chapter. It presents two instances of unfettered profit-only behavior: •

•

Unknowing or uncaring manufacturing profiteers: o

Who misrepresented a very harmful ingredient, and

Others who included that ingredient in their product, which led to lifethreatening consequences for other stakeholders and an erosion of the reputation of the companies involved.

Baidu.com, the Chinese equivalent of Google, being suspected of: o

Misrepresentation of the information it provides by allowing companies to buy a priority place in frequency listings; and

Screening out unflattering news on companies that pay for that service, which also led to a serious erosion of public confidence in Baidu.com and threats to its profitability and ability operate.

Consequently, the case offers the opportunity to review: •

The limits and consequences of profit-only thinking, and the need for balance with stakeholder interests;

•

The importance of reputation based on ethical behavior, particularly its trust components; how it can be lost, and the consequences of losing it;

•

The need for constant skepticism and information challenging even when dealing with people or companies you think can be trusted;

•

How difficult it is to restore trust and reputation, and how to do it. Teaching suggestions

It is useful to start out by asking what the role of a corporation is. This usually produces the response, “To earn or maximize profits,” as well as something like, “Yes, but not at any cost.” I then promote a short debate between these factions to get the profit-only group to open their minds to alternatives. I then ask what the consequences are in this case of focusing only on profit as the two companies did. This discussion leads to a consideration of the loss of reputation and a consideration of the determinants of reputation (Text, Figure 1.3); the rights (particularly to life and health), expectations, and role of stakeholders (see Text, Figure. 1.1, Map of Corporate Stakeholder Accountability) and Text, Table 1.6 (Ethics Risks), and who—the Board and

P a g e | 44 executives–should be responsible for ensuring those rights are respected (see Text, Figure. 1.2, Corporate Governance Framework). During these discussions, when a sufficient platform of knowledge has been built up, or at the end of these discussions, the answers to the case questions can be taken up. I finish the case discussion by asking, if the class members were on the board or were senior executives, how would they guard against the risks evident in this case? This points the class toward the framework and purpose of the rest of the Text. (See, in particular, the Text, Chapter 7 for discussion of ethics risk and opportunity management.) Discussion of Ethical Issues 1. Given strong profit growth, has there been any damage to Baidu.com’s reputation? I would argue yes. Stock price changes reflect who the condition (profit) of the company will be in 6-9 months. Reputation problems usually affect future profits downward, and this is confirmed by the BIDU stock price decline from $308 to $110 noted at the end of the case. 2. What would future reputational damage affect, and how could it be measured? Reputational damage will undermine the support of stakeholders such as customers, governments and so on, that is needed for the company to reach its full potential over the medium and longer term. Given an alternative, customers will shop elsewhere. This impact could be measured by estimating the loss in value of brand image (for which there are measurement models) and by estimating the loss of future contribution margin on goods or services that will not be sold. 3. What steps could Baidu.com take to restore its reputation, and what challenges will it have to overcome? Baidu must restore its standing on the four determinants of reputation (Text, Figure 1.3) by proving (a) that it was not guilty of the allegations, or (b) that it was guilty, but will not transgress again. Proving innocence will likely involve opening up their processes to scrutiny, perhaps by an auditor of high reputation; or by showing appropriate company policy and indicating commitment to and monitoring of those policies. The company may also want to take other measures, such as building an image of good corporate citizenship, to assist in the restoration. Baidu faces the challenge of overcoming rumors about past acts, and competitor restrictions to Baidu web browser spiders. Baidu may wish to become as transparent as possible about its procedures and positions in order to offset the damage caused by the secrecy that seems to suggest that the company has something to hide. 4. Governments throughout the world have been slow to react publicly to serious problems such as SARS, mad cow disease, and now melamine contamination. Who benefits and who loses because of these delays? Unfortunately, delays in reacting lead to delays in publicizing serious problems—thus causing more people to be infected or killed–and the unnecessary spread of the problem, resulting in losses due to curtailment of travel, closing of

P a g e | 45 businesses, and falling productivity. In the end, governments clean up the mess, and we all lose in one way or another, except for the drug companies whose profit may rise due to the treatments involved. It is interesting to note the second order or ripple effects, such as those caused to other patients by the delay of medical procedures due to the diversion of hospital and other care facilities. 5. In some cultures, a “culture of secrecy” or manipulation of the news is tolerated more than others. How can this be remedied by other governments, corporations, investors, and members of the public? Secrecy is usually a misguided policy because the truth usually comes out, and many stakeholders, including those who seek to benefit from the secret, are needlessly affected before it does. That is the lesson from SARS, mad cow disease, suppression of information about rapists, and many other calamities. We must all understand this lesson and encourage/demand full, frank, and early disclosure of such problems. After all, it is the right of stakeholders to know about risks that may reasonably be expected to affect their lives and health. 6. Many other companies with long supply chains, including subcontractors in far-off lands, have found themselves in difficulty. For example, in 1995 Nike was accused of employing child labor in Pakistan and Cambodia through its subcontractors and subsequently changed its policy and practices with respect to the minimum age of employees working in contract factories. However, it is very difficult to verify age when people do not have birth certificates or when they can be bought cheaply on the black-market. a. Under such conditions, what are a firm’s responsibilities with respect to checking that each stage in the supply chain is complying with company policy? [Note: This question 7 in the Text.] Companies must accept responsibility for the quality and integrity of all inputs and processes it uses worldwide, otherwise its reputation and the welfare of its stakeholders are at risk. Company policies must reflect that reality in order to control the risks the company faces.

P a g e | 46 b. Are there organizations that can help companies set standards and confirm adherence to them? If so, what are the organizations’ mandates and website addresses? [Note: This question 8 in the Text.] •

Most large professional accounting firms have this service.

•

See CSR discussion in the Text, Chapter 7 (Section Sustainability, Corporate Social Responsibility, & Corporate Citizenship, page 542ff.)

7. Should Menu Foods be held responsible for the melamine found in its products? [Note: This question 9 in the Text.] Yes, see question 6a., above. 8. Would your response be different if it were the lives of people that were at stake rather than the lives of animals? [Note: This question 10 in the Text.] No. It is not appropriate to provide a product that is harmful to health—to humans or dogs–without disclosing the risks fully and adequately so that users are not misled. Not to disclose risks does not respect the rights of the consumer and ultimately affects us all if time and resources are involved in diagnosis, remediation and prosecution. It is evident that the risks to reputation are similar, so protection is essential from that perspective as well. 9. How and why does Nike disclose its policies and practices with regard to supply chain responsibility, and what are the major factors covered? [Note: This question 11 in the Text.] Nike policies and practices are disclosed on company websites and in printed material. The company does so in order to bolster its reputation and signal to its stakeholders (particularly agents, employees and activists) its expectations and values, and the standards it will monitor. Such disclosure, if credible, will create a cushion of goodwill in the minds of the media and key stakeholders that will give Nike time to tell its story if rumors of malpractice surface. Factors covered in such disclosure can be found in company disclosures. See, for example, the Nike Code related to Child Labor at http://www.apparelsearch.com/Education/Research/Child_Labor_Clothing/Child_Labo r_Fashion_Industry_2005/V_Apparel_Appendices/Surveys_from_companies/Nike.htm . Subsequent Events The officials at the Sanlu Dairy, a company that distributed tainted milk, were convicted of selling fake and substandard products in late 2008 and early 2009. The chairwoman was sentenced to life in prison;, three senior executives were sentences to death; and others were sentenced to life in prison or to terms ranging from five to 15 years. Fines were also levied. (See Vause 2009.)

P a g e | 47 Useful Articles, Links, and Videos “China executes two over tainted milk powder scandal,” (November 24, 2009). BBC News. Retrieved from http://news.bbc.co.uk/2/hi/8375638.stm “China milk poisoning cases rise,” (September 22, 2008). BBC News. Retrieved from http://news.bbc.co.uk/2/hi/asia-pacific/7628622.stm “China’s baby-milk scandal: Formula for disaster,” (September 18, 2008). Economist. Retrieved from http://www.economist.com/node/12262271 “Sanlu Milk Sickens Babies” (December 1, 2010). China Daily. Retrieved from http://www.chinadaily.com.cn/china/china_2008sanlu_page.html This website provides a series of articles, videos, photos and up to date news on China’s Tainted Milk Powder scandal. Vause, John. “Death sentences in China tainted milk case,” (January 23, 2009). CNN. Retrieved from http://edition.cnn.com/2009/WORLD/asiapcf/01/22/china.tainted.milk/index.html

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Cases Concerning the Environment 13. Nestlé Bottles Water in a California Drought (Chapter 1, pages 5253) What this case has to offer This case looks at distribution, extraction, and sustainability for an essential resource that is in great demand, but short supply. It also looks at self-determination and control of resources by First Nations on their remaining land, which, in Canada, has only been possible since 1991. Teaching suggestions I begin by asking how many people in the room have bottled water. Often, they hold them up by the neck and shake the bottles. I ask why they like bottled water. The normal responses are: convenience, portability, and taste (i.e., no chemicals). Then we talk about the pros and cons of bottled versus tap water. Having this discussion before we take up the case, makes the analysis more personal and relevant to the students. This case has an element of “Not in my backyard” or “NIMBY” to it: unethical resource extraction—done for centuries–might be acceptable when it is far away or when the resource is plentiful, but not acceptable when too close to home or when the resource is depleted. Similarly, a sovereign nation (i.e., the Morongo Band of Mission Indians) taking control of its own resources and not sharing them is now being viewed by other stakeholders as unacceptable—but the reverse—relegating first peoples to reserves was once considered nation building. So this case can be used to examine stakeholder perspective (that may or may not be ethical or hypocritical), stakeholder power and influence, as well as business actions that may be legal, but not ethical. Discussion of ethical issues 1. Do you think that it is ethical or unethical for Nestlé to drain the groundwater in the Millard Canyon spring during a drought? Unethical: If we consider that the water is essentially a non-renewable resource, necessary for life, but in short supply, this case shows that the company (and the Morongo Band) may be profiting in the short term at the expense of other Californians living with water restrictions in drought conditions. One might also argue that the Nestlé is profiting at the expense of the Morongo Band who, with fewer resources for economic development, has leased land to the bottling operation. Consider the same question, but when water is not currently in short supply. Aren’t the conditions also unethical? Consider, for example, the story of Nestlé in Elora, Ontario, and how under-valued the

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resource is and has been. Scarcity is a temporal condition. Resources have been extracted unsustainably for decades. Has that been fair to future generations? 2. Does Nestlé have an ethical obligation to disclose proprietary information, such as the amount of groundwater extracted and the water levels in the Millard Canyon spring? Or does Nestlé have the right to privacy and therefore need not disclose water consumption information? That Nestlé doesn’t make public its water extraction data—so to prove that there is enough water to extract–exacerbates the public sentiment that the bottler is not exhibiting the hypernorm values of honesty, integrity, responsibility, compassion and fairness. This, in turn, erodes Nestlé’s reputation. While the company and the Morongo Band have a right to privacy, non-disclosure can damage the reputation of both, because it leads to jealousy and speculation— right or wrong—of collusion, cover up, and lack of fairness. Both organizations have many stakeholders, but these include consumers: is there any evidence that disgruntled local consumers boycotted Nestlé or the Morongo casinos? 3. From a marketing perspective, what, if anything, is required of companies in order to sell bottled water in an ethical manner? Resource protection-minded individuals, consumers, and competitors want to see that resources are managed sustainably, responsibly, and fairly, and that a fair price is paid for the resource from which the company will profit. Chapter 1 discusses how resources, once plentiful and cheap, are now valued more highly as they are depleted. However, Nestlé continues to extract water under drought conditions in Elora, Ontario in 2016.11 Useful Articles, Links, and Videos “WATER our most precious resource,” YouTube video, 5:04, posted by Robeco Asset Management, April 24, 2014. https://www.youtube.com/watch?v=VIaw5mCjHPI [Although this video is produced by a company with a vested interest in desalination, it is an effective overview of limited water resources and their use and necessity.] [Annie Leonard], “The Story of Bottled Water,” The Story of Stuff Project [website] video, 8:04, March 22, 2010, http://storyofstuff.org/movies/story-of-bottled-water/. [The Story of Stuff Project is a group dedicated to reducing consumerism and increasing community activism in environmental issues. While figures are

Leslie, Keith (August 21, 2016). “1Nestlé continues to extract water from Ontario town despite drought: activists.” The Globe and Mail, http://www.theglobeandmail.com/news/national/nestlecontinues-to-extract-water-from-ontario-town-despite-severe-drought-activists/article31480345/

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presented as facts with no references, the video provokes questions to challenge consumers and corporations.] Globe staff (December 7, 2015). “The Globe examines the future of our most critical resource: water.” The Globe and Mail, http://www.theglobeandmail.com/news/headwaters-seriesindexpage/article27517652/ Leslie, Keith (August 21, 2016). “Nestlé continues to extract water from Ontario town despite drought: activists.” The Globe and Mail, http://www.theglobeandmail.com/news/national/nestle-continues-to-extractwater-from-ontario-town-despite-severe-drought-activists/article31480345/ Morongo Band of Mission Indians: A Sovereign Nation [website]. http://www.morongonation.org/ Indigenous and Northern Affairs Canada: First Nations Land Management [website], https://www.aadnc-aandc.gc.ca/eng/1327090675492/1327090738973

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14. The Union Carbide-Bhopal Case (Chapter 1, pages 53-55) What this case has to offer I find this case to be an excellent way of: 1. Breaking the ice with a new group and developing a good learning dynamic. Essentially this means getting to know the group, getting them to start discussing issues which they are not used to and sharing their thoughts and values. I have found that one of the most effective ways of fostering learning in ethics is to create a dynamic where class members are led to discuss issues and to share their values and beliefs with their peers. 2. Developing a greater awareness and appreciation of more ethical issues. Usually, the discussion dynamic produces a greater awareness by everyone of issues which are important to the group and why. Often people are influenced by their circumstances to think narrowly about their own interests, or to dismiss views contrary to their own as hare-brained, but when their colleagues express them, they listen and develop an appreciation for them. 3. Stimulating discussion, leading to a desire to learn more about ethics Bhopal-Union Carbide provides ample opportunity for stimulating discussion about real issues: issues that are relevant and important to business and to professionals. As a result, people see the importance of learning more about ethics and about making ethical decisions. 4. Exploring the following specific ethical issues, among others: • • • • • • • • • •

Do businesses have responsibilities beyond what is prescribed by law? Whose laws should apply, foreign or domestic? Should businesses satisfy the needs of current or future shareholders? Should businesses respond to the needs of non-shareholder stakeholders? Should businesses subscribe to goals other than profit? When/how should trade-offs between profit and safety be made? What is the appropriate role for the company/for government? Can a company get away with unethical behavior in far-away lands? Who is to blame for the tragedy in Bhopal? What can be done to avoid a recurrence?

P a g e | 52 Teaching suggestions Usually, I barely introduce myself and the objectives of the course/session, and then ask the participants to read the Bhopal-Union Carbide Case. It takes them about 7-10 minutes, and then I start the discussion by asking them what ethical issues they noted (question 1) and why they thought each was an ethical problem. The suggestions come with increasing frequency, and the class will want to debate each of the controversial issues as it comes up. I usually resist this until maybe four or five major items are on the table and then I find I can find a natural entry point to begin exploring the issues I have listed on the previous page. The ethical issues brought forward will rarely be in the order I have organized them into, nor will all the issues listed be raised without prompting. I don't worry about this, partly because I can steer the discussion to cover the main issues and partly because I usually want to cut off discussion after about 45 minutes. Even if all the issues are not dealt with by that time, most of the pedagogical objectives outlined above will have been met. I wind up the case discussion dealing with questions 2 and 3, and then move into a discussion of the other issues raised in Chapter 1 using overheads covering: •

Background: a definition of ethics, reasons for heightened interest in ethics

•

Important concepts: stakeholder, corporate social contract, codes of conduct

•

Objectives of business: Milton Friedman's doctrine and rejoinders

This usually takes 90 minutes, in total, at a brisk pace. The students are very energized and keen to go on. Sometimes we have to finish the discussion of Friedman at the beginning of our next session. Discussion of ethical issues/questions 1. What are the ethical issues raised by this case? Profit vs. safety Among the first topics ethical issues suggested will be the causing of death and injury by a commercial process. I usually play devil's advocate here, by asking questions and reminding the participants that “the traditional role of business is to pursue profit and only profit, within the law, of course...” “Isn't it the traditional role of government to create the laws and set standards to protect society?” “Anyway, weren’t most of those killed or injured just illegal squatters or poor living in a shanty town?” It doesn't take long for the class to agree that safety should be one of a corporation's goals, if not for altruistic reasons, then for the self-interest inherent in continued profitability. Where they find difficulty is in assessing the trade-off between safety and profit—or in this case, the reduction of a loss. They don't have a framework to handle this assessment and trade-off, nor the trade-off between short- and long-term profit, and are pleased to hear that the frameworks for ethical decision making will be helpful here. Assessing blame: the role of government, whose laws should apply? The discussion often moves rather quickly to who is to blame for the tragedy. Some will claim that the government was at fault for not regulating tightly enough. After Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 53 all, that is the role of government, and business' role is to respond to government. They often couple this argument with the issue of business needing to be competitive on a global basis and thus—with the encouragement of developing countries’ governments– needing to ovoid heavy cost/red tape safety regulations. To this, I ask how they think laws and regulations are set: do laws reflect how society wants to be governed, and/or is there a lag? What causes this lag time for the political process? How does lobbying by special interest groups, including the companies to be regulated, fit in? So, the class comes to realize that believing that the traditional division of roles of business and government will result in the fair and proper treatment of society may be naïve. In developing countries, the probability of bribery and ignorance influencing the process of standard-setting is significant, so relying on developing countries’ regulations may be risky if your company may be judged by higher standards, such as those in your largest market, or at home. The latter was the case for Union Carbide, even though the Indian government had encouraged the operation (thinking Union Carbide and its products to be of high quality and high value-added). Negligence is a factor that is usually debated. The local management, if they were adequately knowledgeable, clearly lost track during the shutdown of how many fail-safe safeguards were under repair. The loss of good human power as a result of cost-cutting is probably the responsibility of the U.S. firm, even though they only own a slim majority (50.9%) of the company, because they had the knowledge to understand what the result might be. They certainly failed to follow-up on the state of repair of the facility, as they would have done in the United States. A similar case can be made for the culpability of the Indian government, but it is important to note that neither the Indian courts nor the U.S. shareholders took much notice of this. They blamed the management in the United States. The lesson here, in hindsight, is that following the tighter U.S. regulations would have been advisable. Can unethical behavior go unnoticed? Some students will think that they and their companies can get away with unethical or illegal acts. Of course they can, but there is a risk of getting caught, and the cost of restitution may be enormous. Anyone who believes that developing countries are too far away to attract attention is mistaken. The question to be asked on behalf of profit-only advocates is whether the increasing risk of exposure is worth taking. Aside from loss of life and health, what is the greatest loss? This is an interesting question to put to the class. Some will say reputation...and I will ask how to put a value on it. After some thought, the suggestion will come that this cost is represented by an estimate of lost sales to potential customers. Actually the right answer is the lost margin of profit on those lost sales, and this can be estimated relatively easily. The total can be staggering to most companies and far exceeds the legal penalties, which might be assessed. This is a revealing discussion for many hard-line students. What can be done to avoid a recurrence?

P a g e | 54 Most large companies have developed internal mechanisms to maintain safety and ecological standards on a worldwide basis. This usually involves a mechanism for instant notification to head office to enable coordinated, effective crisis management. As a result of this tragedy, the heads of Union Carbide and Dow Chemical in Canada caused the Canadian Chemical Producers Association to develop a self-policing Responsible Care program (see http://www.canadianchemistry.ca/responsible_care/index.php/en/index ) designed to minimize the chance of problems developing and to quickly remediate them if they did occur. This program became so highly thought of that it has been copied in the United States and around the world. It is interesting to note for the class that often such learning and useful programs have to wait until tragedies happen. Proactive management is needed to avoid this. 2. Did the doctrine of "Limited Liability" apply to protect the shareholders of Union Carbide Corporation (U.S.)? Many people have heard that the doctrine of limited liability will protect you, if you are a shareholder, if difficulties arise for the company you own. But they really don't understand what the doctrine means, and, like the Union Carbide shareholders, they are in for a shock in certain circumstances. This is because the doctrine of limited liability applies when a shareholder has bought shares directly from the company and has paid for all that they own in the transaction. If a problem then develops for the company, no one can require the shareholder to put up more money. However, the doctrine does not protect the shareholder from losing the market value of the shares owned. To this extent, any shareholder—like the Union Carbide (U.S.) shareholders–can still be at risk, despite the doctrine of limited liability. 3. Were the Indian operations, which were being overseen by the managers of Union Carbide Corporation (U.S.), in compliance with legal, moral, or ethical standards? One of the more interesting parts of this case discussion occurs when the students grapple with whether the Indian operations were in accord with legal, moral, or ethical standards. This forces them to figure out the differences, if any. Only a very few will continue to argue that there are no differences at all, and these people are generally lawyers. (Lawyers tend to be susceptible to functional fixation in this regard.) Usually the students will want to separate the analysis on two reference dimensions—Indian and U.S.–and arrive at the conclusions in the following table. Compliance With… Reference Society Indian standards USA standards

Legal Yes No

Moral Yes/No No

Ethical No No

I usually have to clarify what I mean by moral and ethical standards, which I do as follows: • •

Moral has to do with habits—what current practices or mores are. Ethical refers to what mores should be—respecting a set of relatively absolute rights or values, like the right to life, to health, etc. In clarifying this concept, I

P a g e | 55 like to ask the students to consider whether the impact of the actions was "right" or not. As society's social consciousness is heightened, the perception of proper behavior appears to move toward the ethical end of the spectrum. In my view this is an outstanding case to start off the study of ethics. Subsequent Events See Union Carbide Corp. (2001-2016). “[Bhopal] Chronology” on the website http://www.bhopal.com/Chronology for an update on events. In 2006, Dow Chemical, which merged with Union Carbide in early 2001, was asked for further funds by the Indian government. Useful Articles, Links, and Videos “Bhopal trial: Eight convicted over India gas disaster,” (June 7, 2010). BBC News, http://news.bbc.co.uk/2/hi/south_asia/8725140.stm Little, Allan (December 3, 2009). “Bhopal survivors fight for justice.” BBC News. http://news.bbc.co.uk/2/hi/south_asia/8390156.stm “Bhopal Disaster – BBC Video – The Yes Men,” YouTube Video mimicking a BBC News video, 5:29, posted by razorfoundation, http://www.youtube.com/watch?v=LiWlvBro9eI . [“Impersonating a Dow Chemical spokesman on BBC, "Jude Finisterra" promises a huge compensation for the thousands of victims of the Bhopal disaster.”] Browning, Jackson B. (1993). “Union Carbide: Disaster at Bhopal.” Union Carbide Corporation. Retrieved from http://storage.dow.com.edgesuite.net/dow.com/Bhopal/browning.pdf [This report was written by retired vice president, Health, Safety, and Environmental Programs, Union Carbide Corporation.] “Company Defends Chief in Bhopal Disaster,” (August 2, 2009). New York Times, http://www.nytimes.com/2009/08/03/business/global/03bhopal.html Union Carbide Corp. (2001-2016). “Bhopal” [ website]. http://www.bhopal.com/Chronology [This website provides background information on the Bhopal gas tragedy, and a series of webpages documenting the history, chronology of events, remediation, litigation, etc.]

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15. Texaco: The Ecuador Issue (Chapter 1, pages 56-58) What this case has to offer This is the case of a company that has to answer for problems from its past in a foreign land that were thought to have been put behind it years ago. It provides a real-life, interesting vehicle for discussion of: •

Responsibility of a corporation on foreign soil and the role of the foreign government involved;

•

The reality of modern stakeholders and the pressures they can bring to bear;

•

The fickleness of a foreign government;

•

The difference between legal behavior and ethical behavior;

•

Lingering consequences of some actions; and

•

Shared liability (with government, and for an act of God). Teaching suggestions

I begin this case with a brief introduction about the challenges of operating in foreign lands with varying cultures. I point out that today’s world is very small, in that: •

CNN will broadcast any problem from any part of the world within one day of its occurrence;

•

A corporation is increasingly accountable to stakeholders in its consumer and capital marketplaces;

•

A corporation is subject to the activities of interest groups from all over the world.

I review the lawsuits that have been filed asking what the claims involve and point out that compensation is being sought for illness, loss of property (livestock), loss of livelihood (from the forest), and loss of sustenance (food and water). This is critical ethically because the reparations made by Texaco do not address all of these issues directly or fully, but I don’t articulate this until the class realizes it, or until the end of the case discussion. I then ask the questions posed by the case and enjoy the discussion they bring. Discussion of Ethical Issues Responsibility of the corporation and of the foreign government The assertion that the company’s goal is to make profit, and the government is to say how, breaks down in this case, because the contest is between unequal adversaries. The company has more knowledge, its resources are more focused, and foreign government officials are often able to be influenced to assist the company. Consequently, unless the company is very careful—and this requires internal motivation beyond immediate profit and Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 57 government initiatives–corporate actions will appear to take advantage of a weaker foreign government and be considered unethical. Stakeholder networks Students should not view Texaco’s problem in a static framework. The stakeholder groups suing Texaco influence each other and also external groups such as Texaco’s customers in the United States. Boycotts are possible. Accountability is now worldwide, and issues management people stay on top of emerging problem areas so that corporations can put their best foot forward at all times in a dynamic world. Legal vs. ethical approach Texaco has relied upon legal agreements with the Ecuadorian government to resolve its problems. Unfortunately, the government has changed its mind—as any political unit will sometimes do–and has joined the lawsuits. Moreover, unless Texaco’s solutions appeal to the aggrieved stakeholders, their actions against the company will continue, and the problem will continue. Unless action considered ethical is taken, Texaco’s problems will continue. 1. Should Ecuadorians be able to sue Texaco in U.S. courts? Why shouldn’t the Ecuadorians be able to sue in U.S.courts? If they weren’t, companies would get away with unethical acts when their assets were moved beyond foreign jurisdictions. Students will come up with many reasons for not allowing such suits. 2. If an oil spill was caused by an act of God, an earthquake, should Texaco be held responsible? A company should not be liable for an act of God unless there is some confounding aspect of negligence, or unless there is a contractual responsibility to pay. Negligence is, however, subject to judgment, such as who should pay for pollution caused by a downpour that washes out a mining tailings pond. Was the dam adequate? 3. Do you find Texaco’s arguments against the lawsuits convincing? Why or why not? Texaco’s arguments showed evidence of concern, but the associated actions did not seem to address the reasonable concerns raised in the three lawsuits. I would find for the Ecuadorians if I were the judge. Subsequent Events In 2001, Chevron and Texaco merged to become Chevron Corporation. See Chevron Corp. (2001-2017). “Ecuador Lawsuit: The Facts About Chevron and Texaco in Ecuador,” https://www.chevron.com/ecuador/ for updates. On August 16, 2002, the U.S. Court of Appeals dismissed the Aguinda v. Texaco and Jota v. Texaco litigation on the basis of forum non conveniens, meaning that the proper venue was in the courts of Ecuador since that was the site involved, and where the plaintiffs, records and Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 58 other evidence was located. In the fall of 2003, a lawsuit was filed against ChevronTexaco in Ecuador (to which ChevronTexaco replied on October 21, 2003). The trial continues in 2009 amid charges of prosecutorial misconduct. Useful Articles, Links, and Videos Berlinger, Joe (Producer)(2009). “Crude” [Documentary film]. See trailer at http://www.imdb.com/video/imdb/vi2637365785/ This documentary details the story of a lawsuit issued by tens of thousands of Ecuadorans against Chevron (Texaco) claiming contamination of the Ecuadorean Amazon. “Chevron Statement on Ecuador Court Filings,” (September 17, 2010). The Wall Street Journal, http://www.marketwatch.com/story/chevron-statement-on-ecuador-court-filings-201009-17?reflink=MW_news_stmp [Link not active in 2020.] Chevron. “Chevron Statement on Ecuador Court Filings [press release],” (September 17, 2010), https://www.chevron.com/stories/chevron-statement-on-ecuador-court-filings. Forero, Juan (April 28, 2009) “In Ecuador, High Stakes in Case against Chevron.” Washington Post, http://www.washingtonpost.com/wpdyn/content/article/2009/04/27/AR2009042703717.html Pelley, Scott (May 4, 2009) “Amazon Crude” [Video]. CBS 60 Minutes, http://www.cbsnews.com/video/watch/?id=4988079n&tag=mncol;lst;1

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Product Safety Cases 16. The Right to be Informed? – The Link Between Talcum Powder and Cervical Cancer (Chapter 1, pages 58-60) What this case has to offer While this case looks specifically at Johnson & Johnson (J & J) and a link between talcum powder and cancer, it can also be used generally to examine the link between J & J’s past deeds—namely, the pulling of all Tylenol from shelves in 1982–and the goodwill and consumer trust that action created. J & J seemed predictably to be a good and trustworthy company. But recent lawsuits against the company because of harmful effects of Tylenol on liver health, talcum powder linked to cervical cancer, and pernicious Risperdal marketing, to name just a few scandals, show that trust is no longer well-founded and its Credo is no longer providing the guidance it once did. Why has this change occurred? Why is it worthy of reflection? Teaching suggestions I begin by reviewing the J & J Tylenol recall of 1982. We talk about the importance of the company’s Credo in influencing the decision to recall the company’s largest selling product worldwide. That sets up a discussion about how a company can lose sight of its values. Why did the company fail to ensure that it continued to promote an ethical corporate culture? The case provides the opportunity to discuss ethical wall art (a well-intentioned Credo without a method of implementation) versus codes of conduct/ethics that require active implementation, review, training, and oversight. In short, this case illustrates what happens when a corporate culture strays badly because the company’s credo is not seen as an important living document. Discussion of ethical issues 1. Was J & J’s decision to not inform its customers of the potential risks of extended use of talcum powder products acceptable? From the viewpoint of its Credo, J & J did not meet the needs of “doctors, nurses and patients, to mothers and fathers and all others who use our products.” From the viewpoint of customers, J & J’s actions—or inaction–were reprehensible. If we evaluate J & J actions on the basis of hypernorm values, they were not acceptable. For example, not acting on the possibility that a correlation existed between the use of the talc and cervical cancer shows a lack of honesty, compassion, fairness, integrity, and responsibility on J & J’s part. That J & J was so responsive in the Tylenol crisis surely led consumers to trust J & J and to believe it would predictably remove a future product— like the talcum powder–if it could cause harm. That trust was later betrayed. 2. If J & J knew about the potential risks of talcum powder products in 1987, should the company have withdrawn all its talcum products in the same way that it recalled all of its Tylenol products in 1982?

P a g e | 60 Tylenol in 1982 posed a double threat: 1) sudden death, and 2) uncertainty of the extent of the problem, since the tainting was post-production and could not be traced to any particular batch number. Talcum powder posed a different threat: 1) prolonged exposure over years was necessary to cause death, and 2) use of the product on one part of the body was most at issue. At a minimum, J & J should have added a warning to its talcum powder label, as soon as correlative effects were observed, to the effect that the product should not be used on genitalia, and that prolonged exposure to the talcum powder may cause cervical cancer. By doing nothing, J & J acted unethically, irresponsibly, and without compassion, fairness, integrity, honesty, or predictability. 3. Do you think that Credos are effective at encouraging ethical business behavior? It depends. No credo, code of ethics or code of conduct can be effective on its own. Unless top management supports the spirit of the document, encourages its use, and is responsible for adherence, the document is just ethical art—to be hung on the wall. That said, if properly supported, a credo can provide excellent directional guidance—as an ethical compass–in a readily digestible form, as it did for J & J in 1982. It is true that a code of ethics or code of conduct has more detail than a credo, and therefore provides more detailed guidance to employees. Usually, it tells employees how to act if they identify misconduct, including whistleblowing. Training is usually associated with a code, and employees may be required to sign off on it, saying that they understand it and will abide by it. Policies and procedures should be reflective of the code; for example, hiring policies may include fairness as a cornerstone. Reward systems may depend to some degree on performance related to the code. Someone, for example, an ombudsperson, compliance officer or ethics officer, is responsible for the code and for overseeing with its implementation, and executives—particularly the CEO—must encourage its use and must visibly “walk the talk” themselves. In the cervical cancer case, we have no evidence that the J & J Credo was anything more than a feel-good statement that required no tangible commitment on the part of J & J employees, executives or subsidiaries. Why did the directors allow such an iconic ethical foundation to be replaced by a focus on short-run profit? Useful Articles, Links, and Videos Kristof, Nicholas (September 15, 2015). “When Crime Pays: J & J’s Drug Risperdal” [Editorial]. New York Times, http://www.nytimes.com/2015/09/17/opinion/nicholas-kristof-whencrime-pays-jjs-drug-risperdal.html?_r=0 Ingram, David, and Krasny, Ros (November 4, 2013). “Johnson & Johnson to pay $2.2 billion to end U.S. drug probes.” Reuters, http://www.reuters.com/article/us-jnj-settlementidUSBRE9A30MM20131104 [This article discusses J & J’s health care fraud, in the form of inappropriate marketing of and kickbacks to pharmacists, for “anti-psychotic drugs Risperdal and Invega and the heart drug Natrecor.”]

P a g e | 61 Brill, Steven [September 15, 2015]. “America’s most admired lawbreaker.” Huffington Post, http://highline.huffingtonpost.com/miracleindustry/americas-most-admiredlawbreaker/ [This is a 15-chapter exposé of J & J’s 20-year Risperdal marketing and cover-ups by lawyer-journalist, Steven Brill. It includes links and videos.]

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17. Valeant Pharmaceuticals vs. Coca Cola – Which Business Model is Worse: Price Gouging or Fostering Obesity & Diabetes? (Chapter 1, pages 60-61) What this case has to offer This case offers the opportunity for students to consider what a business model is, why it is important, and how it may become unsustainable and/or unprofitable because it is unethical. Also, the case raises the opportunity to consider the motivation for developing unethical business models, and how these motivations may be monitored and controlled. Teaching suggestions I find that it is helpful for students to consider first what a business model is, and why it is important. A business model refers to how a company creates value, and how it realizes that value from customers, patients, and others. A successful business model is one where the value created is in demand, and where that demand and value can be sustained in the face of competition, regulation, operational risks, and ethical challenges. Over time, changes occur in how business models are perceived, and that can change how successful they are. For example, MacDonald’s originally made a substantial profit by selling their Big Mac sandwich at a very low profit, but selling their fries at very high profit. That strategy worked until competitors caught up with the value of their offerings and forced MacDonald’s to innovate to create additional items of value. From the point of view of shareholders, executives, and employees, a sustainable business model is to be sought after rather than one which permits a quick profit and then mounting losses and/or risks. The current business models of both Valeant and Coca Cola present significant ethics risks that students should be alert to, and they should consider how to compare and remedy each. Stakeholder assessment can be very useful here, both with regard to impacts on patients/customers, and on executives, particularly in view of the role equity incentive schemes can play in motivating short-term thinking that ignores important ethics risks. Discussion of ethical issues 1. Compare the ethicality of the two business models: (a) price gouging and questionable practices by Valeant to (b) contributing to obesity and diabetes by Coca Cola. Which is worse? a) Valeant Valeant, as part of its business model under CEO Michael Pearson, decided that in-house R&D on drugs was a money loser, and that mergers and acquisitions with/of pharmaceutical companies with medically successful or potentially successful drugs made more sense. A decision was made to slash R&D, slash overheads, and to “… [look] for situations of untapped pricing power in existing drugs,” [companies to buy that had drugs with little or no competition] and to pursue the purchasing and licensing of many so that prices could be raised exorbitantly. Patients were held hostage by their disease: very little, if any, substitution is possible. [Emphasis added.] So, very bluntly, the drug Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 63 users would be forced to pay or suffer and quite possibly die. Paying the exorbitant costs associated with the company’s drugs would mean a huge financial burden on individuals, families, healthcare facilities, insurance companies (who would pass those costs on to others with higher premiums). In Pearson’s six years at Valeant, the company made over 100 acquisitions, and the stock price rose about 800% (Vardi 2014), so shareholders were very happy. That is, until the press began to question Valeant’s approach, and Pearson was summoned to a public hearing in Washington in 2015 to defend the ethics involved in gouging the disadvantaged. Pearson’s executive compensation and the value of shares he owned skyrocketed to $182.9 million for 201612. It should also be noted that Valeant’s mode of doing business involves other questionable practices, in addition to its fundamental business model, including the following: •

A decision was made to purchase Canadian pharmaceutical Biovail—using a Barbados subsidiary (Vardi 2014)–to reduce taxes from 36% to 3% and to try to lower them further. (Larcker and Tayan 2016, 1) Executive incentives in the form of performance awards were based on generating compound 3-year returns and increased exponentially with 3-year return targets.

•

In 2014, a failed acquisition brought Valeant’s business model under scrutiny (particularly, in 2015, “…the extent of its relationship with specialty [U.S.] pharmacy Philidor, which it relied on to fill key prescriptions and guide patients and doctors through the reimbursement process” (Larcker and Tayan 2016, 2)).

•

In 2016, Valeant filed a Form 8-K statement with the SEC. It included the following statement (Valeant Pharmaceuticals International, Inc. 2016): “As part of this assessment of internal control over financial reporting, the Company has determined that the tone at the top of the organization and the performance-based environment at the Company, where challenging targets were set and achieving those targets was a key performance expectation, may have been contributing factors resulting in the Company’s improper revenue recognition and the conduct described [in the 8-K form].” (Valeant Pharmaceuticals International, Inc. 2016) [Emphasis added.]

b) Coca-Cola Coca-Cola’s business model is to offer products that can be addictive. They may cause harm to health and lead to obesity and/or diabetes which, some argue, has reached epidemic proportions. By contrast to Valeant’s customers, Coca Cola customers choose to imbibe or not: they are not forced to use company products by Janet McFarland (June 4, 2016). “The CEOS who cashed in as their companies cut back.” The Report on Business, B6. Available at http://www.globeinvestor.com/servlet/ArticleNews/story/GAM/20160604/RBCDCOVEREXECCOMPMAI N 12

P a g e | 64 circumstances beyond their control. That is not to say that they may not be ignorant of the health effects and may be addicted to sugar and other health-pernicious ingredients, but consumers may be able to overcome those problems with education and discipline. But because being overweight, or having obesity and/or diabetes have significant societal impacts, governments prodded on by health advocates have tried various means by which to reduce sugar, salt, fats, and especially trans-fats in processed foods. An earlier example of a business model like Coca Cola’s would be that of cigarette companies. Coca Cola, it should be noted, has not been as quick to reward executives with stock-based incentive programs. Warren Buffett, through his investment company Berkshire Hathaway, owns 9% of Coca-Cola. He says he loses no sleep over possible negative health effects of the products. In fact, he says he “…checked the actuarial tables, and the lowest death rate is among six-year-olds. So [he] decided to eat like a six-year-old.” In addition to loving coke, eating ice cream for breakfast and potato sticks as snacks, the octogenarian also says, “If I eat 2700 calories a day, a quarter of that is Coca-Cola. I drink at least five 12ounce servings. I do it every day.” (Sellers 2015) Students should come to the realization that several aspects of Valeant’s business model fall short of expectations of ethical behavior because they are not fair to patients and payers of health costs, to taxpayers, and perhaps to competitors. Preying upon patients who are ill through no fault of their own is unacceptable and unethical. Successful maximization of earnings is not sufficient to justify such unethical behavior. Coca Cola’s selling of addictive harmful products to individuals, some of whom understand the risks, and most of whom have non-harmful choices, is also unethical. But diabetes risks are not yet well enough understood by the public to force government regulation related to disclosure and restricted sales practices. Inevitably, the profitability of the business models of both Valeant and Coca Cola will diminish over time, and shareholders, executives and others should take note. 2. From a business standpoint, what is the most significant loss that could occur to each of Valeant and Coca Cola as a result of their business models? In the medium and longer term, reputation loss leading to profit loss could be each company’s biggest problem. With it, end users may choose product substitution, if they can. In the short term, Valeant has been forced to reduce drug prices by the pressure brought to bear through the U.S. Congress, and it has been forced to collapse its conflicted distribution arrangement with Philidor. Whether for health or other reasons, CEO Pearson has been forced out or has chosen to leave. As a result, the value or profit generated by its business model has been greatly diminished. Going forward, Valeant’s reputation has been greatly tarnished, which will diminish its ability to work with stakeholders in the future, and will undermine its sales if and when competing products appear. Valeant has been vilified publicly and politically, and what its business model set up—whether intended or not–as a quiet extortion between patient [or healthcare facility] and company, was publicly exposed, with concomitant public outrage. All that said, Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 65 Valeant became a “Wall Street machine” run by a former hedge fund manager (Pearson). Hedge fund manager Bill Ackman, a major Valeant shareholder, said in 2014, “We like that long term alignment and that leveraged compensation for performance.” (Vardi 2014)—so shareholders were still happy…until the stock fell by 90%. (Larcker and Tayan 2016, 2) For Coca Cola, the slower recognition of its unethical business model will take longer to impact and weaken the value of its business model. However, perhaps to remedy and offset the degree of reliance on harmful products, or in response to competitors like Pepsi, Coca Cola has begun to develop healthier, non-sugary products including bottled water. (Petroff 2016). 3. Based on your assessment of the two business models, what would you do if you owned shares in each company: Continue to hold? Sell? Something else? What was your reasoning for the action chosen? A) If you hold Valeant shares, you have already lost most of their value. If you believe that the company has learned its ethics lesson, still has reasonable growth prospects, and may be temporarily depressed by adverse publicity, then you might want to continue to hold. If not, it would be wiser to sell and seek investments with better ethical business models and prospects. B) If you hold Coca-Cola shares, you could be like Warren Buffett and hold on, because you think consumers will continue to eat like six-year olds, and you have faith that the company will modify its business model successfully. However, if you believe that the traditional value in the Coca Cola business model will continue to be partly unethical and be depressed as a result, you sell. The major lesson for an investor should be that the ethicality of a company’s business model should be part of the investment risk assessment process. Given the rapidity with which the public and regulators have begun to react, investing in companies with questionable business models and practices will be increasingly unwise. 4. Review the incentive remuneration disclosures in Valeant’s Securities Exchange Commission (SEC) 10-K filings for 2012, 2013, and 2014. (See https://www.last10k.com/sec-filings/vrx) or Larcker and Tayan, 2016). Were the incentive arrangements with Valeant’s CEO, Michael Pearson, appropriate? Pearson’s remuneration was dominated by performance stock unit (PSUs) awards that dwarfed the salary, non-equity incentives, and other compensation received. The following table, originally from the Valeant May 19, 2015 Meeting of Shareholders (Valeant SEC Sch. 14A, 2015, p. 56), shows that the non-PSU components are quite reasonable for a company of Valeant’s size. Chair and CEO Michael Pearson’s Compensation, 2012 to 2014 (No PSU Awards Included)

P a g e | 66

ear

014 013 012

2 2 2

alary (Millions) $1.9 $1.8 $1.7

onus

tock Awards

ption Awards

$ -

onEquity Incentiv e Plan

All Other Compens ation

$4.8

$0 .4 $0 .5

$3.8

$0.6

$8.0

otal

$10.3 $7.0 $6.1

Modified table from (Larcker and Tayan 2016, 5)

However, Pearson’s remuneration was also based on performance stock (PSU) award agreements signed in 2008, 2011, and 2015 that specified very large stock awards provided 3-year targets for company profitability and growth were achieved: “The performance units were structured to offer an exponential payout for exceptional longterm share price performance and zero payout if base-level thresholds were missed.” (Larcker and Tayan 2016, 2) Some idea of the size of these allocations can be seen on page 59 of the Valeant Shareholder Meeting Announcement (2015). Initially, the compensation looked reasonable, because it rewarded long-term performance, but on second look, the rewards were possibly the highest ever in the industry. (Milstead 2015) Hedge fund managers and shareholders did not begrudge the compensation package because enormous returns were generated. The company had become a “Wall Street machine.” (Vardi 2014) How the returns were generated was not really sustainable, however: the company could not remain a going—or growing–concern with its business model for wealth, not health. Executives—particularly Pearson, a major shareholder—were becoming very rich, but society wasn’t becoming better off, so the compensation does not seem appropriate. Perhaps the most prescient article on the impact of over-incentivizing of Michael Pearson, was “Valeant Pharmaceutical’s Prescription For Disaster” by Vardi and Gara (May 10, 2016, which is well worth reading at http://www.forbes.com/sites/nathanvardi/2016/04/13/valeant-pharmaceuticalsprescription-for-disaster/#3d1cb3e36c65 It is clear, in retrospect, that the business model that Michael Pearson was incentivized to undertake was not ethical and therefore not sustainable. 5. How much of a price increase for Isuprel and Nitropress would have been considered reasonable, and would not have attracted negative attention? Companies need to make reasonable returns on their capital to remain viable. But when excessive returns are made that cause harm to the health of others, particularly when disadvantaged already and have no choice, those returns are considered unethical. When companies need to cover increases in R&D costs, overheads, or cover costs for low-volume drugs that are essential to treatment of some medical problems, we can understand the need to raise prices. But Valeant worked to reduce overheads and slash R&D costs by buying companies with already marketable Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 67 drugs (Larcker and Tayan 2016, 2). At the same time, the executive incentive payments increased significantly. Valeant bought Isuprel and Nitropress because they had no generic alternatives (Rockoff and Silverman 2015), meaning that physicians would need to prescribe them, no matter what the price. In summary, price increases that would have brought reasonable rates of return (i.e., comparable to industry norms) would have been acceptable. It is worth noting that duty to shareholders is not sufficient to justify unlimited increases in profit, as was inferred by a spokesperson for Valeant in 2015: “Our duty is to our shareholders and to maximize the value” of the products that Valeant sells…Sometimes pricing comes into it, sometimes volume comes into it.” (Rockoff and Silverman 2015) Useful Articles, Links, and Videos Esterl, Mike, and Joann S. Lublin. (October 1, 2014). "Coke Scales Back Executive Equity Compensation, Bowing To Pressure: Beverage Giant Looks to Pacify Investors, Including Buffett, Who Called Pay Plan Excessive." Wall Street Journal, http://www.wsj.com/articles/coca-cola-tweaks-executive-compensation-plan1412170448 (accessed October 26, 2016). [An embedded video talks about Coke's strategy for increasing sluggish sales.] Larcker, David F., and Brian Tayan (April 28, 2016). "CEO pay at Valeant: Does extreme compensation create extreme risk?" Stanford Closer Look Series, https://www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-closer-look-56-ceopay-valeant-extreme-pay-risk.pdf (accessed October 25, 2016). Milstead, David (July 30, 2015). "Valeant’s $3-billion man: CEO's big bet pays off." Globe and Mail, http://www.theglobeandmail.com/report-onbusiness/careers/management/executive-compensation/valeants-strong-performancemeans-big-rewards-for-ceo/article25788189/ (accessed October 25, 2016). Petroff, Alanna (October 17, 2016). "Pepsi gets aggressive on cutting sugar." CNN Money, http://money.cnn.com/2016/10/17/news/pepsi-sugar-drinks-soda/index.html (accessed October 19, 2016). [Petroff writes that “…two-thirds of [Pepsi’s] single serving drinks will have 100 or fewer calories by 2025 as it cuts back on sugar. Currently [2016], less than 40% of its drinks have 100 calories or fewer.” In addition, the company says it will reduce saturated fat and sodium in its snack products.] Rockoff, Jonathan D., and Ed Silverman (April 26, 2015). "Pharmaceutical Companies Buy Rivals’ Drugs, Then Jack Up the Prices." Wall Street Journal, http://www.wsj.com/articles/pharmaceutical-companies-buy-rivals-drugs-then-jackup-the-prices-1430096431 (accessed October 26, 2016). Sellers, Patricia (February 25, 2015). "Warren Buffett's secret to staying young: 'I eat like a sixyear-old.'" Fortune, http://fortune.com/2015/02/25/warren-buffett-diet-coke/ (accessed October 26, 2016).

P a g e | 68 Valeant Pharmaceuticals international, Inc. (April 9, 2015). "Schedule 14A Information" (Notice of Annual Meeting of Shareholders May 19, 2015), United States Securities and Exchange Commission, https://www.sec.gov/Archives/edgar/data/885590/000119312515123856/d898925ddef 14a.htm (accessed January 23, 2017). Valeant Pharmaceuticals International, Inc. (March 21, 2016). "FORM 8-K: Valeant Pharmaceuticals International, Inc." United States Securities and Exchange Commission, https://www.sec.gov/Archives/edgar/data/885590/000119312516511157/d164248d8k.h tm (accessed October 25, 2016). Vardi, Nathan (April 22, 2014). "Bill Ackman Outs Valeant CEO Mike Pearson As A Billionaire." Forbes, https://www.forbes.com/sites/nathanvardi/2014/04/22/bill-ackman-outsvaleant-ceo-mike-pearson-as-a-billionaire/#7f9319bb3b29 (accessed October 25, 2016). Vardi, Nathan and Antoine Gara (May 10, 2016). "Valeant Pharmaceuticals' Prescription For Disaster." Forbes, https://www.forbes.com/sites/nathanvardi/2016/04/13/valeantpharmaceuticals-prescription-for-disaster/#a00870c206c5 (accessed January 23, 2017).

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18. The Betaseron Decision(A) (Chapter 1, pages 62-63) What this case has to offer Betaseron A is a terrific case for breaking the ice with a class, and for getting them to start thinking about business ethics problems in a real-life setting. Specifically, they will have to wrestle with: •

The role of a corporation – is it to make profit, how much, how;

•

The role of government in setting standards and looking after the public;

•

The role of stakeholders in the corporation’s achievement of its strategic goals;

•

The long-run view vs. the short run; and

•

Real trade-offs executives have to make. The case evokes great discussion and provides a memorable learning experience. Teaching suggestions/Major ethical issues

I usually advise the students that the case is based on a real-life problem, and one that pharmaceutical companies face continuously. I then write three headings on the board to facilitate keeping track of suggestions and the discussion on the problems identified at the end of the case: pricing, distribution of scarce product, and supply enhancement. I ask: “Whose fault is this lack of product?” Answers vary between the corporation and the government, but in the end I ask: “If it is the government’s fault, does the company have to worry about it?” The answer is yes, if the corporation wants to maintain the trust and confidence of its customers and the medical community. Both of these stakeholder groups are essential to the achievement of the corporation’s strategic goals. They are primary stakeholders per the discussion of stakeholder theory (See Text, Chapter 4, section Stakeholder Impact Analysis—Comprehensive Tool for Assessing Decisions and Actions, page 206ff). I then put forward that, if the company were to charge $50,000 for a 12-month dosage of Betaseron, the limited supply would be enough to serve the market. I ask if this isn’t the right approach for the company if its role is to maximize profit. A lively discussion ensues and usually turns into a discussion of how much profit is enough. We then turn to the issues of enhancing supply, and of fair, cheap distribution. Opinions differ, and we cover such issues as: should the company care; legal realities caused by unhappy relatives and sufferers, cost, alternatives, giving up secrets to other manufacturers who would be licensed, and so on. I finish by reading the class the actions taken by the corporation that are described in the Betaseron B case that is attached below. The class is always surprised by the long-run, stakeholder-oriented view taken by the corporation. The author, Ann Buchholtz, who is now at the University of Georgia, has an excellent teaching note on the A and B cases:

P a g e | 70 THE BETASERON® DECISION (B) Dr. Ann Buchholtz, University of Georgia On August 20, 1993, Berlex announced its distribution and price plan for Betaseron® and sent a letter to all U.S. neurologists detailing its pricing and distribution. •

Persons who have either commercial medical insurance or an annual family income of more than $50,000 would pay $1000 per month. However, to encourage strict compliance to the treatment regimen, Berlex would give patients two months of the drug free of charge after ten consecutive months of compliance. Therefore, anyone who adheres to the prescribed treatment regimen would pay $10,000 (annually), the highest price to be paid for the drug.

•

Persons with an annual family income between $20,000 and $50,000, without medical insurance, would be provided financial assistance by the company to help support the annual costs of the medication.

•

Persons with an annual family income below $20,000, who have no medical insurance, would be provided the medication free of charge.

To minimize out-of-pocket expenses, Berlex developed the Betaseron® Card which would identify patients to pre-chosen pharmacies and provide information about their payment program and price. Qualified patients would receive interest-free deferred payment for up to 55 days. This was intended to enable most patients to pay their bills after they received reimbursement. The card was provided through a financial institution and financed by Berlex. After 55 days, a finance charge of 12% would be applied to any unpaid balance. Berlex would not receive any portion of the interest payments and would not profit from the card. Distribution was set to begin in October 1993, with distribution handled by PCS Health Systems, Inc., a nationwide network of affiliated pharmacies. This managed pharmacy network served two purposes. First, it enabled Berlex to cut costs by minimizing handling charges; Berlex estimated that patients would save about $2000 per year. It also enabled Berlex to provide the drug only to specifically identified patients and insure that, once therapy has begun, the supply of the drug would be continuous. Initial access to the drug was determined by a lottery, designed to provide equal access to the initially limited supply. Physicians who wished to obtain Betaseron® for their patients enrolled them in the program during an open registration period from August 23 to September 15, 1993. At the conclusion of the registration period, patients were assigned a randomly generated number. Patients who registered for the drug after the close of registration were put at the end of the list on a first-come, first-served basis. Those with numbers under 1000 were slated to begin receiving the drug immediately. Those with numbers under 12,000 would have the drug by year's end. Those with numbers between 12,001 and 40,000 were expected to have access to the drug by mid to late 1994 and those with numbers over 40,000 would probably not be supplied Betaseron® until late 1994 or early 1995. Berlex placed no restrictions on which MS patients physicians could enroll, in spite of the FDA indication for ambulatory relapsing, remitting MS. Patients with MS and their advocates were left with a host of questions. Was the lottery system a fair way to resolve the distribution dilemma? How fair was the pricing structure? Did Berlex do everything possible to guarantee equitable access to the drug? Who were the winners and who were the losers? Lastly, what problems were likely to result from this solution?

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19. Magnetic Toys Can Hurt (Chapter 1, pages 63-64) What this case has to offer This case offers an opportunity to discuss a poorly handled hazardous products case; consider the rights of stakeholders including shareholders, victims, employees and others; and learn about practical risk- and crisis management from an ethical perspective. Teaching suggestions The discussion might begin by asking the class whether Mega Brands acted properly or not, and why. They should raise the following: •

•

Lack of cooperation with the U.S. Consumer Products Safety Commission (CPSC): o

Delays in providing info, and

Delay in recalling products as requested.

New labeling might not provide enough protection

Then the class should be asked which stakeholders benefited (shareholders wishing to sell their shares in the short run) and which were disadvantaged by Mega Brands’ actions (victims, shareholders wishing to hold their investments beyond the short term, and so on). That will provide a platform for asking how Mega Brands’ actions could have been improved, which will set the stage for taking up the end-of-case questions. Discussion of Ethical Issues 1. If you were an executive of Mega Brands, what concerns would you express to the CEO about the Magnetix Toy issues noted above? •

The rights of the victims and their families, our employees (some of whom will leave) who will see their reputations tarnished by association, our distribution channel partners and long-term shareholders have been damaged. Was the loss worth the benefit?

•

Legal liability will likely ensue for the company and its senior executives that will be costly to defend in terms of time and money.

•

Damage to reputation will be lasting and serious, thus depressing sales and profits. Mega Brands sells in the children’s toy market—where children are considered more vulnerable than adults–and the company should realize that it is really selling trust, not toys.

P a g e | 72 •

The company’s risk management systems and practices were faulty: System flaws o

No recording, analysis, and risk assessment of complaints

No scanning of media for potential problems

No reporting system to top management and the Board

No responsibility allocated for someone to champion and oversee the risk management process

Practice flaws: o

Denied responsibility

Non-cooperative with authorities

No worthy risk assessment

No consideration of company values and how those are signalled to employees and other stakeholders

Undermined reputation

2. If the CEO didn’t pay any attention, what would you do? •

Report the matter to the company’s Board through the governance and/or audit committee.

•

Consider whistleblowing to the media.

3. Should the CPSC have more powers to deal with such hazards and companies? If so, what would they be? If not, why not? •

Yes, because companies now seem to be able to ignore sound requests from authorities.

•

Significant investigatory powers and the ability to levy fines for: o

Ignoring requests

Failing to have systems that record, examine, and report on complaints

Failing to monitor the quality of complaints and risk management systems

•

Legal orders for recovery of ill-gotten profits

•

Prosecution for egregious cases leading to fines for companies and jail for officers

Useful Articles, Links, and Videos

P a g e | 73 Consumer Reports (April 14, 2009). “Mega Brands fined $1.1 million for failing to report Magnetix incidents,” https://www.consumerreports.org/cro/news/2009/04/megabrands-fined-1-1-million-for-failing-to-report-magnetix-incidents/index.htm Morgenson, Gretchen (July 15, 2007) “Toy Magnets Attract Sales, and Suits.” New York Times, http://www.nytimes.com/2007/07/15/business/yourmoney/15magnet.html?_r=1&scp= 1&sq=Mega%20Brands%20magnetix%20toys&st=cse “In the News: Magnetix” (2007, 2009). Chicago Tribune, (Feature Article Collections on Mega Brands) http://articles.chicagotribune.com/keyword/magnetix [Link not active in 2020.] [This webpage identified many articles on Magnetix and Mega Brands from 2007 and 2009. In 2020, a search using terms “Magnetix” and “Chicago Tribune” retrieves many of the articles.]

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20. Bausch & Lomb’s Hazardous Contact Lens Cleaner (Chapter 1, pages 64-65) What this case has to offer Most companies do not react effectively and quickly enough to an ethical crisis, particularly over a hazardous product discovery, so this case offers the opportunity to engage students to illustrate the: •

Dangers of ignoring or minimizing the potential problems, and the motivations for doing so;

•

Very real conflicts in the interests of stakeholders, such as shareholders and managers versus the potential victims;

•

Trade-offs needed between these interests, and when to make them;

•

Trade-offs between short-run and long-run interests;

•

Role of corporations; and

•

Due diligence expected of executives and the Board.

Reference to the crisis management discussions and readings in the Text, Chapter 7 would be useful. In fact, this case could be used to illustrate a simple crisis management problem. Teaching suggestions To get the class discussion started, I ask the class to vote on whether the role of modern corporations ought to be to maximize profit or to serve the interests of all its stakeholders, including shareholders. The case will lead them to see that the second objective may (and we hope will) lead to the first, but before they realize that, divide the class into two groups for discussion purposes: one, to take the role of the CEO, Ron Zarrella who has acted in what he thinks is the best interest of the shareholders; the other, to take the role of the victims and their families. The victim’s reps can then be asked what was wrong with the CEO’s actions. They will say that he was too slow to react to save their health by halting sales and sending warnings to users. The CEO’s reps should be asked to respond, and they will say that they didn’t have all the information they thought necessary to halt sales earlier and send warnings, because those actions would have had a serious negative affect on profits and, therefore, on shareholders’ interests (as well as bonuses). At this stage, I ask which shareholders interest they are thinking of: current or potential future shareholders. The normal answer is current shareholders, and I ask if the interests of current shareholders are the same as future shareholders. The answer is not necessarily, and we explore this important point. I ask the class if they think the CEO should be striving to satisfy current shareholders or potential future shareholders. I also ask if the interests of potential future shareholders are the same as for non-shareholder stakeholders. This discussion will lead the students to reconsider the question I asked them about voting on the role of modern corporations and will prepare them for the discussion of what the CEO should have done.

P a g e | 75 The class should be asked if there were anything that should have been done more quickly that happened in real life that could/should have been done earlier to assist in the CEO’s decision. This will lead to a list such as: •

Press for early information on anomalous information (Hong Kong issue and Renu’s fivetimes higher infection than competitors).

•

Implement an online complaint system to enable early warnings to be received, and followup on complaints when they are reported.

•

Monitor world media for potential problems, such as those in Hong Kong, and assess whether our company could be involved.

•

Brief the Board of Directors and seek their input, since they are the representatives of the shareholders and will consider the risks to the company and themselves carefully. This illustrates the governance realities for CEOs.

•

Implement a comprehensive risk management system and mentality in the company.

•

Clarify company values and priorities in advance, as did Johnson & Johnson in their credo, which was so helpful to executives in the Tylenol Crisis by showing that the interests of patients were paramount. (See the Text’s Index for Tylenol entries.)

I finish the case discussion by asking the class what the priorities of the CEO should be when facing another problem such as this. Hopefully they will put the victims’ interests ahead of the current shareholders’ interests. I then ask them to vote again on the question I put to them at the beginning. Discussion of ethical issues 1. What lessons should be taken from B&L’s Renu experience? See above. 2. What should Zarrella have done and when? See above. Useful Articles, Links, and Videos Smith, Aaron (April 27, 2006). “Bausch sold ReNu in US knowing problems in Asia.” CNNMoney, http://money.cnn.com/2006/04/27/news/companies/bausch/ Pettypiece, Shannon (April 14, 2006). “Bausch & Lomb Ads Apologize to Consumers on Cleaner.” Bloomberg, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aTbkZI1HbPW0&refer=u s [Link not active in 2020.] Dobbin, Ben (March 15, 2010). “New CEO, Chairman appointed at Bausch & Lomb.” Associated Press, http://www.boston.com/business/articles/2010/03/15/new_ceo_chairman_appointed_ at_bausch__lomb/ Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 76 Walsh Juliann and Duncan Moore (April 12, 2006) “Bausch & Lomb Isn’t Recalling Contact Lens Cleaner.” Los Angeles Times, https://www.latimes.com/archives/la-xpm-2006-apr-13-fidrops13-story.html Feder, Barnaby (May 15, 2006). “Bausch Issues Worldwide Recall of Contact Lens Cleaner.” New York Times, http://www.nytimes.com/2006/05/15/business/15cnd-eye.html

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Accounting & Auditing Cases 21. Where Were the Accountants? (Chapter 1, pages 65-66) What this case has to offer This case was designed to raise questions about two major scandals (the savings and loan “S&L” crisis and Bank of Credit and Commerce International (BCCI) bank scandal) and one health problem (smoking) and ask why accountants were not more proactive in avoiding the problems, and more proactive in matters which bear upon their expertise. This leadership is what many would like to see in a profession they would like to join. In the process of discussion, students will gain a better understanding of the accountant’s expertise and role as a professional. Teaching suggestions and discussion This case is a good one for assigning students to do some research in advance on the S&L crisis and on the BCCI scandal. For the former, I would refer them to Epstein (1993), and for the latter, to Beaty and Gwynne (1991).13 The students can then report to the class on what they found out about the two scandals to provide background for the discussion. The history involved is something a budding accountant should know, partly in order to avoid a repeat of similar unfortunate happenings. Based on this understanding, I would ask whether the scandals could have been avoided and how? This usually produces the response that, had accountants been quicker to appreciate the danger in each, and had they spoken out more forcefully, the problems could have been avoided or prevented from getting as large and bad as they did. I then ask why didn't accountants recognize the potential of the problem earlier and speak out. The answer revolves around self-interest and lack of understanding of the potential downside. For instance, accountants should have known—and probably did know–about the financial uncertainty of S&Ls but hoped that fortunes would turn around and all would be well. It was not in the short-term self-interests of accountants involved as auditors or as management personnel to blow the whistle too loudly. Jobs and/or clients would have been lost. The motivation for non-disclosure of the BCCI fraud is probably similar, although it was finally brought to light by a report of the firm’s auditors in Great Britain: Price Waterhouse & Co. The lesson here is that a professional's short-term self-interest does not provide a suitable basis for protecting the profession as a whole or the interests of investors, depositors and the public who ultimately have to pick up the cost. In the case of the health-related debate on the costs associated with smoking, I would ask the class how an accountant could have provided leadership in the gathering of information. The discussion should progress from suggestions for employing traditional costs to estimates of costs, which would be part of a cost-benefit analysis (i.e., costs which are

In 2020, many online sources could be used as substitutes if these articles cannot be accessed. Academic libraries should be able to provide free access for students.

P a g e | 78 beyond those which would fit into a traditional financial statement, such as a surrogate cost for pain and suffering). This area is often beyond the scope of many college programs for accountants, but the question is should it be? Accountants are experts in measurement and should be able to contribute to such analyses. As subjects like the measurement of environmental impacts become more important, perhaps accountants thinking of measurement beyond traditional limits will become more popular. When they do, accounting education will adapt, and more accountants will be prepared and willing to speak out on nontraditional, but important, subjects. If they don't, some other group will assume the leadership of the measurement function in these emerging areas. Useful Articles, Links and Videos Atkinson, Dan (January 8, 1999). “Accountants in BCCI net.” The Guardian, http://www.guardian.co.uk/business/1999/jan/08/6 Beaty, Jonathan and Gwynne, S.C. (July 29, 1991). “B.C.C.I.: The Dirtiest Bank of All.” Time, http://content.time.com/time/magazine/article/0,9171,973481,00.html [Link in 2020 provides excerpt only or full article with registration. Article may be able accessible for free through academic libraries.] Epstein, Marc J., (February 1993), “Accountants and the S&L crisis,” Management Accounting 74 (8), p. 24ff. [The full article is accessible through academic library databases, such as http://search.proquest.com/docview/229757929?pq-origsite=gscholar or https://go.gale.com/ps/anonymous?id=GALE%7CA14171389&sid=googleScholar&v=2. 1&it=r&linkaccess=fulltext&issn=00251690&p=AONE&sw=w.] McCarroll, Thomas. (April 13, 1992) “Accounting Who’s Counting?” Time, http://content.time.com/time/magazine/article/0,9171,975255,00.html [Link in 2020 provides excerpt only or full article with registration. Article may be able accessible for free through academic libraries.] Roohani, Saeed, Knight, Lee, and Knight, Ray (January 1, 1994). “S&L Crisis: A learning experience for accountants.” Journal of Bank Cost & Management Accounting 7 (3), https://www.questia.com/library/journal/1P3-7406605/the-s-l-crisis-a-learningexperience-for-accountants [Link in 2020 provides excerpt only. Article may be able accessible for free through academic libraries.] “BCCI Investigation Day 2 Part I,” C-Span video, 59:00, Aug. 2, 1991, http://www.cspanvideo.org/program/IIn ; “BCCI Investigation Day 2 Part II,” C-Span video, 54:00, August 2, 1991, https://www.c-span.org/video/?20576-1/bcci-investigation-day-2-partii ; “BCCI Investigation Day 2 Part III,” C-Span video, 1:38:00, August 2, 1991 http://www.c-spanvideo.org/program/III . [A U.S. Senate subcommittee hears testimony on the Bank of Credit and Commerce International’s finances and its effects on U.S. financial and security interests. Additional testimony available through the C-span.org website.] Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 79 “BCCI Investigation,” C-Span video, 2:08:42, October 25, 1991, https://www.cspan.org/video/?22300-1/bcci-investigation [The Senate Committee on Foreign Relations heard testimony into the Bank of Credit and Commerce International scandal and its effects on U.S. financial and security interests. Additional testimony available through the C-span.org website.]

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22. To Resign or Serve? (Chapter 1, pages 66-67) What this case has to offer This case combines the facts of two real-life situations. It offers the opportunity to: 1. Work with the stakeholder concept, 2. Reason through two business arrangements to produce the best accounting disclosure of the transactions involved from a traditional accounting perspective and an ethical perspective, 3. Face the decision to resign or continue to serve a client, 4. Consider what effort should be made to give your views as out-going auditor to the incoming firm, and 5. Consider when it is appropriate to take on a client when another auditor has resigned. Due to placement of this case in Chapter 1, the discussion of ethical issues and ethical decision frameworks will not be as well developed as it would be if the case were used after the material in Chapter 4 were dealt with. Teaching suggestions Just for fun, I take a vote of the class at the outset to see how many students think that resignation was appropriate, and how many would be prepared to take on the audit after the incumbent had resigned. I believe that the business arrangement put forward in the case needs to be understood before the ethics issues and fundamental questions can be appreciated. Consequently, I begin with a discussion of renegotiations of overdue loans to enable calling them current (which has long been a practice in the lending industry), and of insuring against non-payment of accounts receivable (which has been done by governments for oversees trade and factors for years, but not by the type of company employed as insurer in this case). Based on this understanding, the students can specify who are the stakeholders involved and what their interests are, including: •

Current shareholders: accurate portrayal of reality as a basis for decisions, but higher rather than lower profits

•

Future shareholders: accurate portrayal of reality as a basis for decisions, but lower rather than higher profits

•

Lenders to the bank: continuing arrangements, repayment according to terms

•

Creditors: repayment according to terms

•

Suppliers: continuing arrangements, payment

•

Employees: continuing employment

P a g e | 81 •

Auditors: continuation of reasonable fee for service arrangements, reasonable audit risk, low possibility of lawsuits and legal settlements, no loss of reputation

•

Management: stable/increasing profits to support their continuance, bonuses and the price of shares or options held

•

Accounting profession: no loss of reputation which could damage their franchise and their ability to maximize their independence and future income

•

Regulators, etc.

The conflicts in interest which show up in this listing should be underscored with the students, because they are at the root of most ethical problems, and they provide a framework for deciding how to best disclose the transactions flowing from the two business arrangements. Discussion of important issues Renegotiation of overdue loans to call them current For this to be substantive rather than just form, the collectability of the loans has to be improved and assured. Repeated renegotiations would imply non-collectability, and should be evident during the course of an audit. The case is silent on the audit work undertaken, but the resignation implies that the auditors had decided the collectability was in serious question. Use of insurance against non-collectability This approach is not new, but the familiarity of the insurer to the nature of risk involved, and the capacity of the insurer to pay off in the event of large losses, would have to be scrutinized carefully. Given the extent of losses being experienced by banks in regard to real estate loans, it is unlikely that any insurer, other than a government, could sustain the payout required. Once again this may be why the auditors decided to resign. Persuasion vs. qualification vs. Resignation Customarily, as in the case, an auditor who believes statements should be changed or unfair presentation will result, will call for a meeting with the management and/or the audit committee of the Board and will ask for proper disclosure to be made. If adequate changes are not made, the auditors can qualify their auditor's report and disclose the reason for doing so. They need not resign. If, however, an auditor loses confidence in the integrity of the management of a client, then resignation at the earliest possible moment is the best way to avoid legal liability, which will probably ensue. However, the auditor must also consider his/her responsibility to the shareholders. If his/her resignation is without notifying the shareholder of the reason, then the auditor's fiduciary duty to the shareholder has not been properly discharged, because the shareholder may never know of the auditor's concern until it is too late. Resignation from an audit without rendering a report or advising the audit committee of the reason is most unusual. Courtesy among auditors/Protection of shareholders and auditor’s interests Codes of conduct for auditors usually provide that incoming auditors contact out-going auditors to advise them of their appointment and whether they had any problems with the client to advise the incoming group about. This would be the opportunity to protect the interests of Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 82 the shareholders by passing along concerns, and for the incoming auditor to assess whether he/she should take on the job. If this opportunity does not present itself, and in this case it apparently has not, the outgoing auditor, James, should assess whether he should advise Jack of his concerns. I believe he should do so, and follow-up in writing; otherwise, his duty would not be discharged to the shareholders. If this is not done, I believe James would be acting unethically and probably would be open to legal liability, as well. Students should be able to understand more fully the purpose of an auditor and his/her responsibilities as a result of studying this case.

Chapter 2—Ethics & Governance Scandals Chapter Questions and Case Solutions

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Chapter Questions...................................................................2 Case Solutions.........................................................................11

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Chapter Questions 1. Do you think that the events recorded in this chapter are isolated instances of business malfeasance, or are they systemic through the business world? The events chronicled in this chapter range over an eighty-year period from 1929 to 2010. During that time there were horrendous business failures, frauds and debacles that cost investors, consumers, taxpayers, and the general public billions and billions of dollars, not only in the United States, but around the world. The scandals were worldwide, involving hundreds of companies, only some of whom are mentioned in this chapter. At the same time, however, throughout the world, there were millions of businesses that were supplying the goods and services needed by society, in an efficient and effective manner. They were operating within the law and ethical standards. The examples provided in this chapter, and throughout the textbook are aberrations. Most people and businesses, most of the time, act and behave in a responsible manner. They obey the law, ethical norms, and social standards of behavior. However, if executives, directors and accountants are not mindful of the ethical dangers that lurk in the business world, then they too can become part of this aberration that is so costly to society. These business exceptions challenge the integrity and humanity of everyone who has anything to do with business. 2. The events recorded in this chapter have given rise to legislative reforms concerning how business executives, directors, and accountants are to behave. There is a recurring pattern of questionable action followed by more stringent legislation, regulation, and enforcement. Is this a case of too little legislation being engaged too late to prevent additional business fiascos? No amount of legislation can ever prevent crimes from occurring. One key to preventing additional business fiascos from occurring is to create a business environment in which the focus of business is clear. The purpose of business is not to make a profit at any cost. Moreover, profit is the consequence of providing goods and services required by society, in an efficient and effective manner, while operating within the law and ethical standards. The more efficient and effective the operations, the more profits the business will generate. For far-sighted corporations, profits are not the goal; they are the consequence of action. Many of the fiascos discussed in this chapter relate to greedy business leaders who, perhaps through hubris, lost sight of the goal of business. By focusing on profits they began to compromise their ethical standards, and so began a downward spiral that resulted in fraud and bankruptcy. 3. Is there anything else that can be done to curtail this sort of egregious business behavior other than legislation? Yes, boards and directors and executives can be educated to understand that unethical behavior is bad for business, and that reputation, which determines success, depends on ethical behavior.

P a g e | 85 Archie Carroll, for example, (“The Pyramid of Corporate Social Responsibility: Toward the Moral Management of Organizational Stakeholders,” Business Horizons, JulyAugust, 1991) has argued that businesses must first and always obey the law. Then they must be economically viable. They do this by operating in an efficient and effective manner. Next, they must behave with the highest ethical standards. Finally, businesses must give back to society. If businesses follow these four steps, as well as the lessons contained in this textbook, there will be less need for legislation to govern business behavior. 4. Many cases of financial malfeasance involve misrepresentation to mislead boards of directors and/or investors. Identify the instances of misrepresentation in the Enron, Arthur Andersen, and WorldCom cases discussed in this chapter. Who was to benefit, and who was being misled? Additional information on each case is included in Chapter 9 of the sixth edition of the text, which is available in the Digital Resources for the eighth edition (see www.cengagebrain.com ). Enron Misrepresentation

Result

Premature recognition of revenue using ‘prepays’

Overstatement of revenue

Syndication of special purpose entities (SPEs)

Understatement of expenses

Conflicts of interest by  

Senior management Board of directors False financial statements audited by Arthur Andersen

Financial rewards to the related parties Fraudulent financial reporting

Who Benefited These frauds resulted in net income and stock to increase, which benefited senior management that had lucrative stock options Financial rewards to:  

Jeffery Skilling the board members

Senior management at Enron and partners at Arthur Andersen

Investors, regulators, employees and the general public were all mislead and harmed by this fraud. Arthur Andersen Misrepresentation

Result

Culture focused on revenue production primarily through non-audit services

Compromise on audit quality

Removal of Carl Bass, quality control partner, from providing oversight on the Enron audit

Permitted David Duncan to accept the accounting policies of Enron

Who Benefited In the short-run, all the partners who shared in the profits derived from providing lucrative non-audit services to Enron

P a g e | 86 The partners and employees of Arthur Andersen lost their jobs when the accounting partnership collapsed; all of Arthur Andersen’s clients had to find new accountants. WorldCom Misrepresentation

Result

Capitalized expenses

Overstatement of net income

No oversight of the

Ebbers could orchestrate the fraud

CEO

Who Benefited Ebbers, Sullivan, and all the other WorldCom executives and board members that held lucrative stock options

Investors, regulators, employees and the general public were all mislead and harmed by this fraud. 5. Use the Jennings “Seven Signs” framework to analyze the Enron and WorldCom cases in this chapter. Jennings ‘Sign’ Pressure to meet goals, especially financial ones

Enron

WorldCom

Senior executives Pressure after the had lucrative stock options collapse of Sprint takeover. Ebbers ordered Sullivan to ‘hit the numbers’

Closed organizational culture

Conflicts of interests became acceptable business behaviors

This is detailed in Chapter 9 of the textbook

CEO with sycophants

Board ignored complaints from whistleblower

No one challenged Ebbers’ authority

Weak board of directors

Powers Report and Senate Subcommittee Report blamed the board for a failure to provide oversight

This is detailed in Chapter 9 of the textbook

Nepotism and favoritism Hubris

Ethical trade-offs

None This is detailed in Chapter 9 of the textbook None

None Ebbers had unlimited power with no oversight None

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6. Rank the three worst villains in the film Wall Street: Money Never Sleeps (2010). Explain your ranking. •

Alan Loeb and Stephen Schiff, who wrote the screenplay, for simplifying a complex issue and attempting to make money by being the first to present a fictionalized account of the financial bailout associated with the subprime mortgage crisis.

•

Michael Douglas, the main actor, for reprising a role so that he could say, once again, ‘Greed is good.’

•

The customers, who did not listen to the critics who panned the movie.

7. In each case discussed at some length in this chapter – Enron, Arthur Andersen, WorldCom, and Bernie Madoff – the problems were known to whistleblowers. Should those whistleblowers each have made more effort to be heard? How? Whistleblowers in these cases did not use all of the following steps: •

Begin by talking to an immediate superior or relevant company official. At Enron and WorldCom this would probably have been someone in the accounting or internal audit departments; at Arthur Anderson, it would have been the partner in charge; and with Madoff it probably would have been someone in the accounting department.

•

Notify the audit committee of the board of directors.

•

Communicate with the external auditors.

•

Present a formal complaint to the Securities and Exchange Commission.

Failing all of the steps above, the whistleblower could go public as a last resource (after seeking appropriate legal counsel). In the Madoff case, the whistleblower was outside the company, and tried very hard to be heard, but his warnings fell on deaf regulatory ears. He could have gone public earlier, and perhaps a knowledgeable journalist could have caused some action with a public article. Alternatively, a letter to Elliott Spitzer might have done the trick. 8. The lack of corporate accountability, and an increased awareness of inequities and other questionable practices by corporations, led to the Occupy Movement. Identify and comment upon additional recent instances which have led to concerns over the legitimacy of corporate activities. •

Manipulation of LIBOR rates – see discussion in the Text, Chapter 2

•

Over-leveraging of investment houses during the subprime lending scandal – see discussion in the Text, Chapter 8

P a g e | 88 •

Lack of integrity by credit rating agencies when valuing the subprime mortgages securitizations during the subprime lending scandal – see discussion the Text, Chapter 8

•

Many bribery scandals – see discussions in the Text, Chapter 2 and Chapter 8.

9. It seems likely that the top executives of the major banks involved in the manipulation of the LIBOR rate were aware of the manipulations, and of the massive profits and losses caused by those manipulations. Why did they think that such manipulations could continue to be undetected, and/or unpunished? At least some senior bank officials were probably aware of the manipulative practices because they had gone on so long. Also, the problem appears to have been generally known to insiders, since a top U.S. official, Tim Geithner, Secretary of the Treasury, warned the head of the Bank of England that a clean-up was needed in a letter before the story surfaced in the press. The story came from a whistleblower who had been trying to stimulate action for some time, but no actions had been taken by major banks to curb their personnel who were involved in the manipulations. 10. The new anti-bribery prosecution regime involves serious charges and penalties for bribery in foreign countries during past times when many people were bribing in the normal course of international business, and penalties were not levied. Is it unreasonable to levy extremely high fines at the beginning of the new regime, and/or not to limit the period over which bribery can trigger those fines? Why and why not? Reasons supporting high fines at the start: •

High fines send a strong message to leave no doubt about the risks of bribery.

•

High fines encourage ethical behavior on questionable actions before they become illegal.

•

Low fines may be considered a cost of doing business and produce no change in behavior.

•

Low fines could send a signal that the new anti-bribery regime is not considered high priority for investigators, so they may turn to more important areas.

•

New laws and/or more rigorous enforcement of existing laws do not happen without some public debate or notification.

•

High fines provide more revenue for the government. Reasons against high fines at the start:

•

Levying high fines on unsuspecting companies is unfair.

•

Companies need time to change policies and practices

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Companies will lose business to competitors who bribe if the cost of bribery gets too high. Conclusion – High fines are probably reasonable.

11. At GM and Takata, whose improper actions finally came to light, a whistleblower raised objections to the actions before or very early in the production process. Why were their concerns ignored and risks taken? In VW’s case, why didn’t a whistleblower come forward? What aspects of governance were lacking in each company? At GM and Takata the whistleblower’s concerns were not taken very seriously. Neither company had a whistleblowing program that brought complaints to the senior officers and directors of the company. The culture in both companies was also not encouraging to whistleblowers. In GM, the dominant pressure was to keep costs low, so changes that would increase costs were ignored. The potential harm, cost and reputational loss involved was simply not taken into account in the decision making. Analysis of stakeholder impacts was not undertaken. In addition, at GM, and the approvals required for safety testing and remediation were not scrutinized or reported upward, so a low level official was able to cover the matter up until customer outcries brought the faulty switch problem to light. At Takata, the prevailing culture was not to question or criticize more senior employees or executives who made strategic and operational decisions. This meant that early remediation of the air bag problem did not happen. Needless to say, the top executives at GM and Takata did not encourage whistleblowing or “safety first” thinking at the time. At VW, the pride of VW engineers was at stake because their competitors had been able to design their cars to pass environmental tests, but VW’s had not. The VW marketing people had even incorporated the winning of environmental awards into the VW marketing campaign, although the awards had been falsely won. Because there was a lot at stake, VW engineers resorted to a cheating process that they had used twice before, even though they had been caught twice. Whistleblowers, recognizing that there was a huge amount at stake, did not want to expose their colleagues by whistleblowing and risk the stigma and reputational loss that would follow. Whistleblowing was not encouraged by top management in any case, and a whistleblower protection program with reporting to the Board was not in place. The engineers seem to have been blind to the potential downside problem that could occur, which was a failure of proper decision making to include medium- and long-term stakeholder impacts. 12. The CEOs of Valeant Pharmaceuticals and Turing Pharmaceuticals took the view that they could jack up the price of their drugs by huge percentages because they could, and they failed to consider seriously enough whether they should. Whose fault was this? In a wellfunctioning corporate governance system, what measures should be in place to control such actions? The CEOs of Valeant and Turing had, for some time, gotten away with the strategy of buying fully developed drugs for which alternatives didn’t exist and jacking up their prices to sky-high levels, and this would have continued except for the public outcry and political scrutiny that arose. In addition, the Boards of Directors of each company actively encouraged this business model, probably believing that

P a g e | 90 maximization of profit was OK at any cost. The Board of Valeant actually structured CEO Pearson’s remuneration to include huge performance stock unit (PSU) incentives if Pearson were able to dramatically expand Valeant’s profits, and therefore incented him to press on with an unsustainable business model. Therefore both the CEOs and the Board of both companies were at fault. In a well-functioning company, there should be a continuing assessment by the Board of the ethicality and sustainability of the company’s business model, and a review by the Compensation Subcommittee of the Board of the executive incentive remuneration scheme to see that it does not motivate difficulties such as in the cases of these two companies. 13. What are the reactions and outcomes that can be attributed to the leaked Panama and Paradise Papers? Release of the Panama Papers and Paradise Papers shocked the public and regulators, and galvanized both into action. The public outcry against leaders and others who were evading taxation in the countries they lived or earned their wealth resulted in the resignation of several heads of state, great pressure on tax collection officials, programs to recover unpaid taxes, and efforts to close off exposed loopholes in tax law. In addition, the exposure of individuals who look advantage of questionable methods to hide their wealth produced a chilling effect on the use of such techniques. Several countries were able to encourage repatriation of offshore wealth by offering amnesty, or low-tax programs. The Panama Papers and Paradise Papers also exposed possible avenues for money laundering, which were investigated and curtailed. The extent of disclosures was so vast, that a full investigation of possible secret arrangements will continue for many years. “…The lesson from these two hacks or leaks is that confidentiality or secrecy of malfeasance can no longer be guaranteed, which might dissuade some individuals from evading taxes through questionable offshore processes.” (Text, page 108.) 14. The legal consequences for frauds, bribery, or other malfeasance have become very severe, particularly since 2009. Why has this happened? Are higher legal consequences having much of an impact? Investors and the public realize now that bribery and frauds are very bad for corporate earnings, and that higher financial penalties and jail can serve as deterrents. Also, now, with greater international cooperation in developing evidence for prosecutions, the resulting fines and consequences have escalated (see Text). Whether the incidence of fraud, bribery and malfeasance has diminished or increased, since enforcement has become tougher, is uncertain. However, many large companies have responded to the new enforcement regime by installing preventative systems and increasing their vigilance against bribery and other malfeasance. Students might also consider that legal consequences—sometimes in keeping with the degree of public outrage, particularly over huge bankruptcies (e.g., Enron, Carillion, KPMG tax shelters)—have had notable impacts, particularly in corporate governance. Consider, for example, fines or jail terms for officers and directors whose companies were not in compliance with environmental standards. Leniency in Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 91 sentencing could be induced if a company could prove it had an effective environmental protection program. (Text, Chapter 1, page 3.) In addition, “The credibility gap has not favored business organizations. Lack of credibility has brought increasing regulation, international standards, mainstream interest, increased recognition of stakeholder interests and reporting on them, and profound changes in governance and management practices as well as in the accounting profession.” (Text, Chapter 1, page 11.) Social media has helped increase awareness of malfeasance and to increase the volume of public disillusionment and distrust of the corporations at the center of many scandals that showed willful, widespread illegality. 15. The J & J (talcum powder) and Wells Fargo (unethical incentives) scandals suggest that even companies whose reputations are based on ethical conduct can suffer ethical scandals. Why is this? An organization cannot “rest on its laurels,” because institutional memory fades, and ongoing financial pressures will push executives and employees in unethical directions unless the need for a culture of integrity is well understood and remains a commitment of top management. In other words, without vigilance, an organization’s past ethical behavior cannot be relied upon to guarantee future ethical behavior, as those two cases demonstrate. When corporate governance, corporate leadership, or belief in or application of ethics codes is inconsistent across an organization, or these things stray with time or with the succession of personnel, the corporation risks unethical behavior. The tone at the top and incentive schemes must be ethical, consistent, and mindful of the organization’s stakeholders. 16. Is the 2019 Business Roundtable Statement (BRS) redefining the purpose of corporations likely to make any difference to boards of directors and to activists? Yes. It signals the thinking of a large group of dominant senior executives rather than just idealistic activists. It signals a tipping point. “While many executives, members of boards of directors, and shareholders had already come to believe that stakeholder interests should be recognized and taken into account by corporations, many (including many lawyers) also still believe that only profits should be the focus of corporate planning and decision making. In this splitgovernance regime, the BR Statement provides strong public legitimacy to the broader stakeholder purpose view and should encourage other executives, board members, and shareholders to adopt the broader stakeholder view in the future. This promises to change corporate governance significantly. The question is no longer whether to incorporate stakeholder interests into governance objectives; rather, it is how to do so effectively. The elements of respect and integrity that are inherent in ethical behavior are essential to this process.” (Text, Chapter 2, page 112.) “In summary, directors are now understood to have legal responsibility to shareholders but are also expected to be responsive to stakeholder needs in a strategic sense while discharging these legal responsibilities.” (Text, Chapter 5, page 258.)

P a g e | 92 For many activists, the BR Statement will be welcome news, and a sign that their voices have been heard. Until, however, corporations demonstrate that stakeholder interests and sustainability are genuinely important, rather than profit alone, skeptical activists will continue their vigilance.

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Case Solutions 1. Enron’s Questionable Transactions (Chapter 2, pages 117-122) What this case has to offer The Enron debacle is the icon for massive fraud allowed by failure of the company’s governance system and the conflicted interests of its executives, auditors, and lawyers. It precipitated the loss of credibility and trust in financial markets and corporate governance and accountability that ultimately led to reform of corporate governance and accountability, and of the accounting profession, through the Sarbanes-Oxley Act of 2002. It is a case that all businesspeople and professional accountants should be familiar with and understand. Enron’s Questionable Transactions focuses on a subset of the entire Enron debacle, but facilitates the development of the issues raised by the Enron debacle as a whole. The discussion below is aimed at ensuring that students become familiar with the key issues of the debacle as a whole, as well as with the questionable transactions themselves. Teaching suggestions I use the PowerPoint (PPT) slides (24 to 42) in Session 2 of my Ethics & Governance course to work through the Enron debacle and the Enron’s Questionable Transactions case. These PowerPoints are available through Cengage on the instructor companion website for the Text. First, I set up the importance of having a good governance system; then I use “Enron Affair” (PPT 24) to review the important elements of the case. If you refer to the “Enron Affair” PowerPoint, you will see the order I have found to be very engaging and successful. I then ask the audience to assume the role of a member of the Board of Directors (PPT 25), and then I challenge them throughout the case discussion with the following questions: •

What is your role as a Board member?

•

What questions should you ask? (See PPT 25.)

•

Why didn’t the Enron Board ask those questions?

Depending on the audience (non-accounting or accounting), I review less or more of the details of the debacle and fraudulent transactions. PPT slides 26 to 34 provide a basic set of information. The key is to reveal enough that all audiences understand: •

Basic governance structure and roles of the Board, executives, professional accountants, and lawyers, as well company policy (particularly on conflicts of interest) and compliance systems.

•

What a Special Purpose Entity (SPE) is, the operation of the 3% rule for accounting for transactions, and how income, assets, and liabilities could be manipulated using it.

•

How and by whom the basic frauds were committed.

•

The motivation for the frauds.

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Where the money went.

•

What the impact of manipulation was on Enron’s financial reports and the investing public. Beginning with PPT 34, I challenge the class to consider their assumed roles as Enron Directors, and answer the following questions: o

Which segment of its operations got Enron into difficulties? Wholesale services was the segment where most of the manipulation went on. See PPT 34 for a breakdown of the relative profitability (IBIT) of Enron’s business segments. Look at the huge gains year over year!

How were profits made in that segment of operations (i.e., what was the business model)? Did Enron’s directors understand how profits were being made in this segment? Why not? Frankly, transparency was not in the interest of Enron’s perpetrators. If you read the notes to the original Enron financial statements, you find that what kind of operations gave rise to such explosive growth is very difficult to understand, so the directors probably did not understand what was going on either. However, they should have queried how almost 50% (See PPT 33 for the proportion of manipulated income) of Enron’s profits could have come from SPEs whose operations had no economic substance, or that asset sales and repurchase transactions between Enron and the SPEs were circular. You can’t make money off yourself. Also, there were apparently 1,000-3,000 SPEs created, and a good director should wonder why so many were needed.

What were the impacts of the profit manipulations on Enron’s Income and EPS (PPT 35) and Balance Sheet and liquidity (PPT 36)? These impacts were staggeringly large: the year-over-year growth in Revenues, Operating Income, IBIT, Current Assets, and Current Liabilities was incredible—so much so that, again, no director should fail to notice and ask, “Why?!”

Why did the directors accept the explanations for incredible year-over-year growth and changes? Why did they permit the manipulated statements to be released, if they did not ask the right questions, especially why? I force the students to wrestle with this reality and suggest obvious reasons: ▪

They did not consider asking questions to be part of their role in approving the Enron financial statements (i.e., poor understanding of governance and the role of the directors).

▪

They lacked the expertise to identify the lack of credibility of explanations.

P a g e | 95 ▪

They were conflicted by significant, appreciating shareholdings and flows of dividends (i.e., weren’t those signs of company success?).

▪

They lacked the insight and skepticism to consider manipulative fraud a possibility.

Obviously, a combination of all of these reasons underlay why the Enron directors failed to do their job. •

How the governance system was short-circuited because the directors failed to get objective information and advice. o

The governance system was short-circuited as noted on PPTs 37 to 40, because Fastow and Lay controlled the information provided to the Board, and they were trusted. The internal audit function should have raised red flags for/to the Board, but this was subcontracted to Arthur Andersen who, along with external lawyers used, were conflicted.

•

The role of an ethical or unethical corporate culture in preventing or abetting fraud.

•

Why whistleblowing is important.

•

What Arthur Andersen contributed.

•

What the banks contributed by facilitating the SPE transactions.

•

How the Sarbanes-Oxley (SOX) Act arose.

•

What changes SOX originated (PPT 41 to 42).

•

How ethics risk management can help (PPT 43).

Discussion of Ethical Issues The following questions are presented in the Text for discussion of the significant issues raised in the Enron case: 1. Enron’s directors realized that Enron’s conflict of interests policy would be violated by Fastow’s proposed SPE management and operating arrangements, and they instructed the CFO, Andrew Fastow, as an alternative oversight measure, to ensure that he kept the company out of trouble. What was wrong with their alternatives? The Board’s alternative controls were left to Fastow to institute, oversee, and presumably report upon to the Board. He was the principal fraudster, and there was no internal audit follow-up (Arthur Andersen had taken the internal audit role as a subcontractor), nor did the Board demand feedback. No whistleblower concerns reached the independent member of the Board. Like mushrooms, independent Board members were left in the dark. 2. Ken Lay was the chair of the board and the CEO for much of the time. How did this probably contribute to the lack of proper governance? Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 96 “Kenny Boy” did not serve as a useful foil or overseer of his own CEO actions, as a good independent Chair of the Board should. The inherent conflict of interests in being CEO and Chair has led to increasing separation of these functions as a measure of good governance, and some jurisdictions are requiring it. For example, Lay’s handling of the Sherron Watkins whistle-blowing letter showed either twisted brilliance or evidence of incompetence on conflict of interest matters. He asked the lawyers who advised on creation of the SPEs if what they had done was all right. 3. What aspects of the Enron governance system failed to work properly, and why? See PPTs 37 to 40 and the comments offered above. 4. Why didn’t more whistleblowers come forward, and why did some not make a significant difference? How could whistleblowers have been encouraged? See PPT 39. If you were contemplating coming forward and you knew that Enron’s culture was unethical (see examples) and the bosses knew it, would you come forward? Not likely, because the risk was too high that you would be fired or not welcomed. There would have to be changes in the culture and systems to encourage whistleblowers to come forward, such as measures to make the culture ethical (see Text discussion), and a protected whistleblower program. Because of this apparent flaw, SOX/SEC has subsequently mandated that all SEC registrant companies have a whistleblower system that reports to the audit committee. 5. What should the internal auditors have done that might have assisted the directors? Enron had subcontracted their internal audit function to Arthur Andersen. They should have been alert for flaws in Enron’s conflict of interest policies and for any lack of compliance. When a policy was/is set aside by the Board, internal audit should have been advised or should have realized this by screening the relevant minutes. In addition, they should have been looking for any transactions with questionable economic substance. Their reports should go the Board of Directors as well as management. Unfortunately, Arthur Andersen was not interested in rocking the boat with management by telling them about their faults. 6. What conflict-of-interest situations can you identify in the following? •

SPE activities

•

Executive activities. The Enron debacle shows conflicts of self-interest (personal gain of executives, employees, auditors, lawyers, bankers and directors) versus shareholders (as many were misled and lost significantly) and other stakeholder interests (as the company objectives were not met and jobs, etc., were lost). Each type of conflict has many examples. An interesting additional discussion is how each conflict of interest situation developed; why the professionals and directors lost sight of their need for independence; and what the professional accountants and banker thought that their mandate really was.

P a g e | 97 7. Why do you think that Arthur Andersen, Enron’s auditors, did not identify the misuse of SPEs earlier and make the board of directors aware of the dilemma? Arthur Andersen were aware of the use of SPEs and their quality control partner in Chicago emailed the audit partner in Houston to say that a clean audit opinion should not be given. However, the audit partner ignored the warning, probably because he did not want to aggravate Enron’s management and risk losing the audit that supplied most of his personal remuneration. In summary, the key decision maker at Arthur Andersen was conflicted, decided in favor of his own self-interest, and did not warn or challenge the Board on these matters. 8. How would you characterize Enron’s corporate culture? How did it contribute to the disaster? Enron’s corporate culture was unethical. It was a culture of deception, not of integrity. (See PPTs 38, 39). It was fraught with conflicts of interest; unethical and illegal acts; poor examples set by directors and executives; and the directors, professional accountants and lawyers involved were motivated by self-interest instead of by sustainable interest of shareholders and other stakeholders. In the process of allowing the individual self-interest of the company’s directors, personnel, and agents to be satisfied, they ignored their fiduciary duty to the shareholders and other stakeholders. The Board members, who were independent of management and not conflicted, were in the dark. Measures to make a corporate ethical culture are discussed in the Text and the PowerPoint slides. Additional question, not in the Text: 9. How much time should a director of Enron have been spending on Enron matters each month? How many large company boards should a director serve on? This depends on the complexity of the company’s operations, the competence and trust placed in its management and governance systems, and the competence and skills of the Board member. On a company of significant size, a director may have to spend 4-5 days per month to discharge their duties properly. On this basis, allowing for personal business, a person who serves only as a director could only serve on 3-4 Boards. Subsequent Events May 25, 2006 From Sunseri, Gina, and Rottman, Sylvie (May 25, 2006). “Enron Verdict: Ken Lay Guilty on All Counts, Skilling on 19 Counts.” ABC News, http://abcnews.go.com/Business/LegalCenter/story?id=2003728&page=1 : “Lay, 64, was convicted on all six counts against him, including conspiracy to commit securities and wire fraud. He faces a maximum of 45 years in prison. Lay also faces 120 years in prison in a separate case. “Lay posted a $5 million bond secured with family-owned properties at a hearing following the verdict. He was ordered to stay in the Southern District of Texas or Colorado.

P a g e | 98 "’I firmly believe I'm innocent of the charges against me," Lay said following the hearing. "We believe that God in fact is in control and indeed he does work all things for good for those who love the lord.’ “Skilling, 52, was convicted on 19 counts of conspiracy and fraud. Combined with his conviction on one count of insider trading, he faces a maximum of 185 years in prison. Skilling was acquitted of nine other charges relating to insider trading. "’Obviously, I'm disappointed," Skilling told reporters outside the courthouse. "But that's the way the system works.’ "’I think we fought a good fight — some things work, some things don't,’ he said… “In a separate, nonjury bank fraud trial related to Lay's personal banking, U.S. District Judge Sim Lake found the Enron founder guilty of bank fraud and making false statements to banks. Lake had withheld his verdict in the Lay bank fraud case until the Lay-Skilling jury announced its verdict. Lay faces up to 120 years in prison in that case.” Useful Articles, Links and Videos C-Span (October 25, 2010). “Q&A with Bethany Mclean, author of All the Devils are Here and Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron,” video, 56:54, http://www.c-spanvideo.org/program/296214-1 Gibney, Alex (2006) Film “Enron: The Smartest Guys in the Room” [film preview, video footage and Enron timeline], available at http://www.pbs.org/independentlens/enron/index.html# Rose, Charlie (January 21, 2002). “Enron Bankruptcy: A Conversation about Enron’s Declaration of Bankruptcy and the Implications for corporate America with Allan Sloan of Newsweek and Kurt Eichenwald of The New York Times,” video, https://charlierose.com/videos/9768 [The video includes a series of one-on-one discussions and panels with four journalists, the then-SEC chairman, political critics, and U.S. senators discussing the Enron scandal from its beginnings]. Time [Enron scandal webpage containing many links to stories] at http://www.time.com/time/2002/enron/ [Link not active in 2020.]

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2. Arthur Andersen’s Troubles (Chapter 2, pages 122-130) What this case has to offer Arthur Andersen (AA) will forever be a key part of the Enron-SOX chain that accelerated changes in the accountability and governance paradigm for corporations and the accounting profession. In fact, AA’s problems were systemic, as their root was in the firm’s flawed governance system where the desire for profit was allowed to outweigh the firm’s fiduciary interests to clients, shareholders, and the public interest. The case presents excellent opportunities to review conflict of interest issues, the need for inclusion of ethics in an organization’s strategy, operations and compliance processes, and for illustrating how the expectations of the public can dramatically affect an organization. AA’s disappearance dramatically illustrates how risk managers had been in the habit of placing too low a value on losing the ability to operate—known as “franchise risk.” Post-Enron and post-AA that value has moved upward considerably Teaching suggestions I use the PowerPoint (PPT) slides for the Enron case to tell the story of Arthur Andersen’s Troubles, specifically, PPTs 24 and 26 in Session 2 of my Ethics & Governance course. These PowerPoints are available through Cengage on the instructor companion website for the Text. The key issues are: •

What happened and who did it?

•

The 3% Special Purpose Entity (SPE) accounting rule and how it led to manipulation.

•

How following the 3% rule precisely, and ignoring the overall principle that there must be external validity (an independent outside buyer/seller) to allow the recording of profit, led to manipulation.

•

What the flaw was in AA’s governance system that permitted the Enron, WorldCom, Waste Management and Sunbeam fiascos.

•

Other matters raised in the questions below.

Discussion of ethical issues The following questions reveal the key points of the case: 1. What did Arthur Andersen contribute to the Enron disaster? AA failed to protect the interest of current and future shareholders, and stakeholders that relied upon the financial reports and integrity of the company. AA failed to form a reliable part of the Enron governance system, thereby leaving the directors and other stakeholders at risk. See the list of AA’s apparent mistakes in the case. 2. What Arthur Andersen decisions were faulty? See list of AA’s apparent mistakes in the Text, as well as in the section on AA’s internal Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 100 control flaw. 3. What was the prime motivation behind the decisions of Arthur Andersen’s audit partners on the Enron, WorldCom, Waste Management, and Sunbeam audits: the public interest or something else? Cite examples that reveal this motivation. It was revenue generation and retention. They served their self-interest rather than the public interest by not acting upon the memos from their quality control personnel, and not challenging the manipulative practices and structures at Enron. 4. Why should an auditor make decisions in the public interest rather than in the interest of management or current shareholders? An auditor is the agent of the shareholders, and is elected annually at the Annual general Meeting of Shareholders by the shareholders. As such, the auditor must make sure that audited annual financial statements comply with Generally Accepted Accounting Principles (GAAP), and GAAP are designed to produce statements that do not favor the interests of current shareholders or executives and mislead future shareholders and other stakeholders such as governments, taxing authorities and the like. GAAP is therefore designed to produce statements that are in the public interest, and the auditor is the agent who should ensure GAAP is properly applied. An auditor who does not protect the public interest can face reputational and legal consequences because the expectations of the public have not been met. 5. Why didn’t the Arthur Andersen partners responsible for quality control stop the flawed decisions of the audit partners? They tried via memos, but the firm’s governance structure had earlier determined that the audit partner in charge could override them. Clearly, AA’s governing body made the wrong decision. 6. Should all of Arthur Andersen have suffered for the actions or inactions of fewer than 100 people? Which of Arthur Andersen’s personnel should have been prosecuted? I don’t think so, because it seems unfair to the many innocent partners, staff and audit client stakeholders that lost value because of the resulting discontinuity. I further do not believe that society was well-served by the loss of one of the Big Five, thus concentrating the choices for independent audit work in the future. On the other hand, the disappearance of AA sent a significant signal to the rest of the audit world. I would have preferred larger fine and imprisonment for AA’s decision makers who determined and carried out the policy of audit partner primacy, plus a very large fine and sanctions (e.g., no new SEC clients for 3 months) for the continuing firm. I would also consider carefully whether non-partner audit personnel had a responsibility for whistleblowing, and I would signal how this should be done in the future. 7. Under what circumstances should audit firms shred or destroy audit working papers? Given the developments in the AA Case, audit working papers should not be destroyed before they could be of assistance and/or relevant in any legal, tax or other dispute. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 101 This means that the auditor should retain paper or digital versions for a very long time. In some jurisdictions, the statute of limitations might come into play at the end of seven or ten years, but may not where fraud is concerned. An audit firm may chose not to follow the statutory limits because they might wish to be able to respond to protect themselves for a longer period. Public expectations that affect reputations are not bound by legal limits. 8. Answer the “Lingering Questions” in the case (Text, page 129). See the answer to question 6 above. I do not think that the Big Four firms could be shrunk to the Big Three in the future because it would not be seen to be in the public interest. I think that other AA partners will be brought to trial, but not many. Perhaps only the head of the firm, the lawyer involved, and the partners in charge of the firm, region or function will be brought before the courts. Finally, I am sure that a similar tragedy will occur again—probably after the pain of ignoring the public interest abates again, as it has from earlier scandals in earlier decades. Our memory fades as generations retire, and unless the education system plays a stronger role with students in the future, ethics lessons will be forgotten again. Subsequent events July 15, 2003: From Feeley, Jef (July 15, 2003). “Andersen Worldwide settles Enron Suits.” Financial Post, FP9: “The network of foreign accounting firms once linked to Arthur Andersen LLP will pay US$40-million to resolves lawsuits stemming from Enron Corp.’s collapse… “Andersen Worldwide Société Cooperative is seeking to erase liability in suits filed by Enron investors and workers over the accounting firm’s role in helping Enron hide more than US$1-billion in losses… The accord doesn’t cover Arthur Andersen LLP, Enron’s auditor for more than a decade… Andersen Worldwide also agreed to pay US$20-million to Enron’s bankruptcy creditors. The settlement is a small fraction of the US$29-billion that shareholders and former workers say they lost in Enron’s meltdown.” May 31, 2005: In the case of Arthur Andersen, LLP v. United States (04-368), 544 U.S. 696 (2005) 374 F.3d 281. [May 31, 2005]. https://www.law.cornell.edu/supct/html/04-368.ZS.html The Supreme Court of the United States unanimously reversed AA’s conviction due to serious flaws in the jury instructions. As of 2008, there were over 100 civil lawsuits pending against AA. Useful Articles, Links and Videos C-Span and Washington Journal (January 21, 2002). “Arthur Andersen and Enron,” video, 59:46, http://www.c-spanvideo.org/program/168280-2 Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 102 “Participating by remote connection from Chicago, Mr. Greising discusses the Arthur Andersen accounting corporation and the Enron bankruptcy.” C-Span and Department of Justice Briefing Room (Mar. 14, 2002). “Arthur Andersen Indictments,” video, 17:19, http://www.c-spanvideo.org/program/169155-1 “The deputy attorney general announced that a federal grand jury has indicted the accounting firm Arthur Andersen with obstruction of justice.” C-Span and Washington Journal (Mar. 28, 2002). “Accounting Regulation,” video, 32:07, http://www.c-spanvideo.org/program/169358-5 “Mr. Castellano discussed proposals to regulate the accounting industry as a result of the Enron bankruptcy and the failures at Arthur Andersen…” Oppel, Richard and Eichenwald, Kurt (January 16, 2002). “Enron’s Collapse: The Overview; Arthur Andersen Fires an Executive for Enron Orders.” New York Times, https://www.nytimes.com/2002/01/16/business/enron-s-collapse-overview-arthurandersen-fires-executive-for-enron-orders.html . Ackman, Dan (January 18, 2002). “The Scapegoating of Arthur Andersen.” Forbes, http://www.forbes.com/2002/01/18/0118topnews.html Feeley, Jef (July 15, 2003). “Andersen Worldwide settles Enron Suits.” Financial Post, FP9 Arthur Andersen, LLP v. United States (04-368), 544 U.S. 696 (2005) 374 F.3d 281, reversed and remanded. [May 31, 2005]. https://www.law.cornell.edu/supct/html/04-368.ZS.html

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3. WorldCom: The Final Catalyst (Chapter 2, pages 130-136) What this case has to offer When WorldCom announced massive overstatements of profit in June 2002, it completely shattered the trust in corporate accountability and governance that President Bush and others had been trying to rebuild. Sarbanes and Oxley combined their separate efforts in the U.S. Congress and Senate, and the Sarbanes-Oxley Act emerged in late July 2002, thus triggering a change in corporate accountability and governance, and well as the accounting profession. The WorldCom case involves simple manipulations, but once again offers lessons about the need for an ethical corporate culture, whistleblower protection, avoiding an overdominant CEO, no independent chair of the board, and incompetence of directors. The prosecution and dissolution of AA was so far along by June/July 2002, that their role in not finding the problems earlier was overshadowed by the emergence of SOX. Teaching suggestions I review the events after Enron and up to SOX, and I indicate how it galvanized the development of SOX. I then deal with the questions listed below. Discussion of ethical issues The following questions were presented for discussion of the significant issues raised in the case: 1. Describe the mechanisms that WorldCom’s management used to transfer profit from other time periods to inflate the current period. Details are in the case, but the major mechanisms used included: •

Capitalization of current costs to move them to future periods, and

•

Reduction of current costs by drawing down reserves

2. Why did Arthur Andersen go along with each of these mechanisms? AA may not have known about the manipulations, or at least some of them. Cynthia Cooper, vice-president for Internal Audit was apparently the first to identify the irregularities. According to the SEC quotations in the case, WorldCom went to some lengths to conceal the manipulations from AA. However, this raises the question of how effective AA’s audit work was, because the manipulations were significant. Moreover, if AA knew of some of the manipulations, then is it another case of AA wishing not to confront management and preferring to protect future fee revenue.

P a g e | 104 3. How should WorldCom’s board of directors have prevented the manipulations that management used? An ethical corporate culture should have been developed that would have encouraged the personnel who were ordered to manipulate to whistle blow. If scrutiny and analysis by internal and external auditors were known to have been tighter, then perhaps the manipulation attempts would not have been attempted. Moreover, if WorldCom had not been so dominated by Bernard Ebbers (i.e., if an independent chair of the board and appropriate whistleblowing mechanisms had been in place), then he might not have tried to manipulate, and/or others might have reported the attempt. Ebbers might not have attempted the manipulation if the Board had not allowed him to borrow $408 million and spend it in ways that required rising WorldCom stock prices and/or cash. 4. Bernie Ebbers was not an accountant, so he needed the cooperation of accountants to make his manipulations work. Why did WorldCom’s accountants go along? Because they thought they could get away with it for a while and that when profits returned that “adjustments” would be restored. They might have thought that everyone was manipulating and that smoothed earnings were “good.” They did not see their duty as protecting the shareholders’ interests or the public interest. 5. Why would a board of directors approve giving its Chair and CEO loans of over $408 million? The Board did not recognize the risk that Ebbers would misuse the funds borrowed. To some extent the Board was at fault for allowing a loan arrangement for Ebbers where he could draw down amounts on his own without a reporting mechanism to the Board and for subsequent approvals as amounts rose beyond reasonable levels. In addition, they did not check on the specific use of the money and the value of that usage as collateral. They trusted Ebbers who had built the company up from its early roots. They did allow him to borrow money for the purpose of buying the largest ranch in Canada, which was also unusual. 6. How can a Board ensure that whistleblowers will come forward to tell them about questionable activities? A protected whistleblower mechanism is vital, and its use must be encouraged by top management. Even then, there is no guarantee. In the end, an ethical corporate culture is essential to the promotion of whistleblowing and ethical behavior in general. This topic is discussed further in the Text, in Chapters 3 and 7. Useful Articles, Links and Videos WorldCom Fraud Info Center [Website no longer active in 2017.] http://www.worldcomfraudinfocenter.com/information.php Faber, David (September 9, 2003). “The Rise and Fraud of WorldCom: Former CEO Ebbers talks in CNBC’s ‘The Big Lie [article].’” CNBC TV, http://www.nbcnews.com/id/3072795/ns/business-cnbc_tv/t/rise-fraud-worldcom/

P a g e | 105 The CNBC news show, "The Big Lie: Inside the Rise and Fraud of WorldCom," January 2005 http://video.google.com/videoplay?docid=6560803301631269691# [Link not active in 2020.] This 55 minute CNBC news documentary exposes the extent of the WorldCom fraud. Viewers will gain insight into the actions, decisions, and deception of several key participants, including the then-chairmen of AT&T and Sprint as well as the WorldCom capacity planner who constructed the growth model. “WorldCom Chief Guilty [video]” (March 16, 2005). CBS News, http://www.cbsnews.com/video/watch/?id=680422n [Link not active in 2020.] Bayot, Jennifer and Farzad, Roben (August 12, 2005). “Ex-World Com Officer Sentenced to 5 Years in Accounting Fraud.” New York Times, http://www.nytimes.com/2005/08/12/business/12worldcom.html

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4. Bernie Madoff Scandal—The King of the Ponzi Schemes (Chapter 2, pages 136-146) What this case has to offer Bernie Madoff’s investment scandal is the most recent high-profile corporate fraud in the U.S. As stated in the case, the story of how Mr. Madoff began his scheme, what he actually did, who suspected he was a fraudster and warned the SEC, why the SEC failed to find wrongdoing, who knew, and who did nothing, is a fascinating story of ethical misbehavior, greed, innocence, incompetence, and misunderstanding of duty. As in previous scandals (Enron, WorldCom, etc.), managers, auditors, regulators, and other stakeholders failed to stop the fraud that went on for a long time. This case raises questions about the role of the SEC in regulating and overseeing hedge funds, as well as the effectiveness of currently existing legislation in protecting investors of hedge funds. Teaching suggestions I start this case by asking students what a Ponzi scheme is. According to the SEC: “A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.” (U.S. Securities and Exchange Commission (SEC). 2011) I continue explaining to students that this is one of the oldest known forms of securities fraud. Following that, I ask students to identify the potential red flags of a Ponzi scheme and whether or not these flags where evident in Madoff’s operation, for example: •

High investment returns with little or no risk (i.e., “guaranteed” returns).

•

Overly consistent returns regardless of overall market conditions.

•

Unregistered investments.

•

Unlicensed sellers or a network of investment companies.

•

Secretive and/or complex strategies.

•

Poor disclosure or obscure account statements.

•

Difficulty receiving payments.

Finally, I close the case highlighting that, as it was the case with other corporate scandals, several parties failed to detect and act on the potential signs of fraud. Discussion of ethical issues

P a g e | 107 1. Was Madoff’s sentence too long? The 150-year sentence was the maximum possible penalty for Bernie Madoff’s crimes. A week before the sentencing took place, Judge Denny Chin received a letter from Mr. Madoff’s lawyer, Ira Lee Sorkin (Weiser 2011), asking for a prison term substantially below the 150-year maximum. The lawyer listed several reasons, including Mr. Madoff’s confessing to his sons, knowing he would be turned in, his “full acceptance” of responsibility for his crimes, and his efforts to assist in the recovery of lost assets. Furthermore, the lawyer asked for the chance for Mr. Madoff to be free before his death. In response, Judge Chin stated that he understood Mr. Sorkin’s plea. “It’s a fair argument that you want to give someone some possibility of seeing the light of day,” the judge said in an interview, “so that they have some hope, and something to live for.” Nevertheless, Judge Chin reasoned that “In the end, I just thought he didn’t deserve it…The benefits of giving him hope were far outweighed by all of the other considerations.” Judge Chin explained in a series of interviews that 20 or 25 years would have effectively been a life sentence, and that any additional years would have been purely symbolic. Yet symbolism was important, given the enormity of Mr. Madoff’s crimes. The judge weighed the fraud’s unprecedented scale, its duration over two decades and its thousands of victims. At that point, the judge said, symbolism “carried more weight.” The Judge decided that 150 years would send a loud, decisive message. He felt that Mr. Madoff’s “conduct was so egregious…I should do everything I possibly could to punish him.” Moreover, any sentence of less than 150 years could be seen as showing him mercy. “Frankly, that was not the message I wanted to be sent,” the judge said. Following the Judge’s criteria, the sentence was not too long but just tough, in accordance to the U.S. laws. 2. Some SEC personnel were derelict in their duty. What should happen to them? Arguably, the SEC personnel that failed in their duties should be punished; however, it is difficult to determine the extent of the SEC’s negligence in investigating this fraud. SEC Chairman Christopher Cox stated that the agency would follow-up on its own failure to investigate this case. The SEC had been tipped as early as 1999 that Madoff was running a Ponzi scheme. The SEC sent examiners to the firm twice, including an enforcement team, but came up with nothing. Moreover, since no subpoena power was requested, the SEC conducted its investigations with documents provided by Madoff, and he kept providing false records. After an extensive investigation, the Office of Investigation (OIG) of the SEC concluded: “The OIG did not find that the failure of the SEC to uncover Madoff’s Ponzi scheme was related to the misconduct of a particular individual or individuals, and found no inappropriate influence from senior-level officials. We also did not find that any Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 108 improper professional, social or financial relationship on the part of any former or current SEC employee impacted the examinations or investigations.” (U.S. Securities and Exchange Commission (SEC). 2009) Overall, the investigation uncovered that this case was a failure of the SEC’s policies, procedures and internal controls but, according to the OIG, it appears not to be the direct result of professional negligence of the investigators. The fact that most investigators were lawyers, fresh out of law school without a sufficient understanding of the capital markets seems to bear this assessment out. As well, the failure to have a central registry/oversight of complaints by a senior, fully-knowledgeable person points to a systemic failure. Moreover, the failure to check on Madoff’s answers to interview questions demonstrates a ridiculous lack of appreciation for sound evidence-gathering and verification. On the other hand, Markopolos’ testimony before members of the U.S. Congress seems to indicate that some individuals within the agency chose not to investigate the fraud in depth. 3. Are the reforms undertaken by the SEC (“The Securities and Exchange Commission PostMadoff Reforms” (last update October 16, 2014),http://www.sec.gov/spotlight/secpostmadoffreforms.htm) tough enough, and sufficiently encompassing? The reforms undertaken by the SEC include: •

Revitalizing the Enforcement Division

•

Revamping the handling of complaints and tips

•

Encouraging greater cooperation by “insiders”

•

Enhancing safeguards for investors' assets

•

Improving risk assessment capabilities

•

Conducting risk-based examinations of financial firms

•

Improving fraud detection procedures for examiners

•

Recruiting staff with specialized experience

•

Expanding and targeting training

•

Improving internal controls

•

Advocating for a whistleblower program

•

Seeking more resources

•

Integrating broker-dealer and investment adviser examinations

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Enhancing the licensing, education and oversight regime for 'back-office" personnel

These reforms seem to address some of the biggest problems uncovered after Madoff’s scandal; nevertheless, only time will tell if these measures are effective in preventing similar frauds. 4. Does it matter that Madoff’s auditor, Friehling, was his brother-in-law? It matters, because it is a clear conflict of interest. Auditing standards and professional accountants’ codes of ethics require auditors to be free of conflicts of interests in order to be objective. In the case of an audit engagement, it is in the public interest that the auditor be independent of the entity subject to the audit. The auditor’s independence from the entity safeguards the auditor’s ability to form an audit opinion without being affected by influences that might compromise that opinion. Independence enhances the auditor’s ability to act with integrity, to be objective, and to maintain an attitude of professional skepticism. Independence issues were central to prior corporate scandals and were addressed in the independence rules included in the Sarbanes Oxley Act of 2002; however, these rules would not necessarily apply to the audit of Madoff’s funds as these companies were not a public company. Investors should be mindful of the potential problems of a lack of proper audit by a qualified auditor, and they should always make sure their interests are properly protected. In this case, investors failed to inquire. 5. Does it matter that Friehling did no audit work? Not conducting any audit work was in clear violation of the auditing standards that require that the auditor exercise professional judgment and maintain professional skepticism throughout the planning and performance of the audit. Moreover, it is the auditor’s responsibility to: •

Identify and assess risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control;

•

Obtain sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate responses to the assessed risks; and,

•

Form an opinion on the financial statements based on conclusions drawn from the audit evidence obtained.

As a result of the fraud, the Public Company Accounting Oversight Board (PCAOB) has been given the additional responsibility to supervise the audits of registered securities dealers in the United States.

P a g e | 110 6. Comment on the efficacy of self-regulation in the form of Federal Industry Regulatory Authority (FINRA), and in respect of the audit profession. What are the possible solutions to this? Professional self‐regulation is the regulation of a profession by its members. A central purpose of professional self-regulation is protection of the public from harm. Professional self‐regulation should encourage professional conduct and competence, fairness, transparency, accountability, and public participation. Individual members are personally accountable for their practice through adherence to codes and standards. A fundamental problem with self-regulation is maintaining independence from the interest of individuals or firms influencing the decisions of professional standard setters and enforcers. FINRA was not strong enough or sufficiently independent from Bernie Madoff to investigate the fraud. The self-regulation of the accounting profession, particularly in regard to audit standards, was put to test after the scandals that led to the passage of the Sarbanes Oxley Act of 2002. In essence, the U.S. government decided that self-regulation was not enough to protect the public interest and created the Public Company Accounting Oversight Board (PCAOB). This organization is: “…a nonprofit corporation established by Congress to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports. The PCAOB also oversees the audits of broker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.” (PCAOB 2013-2017) 7. Answer Markopolos’ questions: “How can we go forward without assurance that others will not shirk their civic duty? We can ask ourselves would the result have been different if those others had raised their voices and what does that say about self-regulated markets?” There is no straightforward answer to these questions. In principle, it is an individual decision to act in accordance to ethical principles. In this case, it seems that there were many people who could have raised the flag about the fraud; for example, Madoff’s employees and auditors, the SEC investigators, and a number of investment professionals that did not believe in Madoff’s investment strategy. If these individuals had raised their voices earlier, the fraud could have been uncovered sooner. Of course, the regulator (the SEC) would have to be ready and able to investigate thoroughly, diligently and with proper professional scepticism.

P a g e | 111 8. How could Markopolos and the other whistleblowers have gotten action on their concerns earlier than they did? Being a whistleblower is not an easy task. In this case, Markopolos contacted the SEC, which is the top authority in charge of investor protection in the Unites States. Moreover, Markopolos had strong suggestive evidence to back up his claims. Beyond going to the SEC, he and other whistleblowers could have “gone public” by talking to the media about these issues. Media attention can help to direct the public’s attention toward fraud cases; however, it can encounter fierce criticisms: for example, Bethany McLean, a 31-year-old Fortune magazine reporter challenged Enron’s accounting practices, asking how the company made its money. Enron’s CEO, Jeffrey Skilling, called McLean unethical and hung up on her. The chairman, Kenneth Lay, called Fortune's managing editor to complain. The CFO, Andrew Fastow, flew to New York to tell McLean and her editors that Enron was in great shape. 9. Did Markopolos act ethically at all times? Arguably, Markopolos was driven not only by the public interest, but also by his personal interest as Madoff’s competitor. Markopolos was a former chief investment officer at Rampart Investment Management in Boston. His investigation began in 1999, when a colleague learned of Madoff’s investment returns and urged Markopolos to replicate his strategy. Markopolos soon concluded that the numbers did not add up. Markopolos confronted bosses who urged him to match Madoff’s results, investors who did not want to hear the truth, and SEC’s officials who either did not listen or could not understand his arguments. Moreover, Markopolos initially thought he might be eligible for a sizable reward if the fraud involved insider trading, but that turned out not to be the case. Nevertheless, it seems as though Markopolos acted ethically in blowing the whistle about the fraud. 9. What were the most surprising aspects of Markopolos’ verbal testimony on YouTube at https://www.youtube.com/watch?v=uw_Tgu0txS0 ? “Madoff Fraud Allegations & Financial Markets Regulation: Harry Markopolos [testimony],” video, 12:25, [uploaded] February 4, 2009, http://www.youtube.com/watch?v=uw_Tgu0txS0 and https://www.youtube.com/watch?v=uw_Tgu0txS0 Markopolos’ statement highlights that: •

The SEC repeatedly ignored Markopolos’ detailed warnings.

•

The SEC’s personnel appear to be incapable of understanding the financial transactions involved.

•

The SEC is staffed by people without professional investigative or audit experience. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 112 •

The fraud could have been stopped earlier when Madoff’s investments reached $7 billion.

•

SEC officials at the Boston office were ignored by their superiors and their colleagues at the New York office.

•

The SEC appears to be afraid of investigating high-level cases.

11. Did those who invested with Madoff have a responsibility to ensure that he was a legitimate and registered investment advisor? If not, what did they base their investment decision on? It seems like the decision to invest in Madoff’s fund was a result of affinity, greed, and trust in other investment advisors recommending Madoff’s fund. Individuals should do some research before investing in public or private firms. Furthermore, if an individual relies on an investment advisor, the advisor should perform a thorough examination before issuing a recommendation involving, for example, analysis of portfolio composition, portfolio stress testing, risk management, and asset verification. An article by CBS News on the Madoff scandal, also featured in the TV show 60 Minutes (see “The Man Who Figured Out Madoff's Scheme,” 2009, below), cites Markopolos explaining an affinity scheme, saying that "Bernie was Jewish, so he ran it on the Jewish community in the United States. But that wouldn't get him enough customers, 'cause he always needed new money to keep the scheme going." The article continues: “Madoff extended his reach from New York to Palm Beach, Florida, where he enlisted hundreds of wealthy clients, many of them recruited from his own country clubs. And he also made connections that gave him entree to Europe, and the hedge funds capital of America, Greenwich, Conn.” “It was in Greenwich that Bernie Madoff made some of his biggest deals with large investment firms that were willing to feed him billions of dollars of their clients' money to manage. And in return, Bernie Madoff agreed to pay the so-called feeder funds a fortune in annual fees. The largest of the feeder funds was the Fairfield Greenwich Group… “Boies, Schiller & Flexner LLP, “…one of the most prominent law firms in the US, is representing Fairfield Greenwich investors, who lost nearly $7 billion when Madoff went under. They are suing the firm for gross negligence, claiming it failed to investigate Madoff thoroughly or monitor his activities as it promised to do in its marketing materials.” 12. Should investors who make a lot of money (1% per month while markets are falling) say “Thank you very much”, or should they query the unusually large rate of return they are receiving? The SEC guidance recommends that when individuals consider their next investment opportunity, they should start with these five questions:

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Is the seller licensed?

•

Is the investment registered?

•

How do the risks compare with the potential rewards?

•

Do I understand the investment?

•

Where can I turn for help?

Also, the SEC explains in its guidance (see U.S. Securities and Exchange Commission (SEC) 2011) to be aware of red flags such as: “High investment returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any ‘guaranteed’ investment opportunity. “Overly consistent returns. Investments tend to go up and down over time, especially those seeking high returns. Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions.” 13. Should investors who made money from “investing” with Madoff be forced to give up their gains to compensate those who lost monies? U.S. bankruptcy laws authorize a trustee to recover money that was distributed as part of a fraud and share it among the victims. The purpose of these provisions is to balance the losses among the various investors, but how that balance is supposed to be struck is not clear. Under New York State law, which can be invoked for Madoff recoveries, a trustee can seek redemptions going back six years. In practice, it will be very difficult to force investors to return any money made from their investments with Madoff. Investors may wind up suing each other, as well as the hedge funds and banks that brought them into Mr. Madoff’s funds and the auditors who worked for those hedge funds. 14. Is this simply a case of “buyer beware”? This is a case involving a massive fraud and negligence of various government agencies in charge of investor protection. It is not just a case of “buyer beware,” and it should be a clear call for reforms targeted to avoid similar cases. Several people lost their life savings and some even lost their lives in connection with this fraud. A man that invested his savings with Madoff, mentioned by Judge Denny Chin, died of a heart attack two weeks after the fraud was uncovered. Thierry de la Villehuchet, CEO of Access International Advisors, a money-management operation who placed investors' funds in Madoff’s investments, stabbed himself to death with a box cutter after taking sleeping pills after losing $1.4 billion in the scheme. Mark Madoff, Bernie Madoff's eldest son and defendant in a number of lawsuits launched by the trustees of his father’s investors, hanged himself two years after the fraud by a dog leash on a metal ceiling beam in his Manhattan loft apartment.

P a g e | 114 Useful Articles, Links and Videos Berenson, Alex (December 19, 2008). “Even Winners May Lose With Madoff.” The New York Times http://www.nytimes.com/2008/12/19/business/19ponzi.html “The Man Who Figured Out Madoff's Scheme: Tells 60 Minutes Many Suspected Madoff Fraud; Says SEC Is Incapable of Finding Fraud.” (March 1, 2009). Wired New York, http://www.wirednewyork.com/forum/showthread.php?t=19951&page=4 Kolker, Carlyn, Kary, Carlyn and Kishan, Saijel. (December 23, 2008). “Madoff Victims May Have to Return Profits, Principal.” Bloomberg News, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=awmAWSxKpXRM&refer =home [Link not active in 2020.] Moyer, Liz (December 17, 2008). “[The Madoff Ponzi.] Why the SEC Missed Madoff.” Forbes Magazine, http://www.forbes.com/2008/12/17/madoff-sec-cox-business-wallstcx_em_bw_1217ponzi.html Public Company Accounting Oversight Board (PCAOB) (2003-2017). “About the PCAOB.” https://pcaobus.org/About/Pages/default.aspx U.S. Securities and Exchange Commission (SEC). 2011. Ponzi Schemes – Frequently Asked Questions. http://www.sec.gov/answers/ponzi.htm U.S. Securities and Exchange Commission. Office of Investigations. 2009. “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme.” http://www.sec.gov/news/studies/2009/oig-509.pdf U.S. Securities and Exchange Commission (last update October 16, 2014). “The Securities and Exchange Commission Post-Madoff Reforms.” http://www.sec.gov/spotlight/secpostmadoffreforms.htm Weiser, Benjamin (June 28, 2011). “Judge Explains 150-Year Sentence for Madoff,” The New York Times, http://www.nytimes.com/2011/06/29/nyregion/judge-denny-chin-recounts-histhoughts-in-bernard-madoff-sentencing.html?pagewanted=2&_r=1&ref=nyregion

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5. Wal-Mart Bribery in Mexico (Chapter 2, pages 146-148) What this case has to offer This case shows how executives can thwart the strategic objectives of a company’s owners for their own enrichment, or for corporate goals that seem to make sense in the short term, but not in the longer term. Wal-Mart has been under pressure for unfair business practices, unfair treatment of labor, and the destruction of small competition and local economies. As a result, its new retail developments have often been opposed, which results in delays or extra, unnecessary costs. At the same time, leaders of the owning family, the Walton’s, have been lauded for their contributions to sustainability and other causes. Wal-Mart had developed anti-bribery codes and training programs in line with corporate social responsibility (CSR) objectives, but this case shows how the lofty intent was actively ignored by senior executives at head office and in Mexico who used bribes and protected bribe payers, subverted investigations, and kept the Board of Directors in the dark. Ultimately a New York Times article (see the Text) revealed the problem, and triggered Wal-Mart’s reputational repairs, as well as preparations for defense against charges under the U.S. Foreign Corrupt Practices Act (FCPA). The Waltons’ and Wal-Mart’s credibility suffered significant damage, and allegations of unfair practices, treatment, etc., that the company strove to avoid, were confirmed. It is an excellent case that illustrates: •

The impact of bribery/unethical acts on a company and its owners, including the actions of highly sensitive stakeholders such as the news media, investors, and government agencies.

•

How bribes are used and how agents (“gestores”) are used to make them.

•

How executives can circumvent company policy.

•

How whistleblowers can be vilified.

•

How excellent senior offices who oppose can decide to leave the company out of frustration and apparently do so without letting the Board of Directors know what is happening.

•

How a risk management program can be subverted if directors are too trusting and whistleblowers are not encouraged.

•

The role of an ethical corporate culture in strengthening corporate policies and in encouraging whistleblowers to come forward so that the Board can hear about ethics risks. Teaching suggestions

I would suggest introducing the Wal-Mart Bribery Case by providing a brief overview about the company, its owners, size, challenges, criticisms, and interested stakeholders. That will provide a background to set up and understand the learning experiences mentioned in the

P a g e | 116 list above. Alternatively, students can be asked questions on each of these issues to provide the background. After the background is established, the class can be asked to provide the relevant details of the case, and ultimately the answers to the questions posed at the end of the case. Discussion of ethical issues 1. Where were Wal-Mart’s questionable payments made, and where did this result in serious damage to the company and its executives? Why? Wal-Mart’s questionable payments were made in Mexico, but the reputational fallout, prosecution under the FCPA, and damage to profit occurred in the United States. The negative reactions and consequences were caused by the awareness and interest of stakeholders in the United States and around the world, including the press and media, investors, and other stakeholders, even though those in Mexico were not apparently concerned. 2. The gestores payments were made to third parties, who then bribed local officials. How would a company ensure that its third-party vendors are operating within the law? A company should include its agents (the gestores) in its policies, protocols, training and annual sign-offs, because their actions ultimately impact the company. As well, the company’s internal audit/risk management examinations should cover thirdparty actions, and the reports should be made available to the audit committee and/or risk management committee of the Board of Directors. A company cannot sit back and expect all of its agents to do the right thing. 3. Some of Wal-Mart’s senior executives knew about the bribes, but did not take any effective

actions to curtail this activity. What steps should the board of directors take to ensure that systems and internal controls are in place so that they are informed about questionable managerial activities and actions? The Board should ensure that company policies and systems are robust and comprehensive, and that the internal controls, that ensure compliance, are operating properly. This usually involves periodic examination by internal auditors and or risk management investigators, with reports to the senior executive responsible for the activity and to the relevant board committee. Whistleblowers are a necessary aspect of the control mechanism, so they must be encouraged, supported, and their reports reported to the relevant board committee. The Board must take active responsibility for the oversight of these functions: they cannot rely entirely on senior management to do their job in these areas. The relevant board committee should hear quarterly from the senior executive overseeing these areas and should review a summary quarterly report with access to the specific reports when called for. Reports to the board as a whole should be made by specific committees on a quarterly basis to raise the profile, awareness and importance of these functions. 4. Wal-Mart Mexico seemed to have a culture of the goal justifying the means. How can the board of directors ensure that the operational activities of the company do not subvert proper governance objectives?

P a g e | 117 The Board should be concerned about how the company makes it profits, not just how much. This means that the Board should consider whether senior executives have the right perspective on ethical and responsible action both before they are hired and on a continuing basis thereafter. This is known as ensuring the “right tone at the top.” The roles of reference checks and investigations before hiring are critical. In addition, ongoing examinations of actions by internal auditors and risk management teams, as well as continuous reviews of whistleblower complaints and resolutions, and of web-postings are necessary. All concerns must be followed up, and prompt significant disciplinary action must be evident. Useful Articles, Links and Videos Wal-Mart Hit by Mexican Bribery Claims [video] – Bloomberg Television [April 23, 2012], accessed at http://www.bloomberg.com/video/91194862-wal-mart-hit-by-mexicanbribery-claims.html on September 22, 2016. [Link not active in 2020.] In this report introduced by Erik Schatzker on Bloomberg Television's "InsideTrack", Sara Eisen reports that Wal-Mart is investigating allegations of bribery of Mexican officials by its Mexican subsidiary to speed the opening of stores in that country. In damage-control mode, Wal-Mart is dealing with more allegations that senior executives may have tried to cover up the bribes by shutting down the company’s own investigation. “Not just Wal-Mart: Dozens of U.S. companies face bribery suspicions,” Stephen Gandel, Fortune, April 26, 2012, accessed at http://fortune.com/2012/04/26/not-just-wal-martdozens-of-u-s-companies-face-bribery-suspicions/ on September 23, 2016. The author writes that “at least 81 public companies [are] under investigation by the Securities and Exchange Commission or the Department of Justice for running afoul of the Foreign Corrupt Practices Act, which makes bribery in foreign countries punishable in the U.S. In addition, a growing number of companies have started placing disclosures in their financial documents that say their employees may at times violate the U.S.’s overseas bribery law, despite the company’s best efforts to prevent it.”

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6. LIBOR Manipulations Cause Widespread Impacts (Chapter 2, pages 148-150) What this case has to offer The LIBOR Manipulations Case, which describes an important scandal in easily understood terms, exposes the problem of banks that rely upon public goodwill and trust to operate successfully, abusing that trust to enhance the financial position or profits of the banks and/or their employees at the expense of the public. In fact, the manipulated rates caused harm to bank customers, and others who borrowed (i.e., house mortgages, etc.) or lent funds to the banks all around the world because many contracts are based on these. It is not surprising that banks are often mistrusted by the public. In addition, it is surprising to see how long the manipulation went unchecked, and it is easy to speculate that the top bankers and regulators knew of the practices and let them continue. Although some executives lost their jobs and their bonuses when their banks were charged, some did not. The size of the fines levied is staggering. Going forward, gentle treatment is very unlikely, so top executives and boards of directors need to be more vigilant with regard to such practices. The emails quoted show the cultural acceptance of manipulation within the banks, and the fact that prowess at such falsification was a source of personal pride. The same thing was evident among the risk assessors at the rating agencies during/prior to the financial scandal of 2008. They knew they we acting unethically and/or illegally, but were doing so cheerfully, and without concern. Teaching suggestions I would suggest beginning the case discussion by asking a class member to provide an overview of the case facts. Then I would ask the class how important they thought reputation and trust were to banks. This should trigger a discussion to the effect that they were very important because banks don’t sell durable goods like autos; they sell trust. Then I would ask the class: •

If they were on the board of directors, how they would ensure that the bank’s reputation and public trust would be protected?

•

Why had the boards of directors of the banks not done so?

•

How could the traders come to consider their cheating with obvious pride? Finally, I would deal with the questions at the end of the case. Discussion of ethical issues

1. Which groups were most at fault for the LIBOR manipulations: brokers, traders, bank executives, bank boards of directors, or regulators? Why? I would argue that the boards and the regulators were most at fault because theirs is the residual responsibility for corporate performance. They owe a responsibility Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 119 to society at large, and to investors and other stakeholders for bad actions. It may have been that they were not aware enough of the potential problems, or that their policies were not effective, or that they were not well enforced. Those policies should have informed and kept everyone else from engaging in unethical or illegal acts. 2. What should the regulatory bodies do with the fines paid by these banks? Reduce tax rates for the general public? Use the funds to reeducate investment bankers? Arguably both should be done: practicality is important, and further practical uses could emerge as well. 3. Robert Diamond continues to receive his £2 million pension annually. Should he suffer financially by having to forfeit this pension because the LIBOR scandal occurred while he was CEO of Barclays? It is possible to argue this question either way. If, for example, he did not know of the scandal, then loss of his job could be penalty enough. If he did know, and took no action, then further personal loss could be argued. Other issues to consider would include: Did he benefit directly? By how much? Useful Articles, Links and Videos What's Behind the Libor Scandal? – Bloomberg Television [July 3, 2012], accessed at http://www.bloomberg.com/video/what-s-behind-the-libor-scandalHOu3xR9sStGNPparj5DT4w.html on September 23, 2014. [Link not active in 2020.] Sara Eisen on Bloomberg Television's explains the "London Interbank Offered Rate," or LIBOR. Topic: New developments: LIBOR scandal “Lloyds not off hook yet after $370 million Libor fines,” Matt Scuffham and Huw Jones, Reuters, July 28, 2014, accessed at http://www.reuters.com/article/2014/07/28/us-lloyds-liboridUSKBN0FX13H20140728 on July 31, 2014. Lloyd’s was not yet fined and so does not appear in the text’s list of players fined over the LIBOR scandal (see Chapter 2, page 86). The article says that Lloyds’ penalty is the seventh penalty “but … the first penalty for attempting to fix so-called "repo" rates to reduce fees for a taxpayer-backed scheme set up by the Bank of England to support British banks during the 2008 financial crisis.” They report that Bank of England Governor Mark Carney wrote that “the attempted manipulation could lead to criminal action against those involved.” “This New Libor 'Scandal' Will Cause a Terrifying Financial Crisis,” Jesse Colombo, Forbes, March 6, 2014, accessed at http://www.forbes.com/sites/jessecolombo/2014/06/03/this-new-libor-scandal-willcause-a-terrifying-financial-crisis/ on July 31, 2014. Five-year-long low LIBOR rates, the author asserts, has helped to “fuel a massive economic bubble around the entire world that will end in a devastating financial crisis that will be even worse than the Global Financial Crisis” and cause trillions of dollars of losses—a thousand times worse than losses associated with the LIBOR-fixing scandal. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 120 “First day of business for new LIBOR administrator: ICE Benchmark Administration Ltd take responsibility for administrating LIBOR,” Her Majesty’s Treasury and The Rt Hon Sajid Javid MP [Financial Secretary to the Treasurer], February 3, 2014, accessed at https://www.gov.uk/government/news/first-day-of-business-for-new-libor-administrator on July 31, 2014. As part of the LIBOR reform, this government announcement outlines the transfer of the administration of the LIBOR to the NYSE Euronext Rate Administration Limited, the acquisition of the latter by the Intercontinental Exchange (ICE) Group, and the renaming of the organization to the ICE Benchmark Administration Limited.

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7. General Motors Ignores Obvious Ignition Faults (Chapter 2, pages 150-152) What this case has to offer The case explores how GM made millions of cars with faulty ignition switches that malfunctioned, killing some people and injuring others, even though the fault was known before production began. Was the fault really with the ignition switch or with a corporate culture focused on cost, not safety, and where committees were “responsible,” but no individuals were accountable? Teaching suggestions Most students do not understand what happens to power steering and power braking when a car’s motor stops working, so I begin by clarifying what the faulty switch causes. This approach grabs student attention very powerfully, and paves the way for an animated discussion of how cheap the fix would have been, and how unethical the impact of the focus on cost control was compared to a focus on safety. This exposes the flaws on GM’s corporate culture, and paves the way for a discussion of the questions posed. This case provides the opportunity to discuss: the technical failures (the ignition switch, the loss of braking, power steering, etc.); individual culpability (who knew of the problem and did nothing to stop production); the problems in a corporation so large that no individuals were accountable, where failings ranged from a lack of a safety culture and reporting mechanisms to problems with engineering processes, policies and training, compliance, auditing, and oversight, and recordkeeping. Discussion of ethical issues 1. Why didn’t GM act effectively on suspicions that their ignition switches were faulty? GM personnel, who identified the problem, either did not understand the significance of it, or were not instructed to bring safety problems to their superiors for assessment and disposition. It appears that one engineer (DeGiorgio) had too much responsibility in the sign-off on the faulty ignition switch, and/or GM procedures/policies were inadequate, too loosely adhered to or too loosely enforced. Because DeGiorgio did not speak up, it appears that no one else was aware of the problem or the deviation from policy when DeGiorgio later altered the part but did not change the part number. Later on, DeGiorgio commented that the emphasis at GM was on cost. By contrast, in the Cadillac division, the fault was discovered before any faulty switches were deployed, and a corrected part was created. 2. Who was at fault for the deaths and injuries involved, and why? Fault cascades with this case, because it comes at many levels: •

DeGiorgio, for failing to bring attention to the faulty switch, and for redesigning the switch (2006) but failing to change the part number (against policy).

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Personnel aware of the problem for failing to act and take responsibility, particularly those aware of the switch failing to meet specifications, but still allowing it to go into production.

•

Lack of individual and committee accountability. The Valukas report (Valukas 68) says that “…interviews [for the report] showed a troubling disavowal of responsibility made possible by a proliferation of committees.” The report continues, “… [B]ecause a committee was “responsible,” no single person bore responsibility or was individually accountable.” (Valukas 68-69).

While people make mistakes, employees might argue that the corporation was also at fault for failing to have a robust system of quality control and for failing to have a corporate culture that identifies, learns from, and corrects problems. The Valukas Report’s headings in its recommendations section include the following (Valukas, 2014, p. viii): organizational structure; cultural emphasis on safety; individual accountability; communication between and within groups; communication with NHSTA; role of lawyers; interactions with suppliers; data storage, retrieval and analysis; engineering processes and databases; product investigation process; policies and training; compliance, auditing, and oversight; recordkeeping. 3. Should a company be able to escape liability for harming individuals by declaring bankruptcy? No. After bailouts of 2008-2009, public outcry was loud against GM’s attempt to close the books on its liabilities. If we consider the 5-question approach or examine hypernorm values to assess whether escaping liability is ethical, we can stop at the issue of fairness. It is not fair that the company gets a fresh start when victims’ lives will never be the same again. 4. Should any GM personnel go to jail over the ignition switch failures? If so, who? Yes (see question 2): those responsible, despite the fact that they were not accountable. Engineers are given a great deal of responsibility that must be taken seriously. In the United States and Canada, professional engineers, through legislation, are governed by state and provincial regulatory societies that license, certify, and regulate engineers in order to protect the public. They are subject to professional code requirements to protect the public that may have been violated at GM. However, unlicensed engineers who are not subject to professional codes or regulatory authorities can work as employees for companies. 5. Would you trust GM enough to buy one of their cars in the future? No. Given the problems exposed by the Valukas Report, the company would need to prove that it has a different and better safety-oriented corporate culture. Because the company is so large and the majority of personnel are not likely to change, inertia is against positive, rapid improvement.

6. Was Mary Barra paid enough for the job she was required to do?

P a g e | 123 At an annual salary of “just” $1.6M, Mary Barra seemed underpaid compared to male CEOs, but when the stock awards of $13.7M are factored in, her salary was competitive with other “Big Three” auto CEOs. (Brustein) Useful Articles, Links and Videos Chappell, Bill. “GM CEA Barra is Grilled Over Handling of Ignition Switch Defect.” 1 April 2014. NPR. 12 July 2021. https://www.npr.org/sections/thetwo-way/2014/04/01/297827480/gm-chiefto-detail-handling-of-ignition-switch-defect-on-capitol-hill. McEachern, Sam. “GM CEO Mary Barra Raked in $23.7M in 2020.” 3 May 2021. GM Authority. 12 July 2021. https://gmauthority.com/blog/2021/05/gm-ceo-mary-barra-raked-in-23-7m-in2020/. Schmidt, Ann. “How Many Barra led GM through its 2014 recall scandal and changed the company’s culture.” 12 July 2020. Fox Business. 12 July 2021. https://www.foxbusiness.com/money/mary-barra-gm-2014-recall-scandal-winning-formula. Wikipedia. "Regulation and licensure in engineering." 24 August 2016. Wikipedia. 19 I+October 2016. https://en.wikipedia.org/wiki/Regulation_and_licensure_in_engineering .

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8. VW Cheats on Emissions Tests (Chapter 2, pages 152-154) What this case has to offer This case describes the almost incredible gamble VW engineers took to cheat on vehicle emission tests by using built-in software to defeat the test equipment and win awards when, in fact, their “clean diesels” were emitting nearly forty times the allowable limits. Teaching suggestions It is useful to raise the students’ interest by drawing their attention to the fact that VW had cheated on emissions tests twice before, had been caught both times, and yet tried it again. After discussing the defeat software functionality, I deal with the case questions. 1. Why would VW engineers think they could get away with a defeat device when the technique had been caught twice before? VW engineers thought they could get away with the deceit, because they weren’t counting on anyone to challenge or compare the results of the Environmental Protection Agency (EPA) or California Air Resources Board (CARB) tests. But an independent, nonprofit research group, called the International Council on Clean Transportation (ICCT), did just that. Only because its on-road test results did not jibe with the in-lab test results of CARB or even the less-stringent EPA results, the ICCT approached CARB and the EPA to point out the discrepancies—namely emissions 9 to 38 times the acceptable limits– and the EPA contacted VW. Ironically, the ICCT was trying to show that diesel cars were now running cleaner than gasoline vehicles. (Vincent 2015) “The cars were passing the California Air Resources Board (CARB) tests and the Environmental Protection Agency’s (EPA’s) less-stringent tests in the lab. But when “…the International Council on Clean Transportation (ICCT) … set out [in 2014] to prove diesel vehicles were now cleaner than other cars… their road tests in California…uncovered massive disparities from the Environmental Protection Agency's (EPA) lab tests, sparking the current scandal.” (Vincent 2015) [Note: The ICTT commissioned researchers at West Virginia University to conduct the tests. (Lienert and Gardner 2015)] 2. If they thought they would be caught, why did they try the defeat device? It may be that the engineers reasoned that when the emission control devices were turned off, car performance would be improved in the form of more torque or better gas mileage. (Gates, et al. 2016) Better driving performance and fewer fill-ups would be strongly effective marketing tools—in addition to the bonus of supposedly low emissions–to increase the diesel VWs’ consumer appeal and, therefore, the sale of more vehicles. But it is more likely, according to the New York Times exposé, that VW employees decided to cheat in about 2004 when they realized they could not meet CARB or EPA emission limits legally. (Gates, et al. 2016) Notwithstanding the New York Times’ comments, it is likely that VW engineers realized that the performance of their cars would be so eroded by the software setting Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 125 necessary to meet the emissions limits, that their engineering prowess and the marketability of their cars would be damaged severely. The decision to use defeat software would have been seen to solve both problems. 3. Why didn’t one of the several design engineers and test engineers and technicians involved blow the whistle to top management and/or the regulators? It is important to look at the reward system and corporate culture at VW: were engineers and others being rewarded for clean cars or for selling more cars? Once the decision to cheat had been made in about 2004, because the cars couldn’t meet the EPA and CARB emission limits, was the company “in too deep”? That is, was the deception so large and damning, that executives thought it had to be hidden? Or was arrogance the impetus for the deception: a hacker’s triumph of sorts? Or a denial that German cars were no longer the world’s best? If the rewards system did not reward honesty or continuous improvement (learning from mistakes), and if there were no reporting mechanism (e.g., code of conduct, compliance officer, whistleblowing program), and employees profited by the deception, there may have been no compelling reason to come forward. Also, once a decision to cheat was taken, in an unethical corporate culture, a significant stigma would attach to anyone who exposed the deceit. 4. VW has a governance system, where the Supervisory Board is different from North American boards of directors. a) How is it different from North American governance models? In North America, corporations are overseen by a board of directors elected by shareholders at least once per year. VW has two boards: a Management Board, and a Supervisory Board. The Supervisory Board seats are split evenly between representatives of the union and of shareholders, with the Chair being independent and voting when needed to break ties. The Supervisory Board should oversee the management board and each should be independent of each other; however, the supervisory board lacks independence and authority (Milne 2015), since half of supervisory board seats go to German workers, and the most others go to insiders related to or associated with major owners (Milne 2015), so they are not independent. Only 12% of VW stock is publicly held. Milne (2015) continues, saying: “In most German companies, the chairman would discuss sensitive matters with the shareholder side first, agreeing a common position before bringing it before the full board. At VW, particularly under former chairman Ferdinand Piëch, who was in charge from 2002 until [2015], things worked in reverse. ‘Piëch would first talk to the works council and agree a position. Then he would bring it to the shareholder side,’ says a former director…This created an atmosphere where sensitive matters were resolved far from the boardroom and without management oversight. ‘The board was really just for show,’ says a former senior VW executive. ‘They lacked the ability to ask any deep technical questions—and you see that in the current scandal.’” (Milne 2015) 4b) The VW governance system does not appear to have had a whistleblower encouragement and reporting system. Could the differences in governance have contributed to the decision to cheat, and to keeping it a secret? If so, how? Yes. Without independence and an established reporting and investigative mechanism, there is little incentive for non-board workers to whistle blow to try to sway Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 126 non-independent boards. Even if whistleblowers came forward, Milne (2015) continues, saying, “’It is hard to exaggerate what kind of atmosphere this created,’ says a former supervisory board member. ‘It was very difficult to do anything that hurt workers…But beyond that it just killed the board as a place of proper discussion.’” 5. Describe how VW would have to change to institute a culture of integrity. At a minimum, the Supervisory Board would require independence (and more outsiders) and technical, financial, and governance expertise to allow fulsome discussion of those topics. 6. How would VW ensure that their policy on environmental protection be upheld? The compensation system could reward meeting or improving environmental protection policy targets. Responsibility for reaching those targets could be part of performance contracts so that someone is accountable and responsible for meeting them. In addition, internal auditors, and/or those involved in enterprise risk identification and assessment should be reviewing VW policies and situations where policies were not being followed. Sanctions should be meted out for those who fail to meet important policies and put the enterprise at risk. 7. Should VW engineers, managers and the CEO be sent to jail? Why and why not? Those shown responsible or taking part in the cover up should be held responsible. The defense would likely be that they were acting in the manner expected of them and so they saw no wrong in their actions. 8. Would you buy a VW? Why and why not? Consumers who intended to purchase or did purchase VWs for better mileage than gas-fuelled cars might still decide to purchase VWs, reasoning that better gas mileage was worth some environmental points, even though the emission of nitrogen oxides was worse than reported. Some consumers, solely price-driven, may have purchased VWs particularly because of the sale prices seen after the scandal broke. Those consumers feeling duped by a manufacturer that claimed to be efficient and clean, as well as environmentally-conscientious consumers, would likely avoid VW. Useful Articles, Links and Videos Gates, Guilbert, Jack Ewing, Karl Russell, and Derek Watkins. "Explaining Volkswagen’s Emissions Scandal." New York Times. Updated September 12, 2016. http://www.nytimes.com/interactive/2015/business/international/vw-diesel-emissionsscandal-explained.html?_r=0 (accessed October 20, 2016). Lienert, Paul, and Timothy Gardner. "Volkswagen's 'clean diesel' strategy unraveled by outside emissions tests." Reuters. September 21, 2015. http://www.reuters.com/article/us-usavolkswagen-emission-idUSKCN0RL2EI20150922 (accessed October 20, 2016). Milne, Richard. "Volkswagen: System failure: VW’s culture has been blamed for fostering dysfunction but the company’s politics may hinder change." Financial Times. November 4, 2015. https://www.ft.com/content/47f233f0-816b-11e5-a01c-8650859a4767 (accessed October 21, 2016). Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 127 Vincent, Michael. "Volkswagen emissions scam: Man who uncovered VW fraud wants other carmakers under spotlight." ABC [Australian Broadcasting Corporation] News. September 22, 2015. http://www.abc.net.au/news/2015-09-23/man-who-uncoveredvw-emissions-scam-wants-wider-probe/6797082 (accessed October 20, 2016).

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9. Deutsche Bank—A Cultural Disaster (Chapter 2, pages 154-157) What this case has to offer This case illustrates that without strong, consistent, ethical leadership, firms can develop aberrant organizational cultures that foster and encourage unethical and illegal behaviors by employees and that undermine the development and maintenance of an ethical corporate culture. In this case, consistently unethical and illegal acts resulted in the payment of huge fines and the closure of a very large component of the company’s business. Teaching suggestions The facts of the case are straightforward, but the following detailed list may be helpful in pointing out to students the extent and duration of significant illegal acts by Deutsche Bank (DB) that triggered huge fines or settlements, including:14 •

Manipulation of LIBOR rates and foreign exchange rates have resulted in overcharging and short-changing millions of people around the world over lengthy periods – $2.179 billion, U.K. and U.S.15

•

Tax violations – $680 million, U.S. in 2010, 2015, 2017

•

Investor protection violations – $216 million, U.S. in seven separate years.

•

Securities issuance or trading frauds – $103 million, U.S.

•

Banking and economic sanction violations – $58 million, U.S.

•

Anti-money-laundering deficiencies/banking violations – $41 million, U.S.

•

Benefit plan administrator and pension plan violations – $21 million, U.S.

•

Fines or settlements under$10 million: o

Data submission deficiencies, U.S.

Accounting fraud or deficiencies, U.S.

Energy market manipulation in California

Transaction reporting beaches (equity swap transactions), U.K. (FCA, 2014)16

All information, except where otherwise indicated, comes from: Good Jobs First, “Violation Tracker Parent Company Summary [for Deutsche Bank],” https://violationtracker.goodjobsfirst.org/parent/deutsche-bank. (accessed July 31, 2019). 15 FT Reporters, “Deutsche Bank pays record fine for Libor manipulation,” Financial Times, April 23, 2015, http://www.ft.com/cms/s/0/ccf7af08-e904-11e4-a71a-00144feab7de.html#axzz40HhuYOeH. [In addition to Violation Tracker source above.] 16 Financial Conduct Authority. Deutsche Bank fined £ 4 .7m for failing to properly report transactions [Press release], 2014. UK Financial Conduct Authority (FCA), https://www.fca.org.uk/news/press-releases/deutschebank-fined-£47m-failing-properly-report-transactions. 14

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Some fines have been reduced or mitigated in return for early confessions, or assistance with information on other schemes. For example, collusion from 2009-2015 with four other banks in a trading cartel was reported by DB in 2018, resulting in immunity from prosecution by the European Commission.

This staggering record of malfeasance, fines, and settlements over many years indicates that DB employees were regularly and systematically violating the laws of the countries in which they operated. Discussion of these items makes it evident that DB’s culture was turning a willful blind eye to illegalities and/or was actively encouraging illegalities. The bank certainly did not have a culture of integrity. I then ask students to reflect on their work experience and to identify factors that they thought contributed to, or detracted from, their employers having an ethical organizational culture. This yields the possibility of discussing problems that a lack of an ethical corporate culture can bring. Discussion of ethical issues 1. What were the deficiencies in the bank’s corporate culture? There were many deficiencies in the bank’s corporate culture:

•

Ruthless internal competition encouraged employees to engage in misrepresentations in order to earn high commissions.

•

Cooperation was lacking between internal departments.

•

Senior management failed to notice irregularities and question suspiciously high profits.

•

Senior management failed to impose internal controls, even when they were available.

•

Governance structure at the board level was ineffective and complicated.

Do you think that Slatter’s five-year plan will be enough to change the bank’s culture? Students will argue that the five-year plan: •

Demonstrates a concerted effort to change the corporate culture,

•

Is well-meaning and was crafted by the head of strategy, and

•

Is probably implementable.

However, the plan focuses on compliance and structure, rather than on ethical values. The latter should be the case if a company wants to develop an ethical corporate culture. A compliance culture without ethical roots is not going to be as successful as an ethical culture, because employees will not understand the underlying rationale and may attempt occasional questionable acts for short-term profit at the expense of longterm objectives.

P a g e | 130 Others will argue that changing cultures is like turning an ocean liner. It cannot be done quickly. It takes a long time for an embedded culture to be altered. The plan is flawed because it was designed by the legal department that tends to adopt a compliance attitude, rather than ethical accountability. Ethics is more than simply obeying the law. (Draw the students’ attention to the discussion in Chapter 3, page 165, on Ethics, Business, & the Law.) Cultural change will only occur when all the employees buy into the new attitude, beginning with the board of directors and senior management, and championed by the CEO and chair of the board. 3. Are there any other measures that can improve the bank’s culture? Important characteristics of an ethical culture are included in Chapter 5, Table 5.10 (Ethical Culture: Important Aspects). Have the students review those nine features and discuss which ones they think would, and would not, work at Deutsche Bank. 4. Why do you think that the bank developed a culture of willful blindness that deliberately turned a blind eye to the misconduct of its employees? DB’s corporate culture, particularly in the investment banking division, was driven by a desire for short-term gains or profits, and longer term legal, financial or reputational consequences were not of concern or were ignored. DB incentivized this behavior, and even promoted to co-CEO the leader who promoted it. Those in charge of governance at DB simply did not understand the alternatives. They did not understand that DB’s future depended on developing trust based on ethical behavior, not on systematically taking advantage of the company’s stakeholders. This question addresses the consequences of student responses to question 1. One of the consequences of an aberrant organizational culture is that employees will not recognize it as such, and so will not view the misconduct of other employees as wrong and worthy of being reported to senior management. Useful Articles, Links and Videos See the Text.

Business & Professional Ethics for Directors, Executives & Accountants, 9e Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

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Chapter 3—Ethical Behavior—Philosophers’ Contributions Chapter Questions and Case Solutions

Chapter Questions..................................................................2 Case Solutions........................................................................5

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Chapter Questions 1. How would you respond when someone makes a decision that adversely affects you while saying, “it’s nothing personal, it’s just business”? Is business impersonal? Business is a social activity, conducted by humans, not by autonomous agents. We live in society, we like to be with other humans, we like to work with other humans, and we like to conduct business with other humans. Business is extremely personal. Because it is personal it is also emotional. However, when two people are in an emotionally charged situation, such as a boss firing a subordinate, in order to artificially insulate oneself from the emotional aspects of the situation, the boss might say “It’s nothing personal. It’s just business.” Often this means it is extremely personal, but the boss is too emotionally immature to handle the emotional content of the situation. So, the boss tries to deny its existence by saying “It’s nothing personal.” 2. Is someone who makes an ethical decision based on enlightened self-interest worthy of more or less praise than someone who makes a similar decision based solely on economic considerations? Enlightened self-interest implies that a decision maker understands that furthering the interest of others might also further the decision-maker’s interests. This attitude takes a long-term perspective. The decision maker realizes that forgoing a short-term benefit or enduring a passing inconvenience may result in a long-term gain that the decision maker will enjoy. Enlightened self-interest also recognizes that if everyone adheres to ethical principles then everyone, including the decision maker, will be better off. 3. Since happiness is extremely subjective, how do you objectively measure and assess happiness? Do you agree with J. S. Mill that arithmetic can be used to calculate happiness? Is money a good proxy for happiness? The measurement problem is one of the weaknesses of the utilitarian theory. Happiness, enjoyment, and pleasure have both qualitative and quantitative aspects. The quantitative aspects can be measured, albeit, not precisely. For some, money is a good proxy for these quantitative aspects. However, it is the qualitative aspects of personal happiness or utility that are very difficult to measure because they are extremely subjective. Also, for many, the qualitative aspects often exceed or dominate the quantitative aspects—hence the expression that money (a quantitative factor) cannot buy happiness (a qualitative factor). 4. Is there any categorical imperative that you can think of that would have universal application? Isn’t there an exception to every rule? For Kant there are two categorical imperatives that apply to everyone in all situations: (a) treat people as ends and not as means. In other words, treat everyone equally under moral law (see Chapter 3, page 173); and (b) the decision maker cannot be exempt from the categorical imperative. If a decision maker is willing to make exceptions, then there can be no categorical imperative. For example, if everyone should act honestly, you cannot act dishonestly and consider lying okay for you, but not others. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 133 5. Assume that Firm A is a publicly traded company that puts its financial statements on the web. This information can be accessed and read by anyone, even those who do not own shares of Firm A. This a free-rider situation, where an investor can use Firm A as a means to making an investment decisions about another company. Is this ethical? Does free-riding treat another as a means and not also as an end? Free riding means that one party is receiving a benefit without paying a fair price for that benefit. Investors use the information produced by one firm to make decisions about another firm. This is a benefit to society as a whole because increased information makes for better investment decisions and resource allocations. However, the firm that produces the information may not receive a commensurate benefit. This means that society free rides at the expense of the information-producing firm. As such, the information-producing firm may want to provide less information to the marketplace. Regulation is therefore needed to ensure that firms provide the information necessary for the marketplace to function properly. Because of regulation, the system as a whole is fair, even though the proportionate cost of providing information may not be fairly distributed among firms. The cost of information may be less for some firms than for other firms. 6. How does a business executive demonstrate virtue when dealing with a disgruntled shareholder at the annual meeting? Virtue is demonstrated by exhibiting patience, understanding and sympathy. Attempting to understand the complaint of the disgruntled shareholder, as seen from the shareholder’s point of view, is a sign of a virtuous CEO. Allowing the shareholder to speak, and not cutting off the individual, shows respect for the views and opinions of the shareholder. Accepting constructive criticism without cowering or rashly dismissing the complaint of a disgruntled shareholder, who has money at stake, is a sign of courage. 7. Commuters who have more than one passenger in the car are permitted to drive in a special lane on some highways while all the other motorists have to contend with stop-and-go traffic. Does this have anything to do with ethics? If so, then assess this situation using each of the following ethical theories: utilitarianism (ignores motivations; looks at consequences), deontology (considers duty, responsibilities; ethics based on the motivation of the decision maker), justice, fairness and virtue ethics. Utilitarianism and fairness: We have limited natural resources, and it is not fair that some over-consume these resources. The special lane rewards those who conserve those resources. Deontology and fairness: Gas, oil and the funds for road repairs are limited resources. If some people over-consume by driving by themselves, they will have to live with stop-and-go traffic. It is fair to drivers with other passengers in their cars to drive in the special lane, because they are conserving resources, reducing wear and tear on roads. They are also sharing commuting costs. (Note that the third motivation is different from the first two. Is it as virtuous?) Justice, fairness, and virtue ethics: From the point of view of society as a whole, in order to make the system fairer, those who save resources—especially because they

P a g e | 134 know those resources are in limited supply and are demonstrating virtuous behavior by conserving them--should pay less than those who consume more resources. The way society makes the over-consumers pay is by preventing them from traveling in a car pool lane on the highway. Their commute will take longer and so they may be motivated to car pool even if their motivation is the quicker commute, rather than conservation.

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Case Solutions Cases Involving Improper Behavior 1. An Illustration of Ethical Decision Making (See Chapter 3, pages 185188) 2. Spy versus Spy: Corporate Espionage in the Canadian Airline Industry (Chapter 3, page 188-189) What this case has to offer This is an interesting case because neither WestJet nor Air Canada broke any laws. However, their techniques for gaining competitive intelligence were highly questionable. The students will probably debate whether a pricing issue violates the public interest and/or appropriate standards of behavior. Some will argue that the public interest is economic, while others will argue that public interest covers social as well as economic welfare. Of course, students (and many professionals) do not always understand that what is in the “public interest” is not always ethical, since some individual interests may be damaged or disadvantaged in pursuit of what is perceived to be the best for the largest number of people. All actions should be judged on their overall ethicality, not just on what is in the public interest. In this case, the right to private information has been violated, and the shareholders of Air Canada have been damaged. Even if this damage is not significant, questionable behavior in one instance can lead to bad behavior in others and can erode the objective of consolidating an ethical corporate culture. Teaching suggestions I begin by asking students what comes to mind when they hear the term “public interest.” Some will restrict the term to economics; for example, by reasoning that the public is best served when the economy prospers. Others will argue that it entails more than that and includes the social welfare of the country. Then I ask if a reduction in prices is in the public interest. Once again, those who take a narrow economic perspective will answer in the affirmative. Those with a broader perspective will consider why and how the pricing decision was made, and its impact on how society will view the business decision. For example, is this predatory pricing, or pricing designed to eliminate competition? We then explore the issue of violating privacy rights related to confidential information, the links to undermining ethical behavior, and the erosion of an ethical corporate culture. Discussion of ethical issues 1. Did WestJet do anything wrong?

P a g e | 136 Crane (2005) argued that corporate espionage would be unethical when: •

Tactics used to gather the information are questionable,

•

Information is private or confidential, and

•

Information will be used against the public interest. In this case, WestJet engaged in highly questionable tactics:

•

Air Canada’s website was intended for former Air Canada employees, such as Jeffrey Lafond. However, the website was accessed over 200,000 times by Mark Hill, who was not a former Air Canada employee.

•

Information on the website was private, intended to be accessed only by former Air Canada employees. It was not public information, and that was why the information was of value to WestJet.

•

Crane’s third point—the public interest–may be considered by some students to be irrelevant. This was simply a pricing issue from WestJet’s point of view.

WestJet appears to have violated Crane’s first two principles—that tactics were questionable, and the information was private–so the students may conclude that WestJet acted unethically. 2. Did Air Canada do anything wrong? Air Canada also engaged in highly questionable tactics: •

It hired private detectives to go through Mark Hill’s trash, then had the shredded documents digitally reconstructed.

•

Hill’s information was private and confidential. That is why he shredded it.

Air Canada also appears to have violated Crane’s first two principles: the tactics were questionable, and the information was private. Air Canada may also have acted unethically. 3. Melvin Crothers received no financial benefit or any thanks from WestJet or Air Canada for what he did. Did Crothers do the right thing? Brenkert (2009) argues that there are five conditions associated with reporting corporate wrongdoing. 1.

The individual has gained some privileged information.

The individual considers the activity to be illegal, unethical or contrary to the firm’s basic core values.

The reporting of the wrongdoing is to a level of authority capable of effectively dealing with the issue.

The wrongdoing is substantive.

P a g e | 137 In this case, Crothers gained privileged information that he thought was substantive and contrary to the values of WestJet. He attempted to report the matter to the CEO, who would have been in position to deal with the matter. The first four criteria seem to have been met. Students may then debate whether a pricing issue affects the public interest. It should be noted that the legal profession believes that financial benefit is very important in determining the illegality of the harm of a conflict of interest. This misses the point that benefits can range well beyond financial to, for example, preferred treatment for the wrongdoer or his/her family, personal recognition or status, favors such as jobs or loans for relatives. Useful Articles, Links, and Videos Brenkert, George G., “Whistle-Blowing, Moral Integrity, and Organizational Ethics,” In The Oxford Handbook of Business Ethics, eds. George G. Brenkert and Tom L. Beauchamp, 563-601. New York: Oxford University Press, 2010. Crane, A. “In the Company of Spies: When Competitive Intelligence Gathering Becomes Industrial Espionage.” Business Horizons 48 (2005): 233-240. Paine, L.S. “Corporate Policy and the Ethics of Competitor Intelligence Gathering.” Journal of Business Ethics, 10 (1991): 423-436. Zahra, S.A. “Unethical Practices in Competitive Intelligence: Patterns, Causes and Effects.” Journal of Business Ethics, 13, no. 1 (1994): 53-62.

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3. Art Forgeries: Is Deceiving Art Experts Unethical? (Chapter 3, page 190) What this case has to offer This case describes two art forgers who donate their forgeries to museums, galleries, etc., without requesting any payment (or tax breaks?) Their acts are not illegal, but are they ethical? Teaching suggestions This case shows that laws are not always in place to make it clear whether or not an act is lawful. Even where no money changes hands, so no one loses money, loss can still occur, for example, as trust and reputation. This case allows the discussion of outcomes of actions, and a comparison of self-interest and selfishness, to help judge whether or not the forgers’ actions are ethical…and we find they are not. Discussion of ethical issues 1. Is it ethically acceptable to sell forgeries to art experts who should be able to differentiate a fake from an authentic work of art? Selling forgeries to an expert who should be able to tell a forgery from an authentic piece of art, compared to selling to an amateur, just means the deception is greater. Is deception ethical? It is dishonest; it is unfair; it is an action that lacks empathy, and compassion. It is not in keeping with the Golden Rule; that is, to treat others as you would have them treat you. Therefore, since the action is not in keeping with hypernorm values—those that most people would accept—it is not an ethical act. It certainly does not display basic expected virtues. 2. Comment on Hebborn’s personal moral code. As in the answer for question 1, to deceive an expert, compared to an amateur, Hebborn’s degree of and motivation for deception is greater. He reasons that an expert is trained to detect fakes or to understand fine painting or antiquity or some other characteristics, while an amateur is not, so it would be unfair of him to try to dupe an amateur, because the duping would be too easy. His reasoning acknowledges that he recognizes that duping is unfair, and that the duping of an amateur would be less fair than of an expert. He may also believe that most experts are fakes, and so he wants to prove that is true—possibly as a backlash to the way he was treated as an artist. Where his moral code is misguided is in its lack of universality (Kant’s categorical and practical imperatives): if deception of one group is unethical, then deception of another group is still unethical.

P a g e | 139 3. Was anyone harmed when Landis donated his forged paintings to various art galleries and museums? Yes. From a teleological perspective; that is, looking at the consequences or impacts of decisions, we could say that the reputation of curators, galleries, and museums could suffer. Donors, by association, could feel duped and disheartened if their funding dollars went to facility improvements to house fakes. Art students could feel duped about studying fakes. People associated with the art, galleries, or museums may feel less trusting, and that could result in negative feedback and a reduction of funding for the arts. In the future, should the institution decide to sell one of the forgeries, believing to be authentic, the institution’s reputation could suffer even more, as could the unsuspecting buyer. A New Yorker article (Wilkinson 2013) reported that although Landis was not paid by a museum, he was treated “like royalty” for donating a picture, and was invited to take anything he liked from the gift shop by the museum’s director. So, the museum did suffer monetary losses as a result of the deception. At another museum, art by Renoir was displaced to make room for one of Landis’s forgeries. So, the museum may have disappointed or lost patrons who came to see the Renoir. In Chapter 3 of the textbook, Adam Smith’s model of business was described as requiring that trade be dependent on fair play, honoring contracts, and mutual cooperation. Landis and Hebborn fail at all three. 4. Does the fact that Landis did not profit from his donations mean that it was ethically acceptable to give forgeries to art galleries and museums? No, it was not ethically acceptable, for the same reasons as in questions 1, 2, and 3. He seemed to be feeding his own ego at the expense of others’, so he seems to be acting selfishly, rather than with self-interest. He may argue—from a utilitarian perspective--that he improved the art world and society’s access to art by providing great art for free, and, so, increased happiness. However, he misrepresented the art (so, under rule utilitarianism, he lied, which would be considered to produce more pain than pleasure most of the time). If he wanted to give away his own art, under his own name, he could, and he would be acting ethically. But, in effect, he plagiarised. He could again argue that he hurt no one, since the artists copied were dead. But, again, if the works were copyrighted, he would be infringing on copyright laws, and he would be doing harm. Useful Articles, Links, and Videos See Text.

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4. Gender Discrimination at IKEA (Chapter 3, pages 190-191) What this case has to offer This case raises the important topic of gender discrimination. Unlike many cases where discrimination occurs in the hiring process, this case involves discrimination in a marketing campaign, where women were intentionally air-brushed out of the IKEA furniture catalogues that were distributed in Saudi Arabia. Teaching suggestions IKEA was/is proud of its culture, and relied upon its reputation to attract customers and staff, so the charge of gender discrimination was potentially very damaging. To illustrate IKEA’s problem have a class member provide an overview of the case facts, and then link this overview to a discussion about organizational culture and hypocrisy using the following suggestions before discussing the ethical issues noted below. •

Discuss the importance of winning awards such as “best place to work.” o

•

Do these awards reflect the organization culture of the firm?

Discuss the issue of hypocrisy—when a company engages in an activity that is contrary to its organizational culture. o

What would be the implications for various stakeholder groups, such as employees and customers?

Discussion of ethical issues 1. Discuss the pros and cons of altering the catalogue using: (a) deontology, (b) utilitarianism, and (c) virtue ethics. Deontology looks at the motivation of decision-making. In this case, altering the catalogue was a violation of fundamental deontological principals. •

Deleting women from the catalogue treated women as means and not as an end. IKEA was discriminating based on gender, which treats women as a means to an end and not as ends in themselves.

•

Equals were not being treated equally. Women and men are equal with respect to using IKEA furniture. By deleting the women, IKEA was treating them unequally; that men could be in the advertisements but women could not.

Utilitarianism assesses the ethicality based on the consequences of the decision. That is, whether the consequences are good for society. •

Deleting women from the catalogue might increase sales in Saudi Arabia (economic consequence) but is damaging to the image of women (social consequence). Utilitarianism uses social rather than just economic criteria to Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 141 assess ethicality, and so, deleting women would be a violation of the fundamental utilitarian principles of creating the best social consequences. Virtue ethics focuses on the moral character of the decision maker. •

IKEA has won awards because of its ethical treatment of women. Deleting women from the catalogue is inconsistent with IKEA’s traditional attitude towards women. Consequently, altering the catalogue would be a violation of virtue ethics.

2. Should a company alter its marketing campaign to reflect biases that might be prevalent in various countries in which the company does business? There are economic benefits to IKEA from having a standardized catalogue that is distributed around the world. There are also ethical benefits. By being consistent with a firm’s core values, the firm projects a positive ethical image which can enhance the firm’s reputation. A violation of core values can have harmful repercussions, as was evident when IKEA apologized for its error. Useful Articles, Links, and Videos “IKEA accused of gender discrimination by erasing women off Saudi catalogue.” Scandinavian Companies & Market: Companies News, October 1, 2012, accessed at http://scancomark.com/Companies/Ikea-accused-of-gender-discrimination-byerasing-women-off-Saudi-cataogue-01102012 . This article provides examples of catalogue photos altered to remove women.

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5. Deciding Who Receives the Swine Flu Vaccine (Chapter 3, page 191-192) What this case has to offer This is an interesting case because it highlights potential trade-offs inherent in deciding what is ethical and the different approaches to decide on what is a fair distribution of a scarce resource. There is no straightforward solution to the problem of allocating a potentially life-saving vaccine when the supply of the vaccine is not enough to inoculate everybody. Teaching suggestions I start this case by asking students if it is possible to objectively decide who is important for society. Following, I ask students whether or not that should be the most important criteria in distributing the vaccine. This is a very good case to discuss the merits and limitations of utilitarianism and justice as fairness approaches to ethical decision making. Utilitarianism seems to be more objective, but decision making under utilitarianism may be perceived as unfairly benefiting some stakeholder groups at the expense of other stakeholder groups. On the contrary, the justice as fairness approach seems to recognize that individual needs have different weights, but decision making under justice as fairness involves a high degree of judgment and subjective evaluation. Discussion of ethical issues 1. From a utilitarian point of view, who do you think should be in the priority group? From a utilitarian point of view, the decision maker must take a broad perceptive concerning who, in society, might be affected by the decision. As stated in the Text, the key aspects to utilitarianism are, first, that ethicality is assessed on the basis of the consequences of the decision, and that these involve social consequences not economic consequences. Next, ethical decisions should be oriented towards making society as a whole better off. This is often measured in terms of increasing happiness and/or reducing pain, where happiness and pain can be either physical or psychological. Furthermore, happiness and pain relate to all of society and not just to the personal happiness or pain of the decision maker. Finally, the ethical decision maker must be impartial and not give extra weight to personal feelings when calculating the overall net probable consequences of a decision. Under this approach to ethics, the people that contribute the most to society’s well-being should be saved. The student must clearly explain why the group that the student has selected—for example, scientists, politicians in high government charges, businesspeople—contribute more to society than any other group. The contribution must not be economic, but rather explained in terms of how society as a whole better is off for because of their contributions.

P a g e | 143 2. From a justice as fairness perspective, who should be in the priority group? From a justice or fairness point of view, people should be assessed differently based on relevant criteria. Overall, the distribution of the vaccine should be perceived as “fair”. Under distributive justice there are three main criteria for determining the just distribution: need, arithmetic equality, and merit. Under the need criteria, people that may fall ill and suffer the worst consequences of the disease should receive the vaccine. This group should include, for example, young children, pregnant women, and elderly people. Under the arithmetic equality criteria, all high-risk people should have the same probability to receive the vaccine. Similarly, there should be a chance to low-risk people to also have access to the vaccine. There could be a lottery system and not necessarily a first-come first-serve approach to distribute the vaccine. Under the justice as fairness principle, equals should be treated equally, and unequals should be treated unequal in proportion to their inequalities. The default position is that all are equal by virtue of their humanity. This means that the decision maker must clearly explain why one group is not equal to all the other groups. Why should, for example, scientists, politicians in high government charges and businesspeople be put in a group that is separate from all other people? Why should that group receive the vaccine while all the other groups do not? Why is the former group unequal with the other groups? Why does one group merit the vaccine while the other groups do not? 3. Should people who make society flourish through their economic productivity, such as the employees of Goldman Sachs, be put into the priority group? Under both the utilitarian view and the justice view, it seems fair to allocate some of the vaccine’s doses to people that contribute to society; however, deciding which individuals contribute to society is not easy. This often depends upon your social perceptive of value. •

From a utilitarian point of view, it is the group that makes society better off. But the student has to clearly explain how this group makes society better off, and not in economic terms.

4. Should people who contribute to making life enjoyable, such as entertainers and athletes, be put into the priority group? •

For a justice perspective, the student has to explain why those in one group, for example, those who contribute to economic productivity, have a higher priority level than athletes or entertainers. This requires a clear explanation of the student’s perception of social value.

5. If you were the CEO of the company that manufactured the swine flu vaccine, would you ensure that all your employees were inoculated first, or would you recommend that they too wait in line?

P a g e | 144 There could be some reasons that will encourage the manufacturer to inoculate its employees: •

The supply of the vaccine is so important to society that the company cannot afford its own employees falling sick.

•

The company would want to discourage its employees, with access to the manufacturing facilities, to steal any doses of the vaccine.

•

The people at the firm have contributed to the development of the vaccine and might have even been at risk of being in contact with the virus.

There could be some reasons that will discourage the manufacturer to inoculate its employees first: •

The company might be perceived by the rest of society as selfish or unfair.

•

There could be people in high-risk groups who need the vaccine immediately.

Useful Articles, Links, and Videos See Text.

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6. Insurance and Genetically Inherited Diseases (Chapter 3, page 192-193) What this case has to offer This case is an example of an ethical dilemma resulting from allowing high-risk individuals, with genetic predisposition towards certain diseases, to purchase insurance at the same cost as other individuals with lower risk. The results of a genetic test can confirm or rule out a suspected genetic condition or help determine a person's chance of developing or passing on a genetic disorder. Arguably, individuals could be denied insurance coverage if a genetic predisposition is considered a pre-existent condition. Teaching suggestions An interesting way to start this case is by discussing the concepts of adverse selection and pre-existing condition before discussing the ethical dilemma associated with genetic testing. Ideally, a health insurer would like each person to pay insurance premiums proportionally to the expected cost of treating all individuals in an insurance pool; and also, the health insurer should encourage all individuals in the pool to take care of their health in order to reduce the overall insurance cost for all individuals insured. In order to identify the expected cost of insurance, the insurer needs to calculate the probability of each individual of contracting a disease and the cost of treating the disease. If an individual is already diagnosed with a disease, a known pre-existing condition, the expected cost of medical bills would be much higher than the average and it will likely be incurred in a shorter period of time. Next, I ask students to what extent a genetic test can be used as evidence of a pre-existing condition, and what are the cost and benefits of genetic testing, including the potential costs at the individual level and to the whole society from allowing or denying health insurance to high-risk individuals. Discussion of ethical issues 1. Do you consider it to be unethical for insurance companies to charge high-risk people a higher premium than low-risk people? Health insurance is insurance against the risk of incurring medical expenses among individuals. By estimating the overall risk of health care expenses among a targeted group, an insurer can develop a finance structure, such as a monthly premiums or payroll tax, to ensure that money is available to pay for future health care benefits specified in the insurance agreement. The insurer considers the losses expected for the insurance pool and the potential for variation in order to charge premiums that, in total, will be sufficient to cover all of the projected claim payments for the insurance pool. The premium charged to each of the pool participants is that participant’s share of the total premium for the pool. Under this view, it does not seem unethical to charge higher premiums to individuals with higher risks; however, this does not consider (1) the possibility that the additional insurance cost may

P a g e | 146 make it unaffordable to be insured, or (2) the possibility of being denied insurance if the insurer deems the risk to be too high. Under these circumstances, it is not entirely clear-cut whether or not society is better off by denying insurance coverage to some people. Is society better off when it discriminates people based on their risk profile? 2. Are insurance companies acting responsibly when they require customers to disclose medical information and/or submit to a medical examination? The answer to this question is related to the answer of the previous question. Asking customers to provide medical information and/or submit to a medical examination should prevent individuals with a pre-existing condition from benefiting from immediate coverage. Moreover, this information can be used by the insurer to determine the expected costs of future claims more accurately; nevertheless, this information could be potentially used to discriminate against certain individuals based on their clinical history or the results of the tests. 3. Argue in favor or opposed to Senator Cowan’s proposed legislation. In favour This legislation should be passed for the following reasons: •

Under the Distributive Justice principle and Rawl’s approach to justice, discrimination against otherwise-healthy individuals on the basis of a genotypic variation is unfair. People that were born to families with predisposition to genetic diseases did not have any control over their condition.

•

Before the existence of genetic testing, people with predisposition to genetic diseases were insured and the health insurance costs were affordable by all individuals, implying that risks were pooled or diversified to an acceptable level.

•

Having a predisposition to genetic diseases does not imply that an individual will not contribute to the insurance pool for a number of years before actually contracting the disease. Denying insurance to these people will cause them to not contribute to an insurance plan and later on, if they contract the disease, they will have to be covered by public health programs subsidized with taxpayers’ money.

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If insurers use the information from genetic tests against people, this could discourage people from taking a test which may be in their interest. It may stop them from having early diagnosis for treatable illnesses.

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Even with the advances in genetic testing, it is not yet entirely possible to get large sample statistics on the accuracy of these tests. People may be denied coverage based on false positives. Furthermore, it is not clear whether or not the expected costs of treating certain genetically inherited diseases will decrease if new treatments become available.

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Employers may deny hiring people with genetically inherited diseases if the cost of insuring these people is higher. This again will result in unfair disadvantage to these people.

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Legislation that gives comprehensive protection against all forms of genetic discrimination is necessary to ensure that biomedical research continues to advance. Such legislation is necessary so that patients are comfortable availing themselves to genetic diagnostic tests. Opposed This legislation should NOT be passed for the following reasons:

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From the utilitarian perspective, the ethically correct action is the one that will produce the greatest net social benefit, often measured in terms of the amount of pleasure or the least amount of pain. In this case, subsidizing high-risk individuals may harm many other individuals or families also struggling to afford health insurance.

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It is not unethical to charge a higher premium to high risk individuals. Other high-risk individuals, such as smokers, already pay higher premiums.

Useful Articles, Links, and Videos See Text.

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7. Terrorist Payments (Chapter 3, pages 193-194) What this case has to offer This case allows the students to apply the ethical theories of utilitarianism, deontology and virtue ethics to a real situation, although the names have been altered so not as to bias any discussion in class. On March 14, 2007 Chiquita Brands International entered into a plea agreement with the U.S. Department of Justice. Chiquita agreed to pay a $25 million fine after it admitted that it made payments to a terrorist organization for protection of its operations in Columbia. Teaching suggestions I find that this case works well when each ethical theory is used separately to analyze the situation. I begin by asking the students to summarize the key utilitarian notions and then apply those concepts and principles to the case facts. After a thorough analysis, we then define deontology and apply it to the case facts. Finally, we do the same with virtue ethics. What the students find interesting is that they will often argue in favor of one position using one of the ethical theories and then argue for a diametrically opposed position when using a different ethical theory. This is a useful exercise for illustrating that ethical theories help in the analysis of problems, but that, because ethical theories approach problems differently, it makes sense that their recommendations will not always be the same. Discussion of the Ethical Issues 1. Should Alex join the board of directors of Consolidated Mines International Inc.? This is a good opportunity to remind students of a director’s functional responsibilities (see Text, Table 5.1) as well as the behavioral expectations of directors (see Text, Table 5.2). If Alex thinks that he has the skillset to be able to fulfill these responsibilities and expectations as well as contribute to the wellbeing of CMI and his own personal growth and development, then he should join the board of directors of CMI. 2. If Alex joins the board, should he vote in favour of continuing to make the payments to the United People’s Liberation Front? Economics The only argument in favor of making the terrorist payments, other than saving company employees from harassment, is economic. CMI paid $1.7 million over an eight-year period from 1997 to 2004, or $212,500 per year on annual revenues of $4.5 billion. The payments are immaterial. Also, the amounts are analogous to the premiums on an insurance policy. By making the payments, the company is ensuring that its operations are not disrupted, and its employees are not harmed. From an economic perspective, the payments are cost-effective, and a necessary business expense, regardless of whether they are classified as “security payments” or “extortion payments.”

P a g e | 149 The arguments against making the payments are legal (counsel has advised CMI that the payment is illegal) and ethical (a variety of ethical theories can be used). Utilitarianism Utilitarianism contends that the best option is the one that promotes the most happiness for humanity. In this case, not paying the terrorist would promote the most happiness. The National Peoples Liberation Front is involved in murder, rape, torture and the cultivation and exportation of cocaine. These negative societal impacts far outweigh the positive of protecting the CMI workers in Columbia and the profits that accrue to the owners of the mine. So, a utilitarian would argue not to make the payments. Utilitarianism also argues that probable consequences have to be considered. This means that CMI cannot just sell its operations to another company and transfer the problem to the new owner. Presumably the terrorist would extort payments from the new owners, which does not promote the overall happiness of society. So, transferring the problem to another is not an acceptable ethical alternative. Deontology Rather than focusing on consequences, deontology examines the motivation of the decision maker. Two useful rule-questions are: are you prepared to have your decision universalized, and are you treating people as ends or as means? If everyone was prepared to make payments to terrorists and other extortionists, it would contribute to the collapse of society. So, from a deontology perspective, making the payments is unacceptable. Also, it would be unacceptable to sell the mining operations to another, who would then be forced to make the extortion payments. Deontology would not accept the position that it is ethically correct to solve a dilemma by transferring it to another decision maker. CMI has been operating in these countries for over a hundred years. CMI knows the political landscape. It chose, in the early years, to operate in countries in which it knew that extortion and bribes were commonplace. At that time, it made the decision to treat these payments as a means to furthering the financial results of the company. So, the ethicality relates not to the current payments but to all the previous payments the company has been making since the 1870’s. This line of reasoning forces the students to consider the motivation of the company from the beginning of its operations in these Latin American countries. (Instructor note: this is an opportunity to lead a slightly tangential discussion of the current business dilemma of opening branch operations in third world countries.)

P a g e | 150 Virtue Ethics Similar to deontology, virtue ethics examines the motivation of the decision maker, rather than the consequences of the decision. Firms are to demonstrate courage, candor, and integrity. Standing up to the terrorists, maybe more foolhardy than courageous. However, the firm may choose to be candid, by disclosing that what is happening in Latin America and that it is making the payments not as ‘security payments’ but rather as ‘extortion payments’. This would allow all interested stakeholders, including the U.S. government, to know where CMI stands, and how it is conducting business abroad. 3. What other options are available to Alec? This question allows the students to use their moral imaginations and come up with creative solutions to this dilemma. For example, from a utilitarian perspective, rather than make the payments to the terrorist, CMI could invest in a defensive force to protect its employees. Although this would probably be much more expensive than the $1.7 million extortion payments, it would provide a greater social benefit than promoting terrorism. From a deontological perspective, perhaps CMI can work with the local governments to enhance the rule of law within these countries. However, this is presumably a very costly option. Are there any others that may be more cost effective? From a virtue ethics perspective, CMI can demonstrate integrity by not making the payments and instead by developing a creative strategy that ensures the security and safety of its operations and personnel. A virtue ethics approach allows students to be imaginative, and not fall into thinking of the false dichotomy of either make the payments or quit Latin America. Additional Information In 1871, Henry Meiggs formed the United Fruit Company. In 1970 it changed its name to United Brands Company and in 1985 to Chiquita Brands International. Often, there have been allegations of questionable business activities. Since its early years of operations, the United Fruit Company was accused of bribing various government officials for preferential treatment. On November 12, 1928 a strike at a United Fruit plant in Columbia was put down with the support of government troops. United Fruit was implicated with the CIA in the overthrow of the democratically elected Guatemalan government of General Guzman in 1954. In 1998 the Cincinnati Enquirer launched a series of subsequently retracted articles on the misdeeds of Chiquita, including pollution, bribery, and complacency in importing cocaine into the United States. From 1997 to 2004, Chiquita admitted that it paid approximately $1.7 million to the United Self-Defense Forces of Columbia (AUC in Spanish), a right-wing paramilitary group. Through its subsidiary, Banadex, Chiquita made more than 100 monthly payments, often in cash, to the AUC, which were recorded as being for security services. As control of the bananagrowing region shifted, Chiquita then made payments to two other terrorist groups, the National Liberation Army (ELN) and the Revolutionary Armed Forces of Columbia (FARC). Chiquita’s board of directors was aware of these payments, and had been advised by legal counsel, in 2003, to stop making the payments. The U.S. State Department had formally designated both Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 151 the FARC, in 1997, and the AUC, in 2001, as terrorist organizations. In 2004, Chiquita sold its Columbia subsidiary, Banadex. In 2007, Chiquita pleaded guilty to doing business with a terrorist organization and agreed to pay a $25 million fine. Useful Articles, Links, and Videos “Chiquita Brands International.” New York Times, November 30, 2010. http://topics.nytimes.com/topics/news/business/companies/chiquita-brandsinternational-inc/index.html This website provides links to several articles on Chiquita Brands International Inc., up to 2015. Leonnig, Carol. “In Terrorism-Law Case, Chiquita Points to U.S.” Washington Post, August 2, 2007. http://www.washingtonpost.com/wpdyn/content/article/2007/08/01/AR2007080102601.html McQuillen, William. “Chiquita Faces New Claims Over Colombia Terrorism.” Bloomberg, April 15, 2010. https://www.bloomberg.com/news/articles/2010-04-14/chiquita-faces-newclaims-it-aided-murders-by-colombian-terrorist-group.

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8. The Case of Cesar Correia (Chapter 3, page 194-195) What this case has to offer This is a true story of a young man who committed a crime, went to jail, served his time, began a career in computers and started a business with a colleague. He is now being penalized a second time. Is that fair? This case lends itself easily to analyses based on the theory of rights, justice as fairness, utilitarianism and virtue ethics. Teaching suggestions Rather than have the students read the case, I give them the basic facts contained in the first paragraph, the setting up of Infolink Technologies and the lawsuit. I have them vote on whether or not George has a right to be told about Cesar’s background. I then ask them to vote on whether or not Cesar has a right to not tell George. Any student that votes both ways needs to explain why. I tell them I will give them any additional information that they think would be relevant in supporting their initial position. The students ask the normal questions about the background, nature and causes of the crime, the judge’s opinion, and the pardon. In this way all the facts of the case are given to the students. It is interesting to watch the students change their opinions as new information is provided, and then have them explain why that new bit of information was important. Discussion of Ethical Issues 1. Ignoring any legal issues, was Cesar ethically obligated to inform his partner, George, of his criminal past? The theory of rights contends that individuals have certain entitlements, regardless of their economic condition, gender, age, and geography. Included among these rights are the right to privacy and the right to information. The right to privacy means that personal information need not be disclosed if the withholding of that information would not harm either the individual or anyone else. Examples include not disclosing information about one’s religion, sexual orientation, or political affiliations. A right to information means that an individual must be given all the relevant facts and information, including probable implications, so that they can make an informed decision. Examples include product warning labels, the risks associated with various investments, and hazardous work conditions. Students can make arguments both for and against disclosure using these two theories. This is an opportunity to illustrate that reasonable people can come to different ethical conclusions while using the same general philosophical theory.

P a g e | 153 Do Not Disclose •

Cesar has a right to privacy. He was pardoned. Therefore, for all intents and purposes the crime never occurred. So, there is nothing to confess or disclose.

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The crime, fratricide, has nothing to do with providing information services. So, because there is no link between the two, there is no need to make the disclosure. Make the Disclosure

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To be effective in business, partners need to be able to trust one another. George has right to know the background of his potential partner, so that he can decide whether or not this is the sort of person with whom he can rely. George has the right to information so that he can assess the risks of having Cesar as his business partner.

2. Did George have a right to know about Cesar’s criminal past? Rawls argues that each person has a right to liberty that is commensurate with the liberty of everyone else. Also, inequalities should be to everyone’s advantage. In this case, under the double-jeopardy rule, a person should not be convicted of the same crime twice. If Cesar discloses and he suffers as a result, then he is being punished for the same crime twice. This would not be fair. On the other hand, if George is not informed then he is not on an equal plane with Cesar. Cesar knows something that may be potentially harmful to the business; that they may lose clients because of Cesar’s conviction. This inequality in information is not to everyone’s advantage. So, Cesar should make the disclosure. George may nevertheless accept Cesar as a legitimate business partner. He may view the crime as being justified, with a debt that has been repaid to society, and a crime that is not relevant to their business venture. Utilitarianism focuses on the consequences of actions. If you murder your father, these are some of the consequences: imprisonment, being shunned by many segments of society, carrying the stigma of being an ex-convict, and having business colleagues view you in a jaundice manner. Cesar may very well lose George as a potential business partner if he makes the disclosure, but that is one of the consequences of his crime. The ethical action is for Cesar to make the disclosure and live with the consequences. Virtue ethics takes a more holistic approach, looking at all the characteristics and traits of the individual. The murder of his father was a horrendous crime, and his reticence about disclosing this to his partner demonstrates a lack of candor and respect for George. On the positive side, however, he argued that the murder was based on compassion for his mother and brother. He demonstrated determination by completing his university while in prison. He was succeeding as a businessman, running a publicly traded company. His behavior was good enough to earn a pardon. So, like everyone else, Cesar has both good and bad aspects to his character. The students can then

P a g e | 154 explain whether they put more weight on the positive or the negative aspects of his character.

Chapter 4—Practical Ethical Decision Making Chapter Questions and Case Solutions Chapter Questions..................................................................2 An Illustration of Comprehensive Ethical Decision Making.................................................................................. .5 Illustrative Applications of Stakeholder Impact Analysis................................................................................ ..5 Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

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Case Solutions........................................................................5

Chapter Questions 1. Why should directors, executives, and accountants understand consequentialism, deontology, and virtue ethics? Directors, executives and accountants frequently encounter problems requiring decisions where the right action is not covered in law or a company’s code, or where the code is being created or re-examined. In those instances, the traditional philosophical approaches to ethical decision making can raise issues for consideration and provide guidance for ethical decisions. Understanding why the consequences of an act are importance, and how to assess them with regard to expectations of duty, observance of rights and fairness, and of virtues to be demonstrated, can provide important insights. In the future, decisions will be increasingly scrutinized for their ethicality as well as their legality and profitability, and must be, and be seen to be, defensible according to traditional considerations. 2. Before the recent financial scandals and governance reforms, few corporate leaders were selected for their “virtues” other than their ability to make profits. Has this changed, and if so, why? Yes. With the recent revision and stiffening of governance requirements, directors are now expected to select and monitor senior executives (CEO and CFO, at least) based in part on their ethicality as evidenced by their contribution of a wholesome “tone at the top.” Without proactive ethical leadership, a company’s ethics program (see Text, Chapter 5, Figures 5.7, 5.8, 5.9, and 5.10) will not succeed. 3. Is it wise for a decision maker to take into account more than profit when making decisions that have a significant social impact? Why? Yes. An organization needs the support of its primary stakeholders to attain its strategic objectives in the long run. It cannot afford to ignore the interests of these stakeholders and those that they are influenced by. Profit is usually a short-term concept that needs to be stretched into a multi-period framework by considering more than just the next buck. 4. If a framework for ethical decision making is to be employed, why is it essential to incorporate all four considerations of well-offness, fairness, individual rights and duties, and virtues expected? It is possible for a set of stakeholders to be better off as a whole, but the proposed action may be grossly unfair to one group (say, the children involved) or may offend the rights of one or more groups (say, women or men) to a degree that may cause the decision to be considered unethical. Moreover, failure to consider expected duties and virtues will damage the corporation’s credibility and reputation, thereby weakening the Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 156 support of various stakeholder groups and the organization’s ability to reach its strategic objectives. 5. Is the modified 5-question approach to ethical decision making superior to the modified moral standards or modified Pastin approach? Not really. The superior approach for a specific problem depends on the nature of the impacts involved. If future impacts of a subjective nature are involved, then costbenefit analysis should be employed. If the ground rules of a company are expected to influence the implementation of a decision, then they should be canvassed. If a commons is at stake, then employing that concept may help the executives involved to analyze the proposed actions ethically. A particular executive’s preference or style may also have to be taken into account. The circumstances will dictate the approach which is most attractive/suitable. 6. Under what circumstances would it be best to use each of the following frameworks: the philosophical set of consequentialism, deontology, and virtue ethics; the modified 5question; the modified moral standards; and the modified Pastin approach? The traditional philosophical approaches—consequentialism, deontology, and virtue ethics–are time-honored approaches that have been refined into the modified 5question approach; the modified moral standards; and the modified Pastin approaches for convenient decision making in those instances noted below. The philosophical approaches, taken as a set, can be applied to any problem rather than a specific subset, and they would be superior where there are strong expectations for the demonstration of duty and of virtues in the solution. Given what was said in response to the last question, the modified 5-question approach seems best suited to short-term, profit-oriented problems that confront the law and impact the environment or require a tailored, specific fifth question. The modified moral standards approach is suited to people-related or future-oriented problems where externalities are present that are not captured in the profit measure. Modified Pastin's approach suits problems internal to an organization. Each approach/or part thereof can be used on almost all problems. 7. How would you convince a CEO not to treat the environment as a cost-free commons? Depending on the person involved, they may be responsive to: altruism, the avoidance of big fines (corporate & personal) or jail; or to arguments that under-pricing the use of the environment can lead to resource allocations which will look foolish in a few years because the cost structures will change, or that opportunities for opening up new markets or competitive advantages will be lost, or that whistle-blowing or activist groups will make things uncomfortable, etc. I would show the CEO what a cost-benefit or risk benefit analysis would look like that would bring such factors into the decision computation. The decision would be up to the CEO, but at least all the factors would be on the table, not hidden or forgotten.

P a g e | 157 8. How can a decision to down-size be made as ethically as possible by treating everyone equally? Equal treatment (laying off by seniority or age or?) may not be fair to those who can least withstand it. I would advise building in an appeals mechanism to any downsizing process to allow for such things as serious impacts on autistic children, or the disabled, who would be displaced, etc. Each case would have to be subject to the agreement of the unions involved, but I believe this approach would be received well if broached in advance. Recent studies have developed a concept of ethical renewal that involves a mechanism for fairly encouraging and evaluating opportunities to make the organization better. Part of the process involves developing trust among employees that they will be treated fairly and will not suffer in the process of continuous improvement. 9. From a virtue ethics perspective, why would it be logical to put in place a manufacturing process beyond legal requirements? A manufacturing process that protected the environment or the workers involved would engender the support of key stakeholder groups such as environmentalists and workers, leading to cooperative government and media relations and the higher commitment of current employees to do their best, and future employees to join. Reputational factors are definitely sensitive to the demonstration of expected virtues. 10. List the companies that have faced ethical tragedies due the following failings in their ethical culture: a. Lack of ethical leadership: Livent, Enron, WorldCom, Tyco, Adelphia, Siemens, Parmalat, Goldman Sachs, Hollinger/Ravelston, Valeant Pharmaceuticals, VW (emissions cheating) b. Lack of clarity about important values: Arthur Andersen, KPMG, E&Y (aggressive tax shelters), Ford, Firestone c. Lack of ethical awareness and expectations by employees: Dow Corning, MCI d. Lack of monitoring of ethicality of actions: Barings Bank, Société Générale e. Unethical reward systems: Sears (auto centers), Banker’s Trust, Royal Ahold, many brokers, Merck (Vioxx) f.

Unreasonable pressures for unrealistic performance: MCI, HealthSouth

11. Give an example of behavior that might be unethical even though ‘‘everyone is doing it.” •

Mechanics telling customers they need new tires before they really do

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Cell phone companies selling warrantee programs on the basis that they provide for every eventuality, but require sending you phone away for repairs for 3-4 weeks each time, multiple times before they will give you a new phone

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Selling products through unwarranted flattery

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Blaming others for your own shortcomings

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Using company resources (e.g., photocopier or printer or long-distance telephoning) for personal use

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An Illustration of Comprehensive Ethical Decision Making 1. Dealing with Disappointed Apple iPhone Customers (See Chapter 4, pages 228-229)

Illustrative Applications of Stakeholder Impact Analysis 2. Bribery or Opportunity in China (See Chapter 4, pages 229-232) 3. Proposed Audit Adjustment—Castle Manufacturing Inc. (See Chapter 4, pages 232-237) 4. When Does an “Aggressive Accounting” Choice Become Fraudulent? (See Chapter 4, page 237-238)

Case Solutions 5. Concussions in the NFL (Chapter 4, page 238-239) What this case has to offer Concussions are imperiling NFL players and the game of football as we know it. The ethicality of the NFL’s actions has become the subject of a sensational movie and future analysis may guide future resolution. This case explores how techniques of ethical analysis may help. Teaching suggestions The case provides an example of how a corporation’s culture of secrecy can be used to defend business as usual while harming stakeholders and benefiting others. Motivated by fear of big business losses, a culture of denial may ultimately work against the NFL. Over time, it may find itself in the middle of a cultural shift toward protecting the health of participants. While such statements about the sport that in the U.S. “…makes the most money, garners the highest ratings, and sets the trends” (Reuter 2013) may seem absurd, markets do change and cultural shifts do occur--similar to the cultural change in acceptability of driving drunk. Playing catch up with research to reduce concussions, suffering reputation loss and financial loss as evidence of denial are revealed in lawsuits that continue to work their way through courts, the NFL may reembrace the damage-control mode that followed the 2015 Sony Pictures’ release of the movie, Concussion.

P a g e | 160 Discussion of ethical issues 1. Is the NFL’s stance on controlling the harm of concussions ethical? That the NFL moved slowly on changes that can reduce concussions; that it had a culture of denial and secrecy in order to preserve the big business of the NFL for its owners: no, it is not ethical, because it lacks fairness, integrity, and transparency. Changes to the game have occurred over time to reduce player injury—for example, the use of helmets starting in 1943; improvement in helmet materials over time; research into force-reducing “wearables”; changed rules about player contact; and new sideline concussion tests for doctors and trainers to administer to impacted players. (Mangels 2012) It is possible that these changes may stem from risk management, rather than altruism: that is, if fewer players are sidelined, fewer medical bills and expenses are incurred, player management is more cost effective, fans are happier, and ticket sales continue. Undoubtedly, the changes do benefit players, but a more ethical approach would have seen faster response time by the NFL and a more impartial, transparent approach to the dangers of the game. 2. Should the NFL have moved earlier on the concussion problem? If so, when and how? Yes, signals that concussions presented significant harm for players have been evident for some time. In 1994, when the NFL first began studying the problem, a virtuous organization would have told players—at a minimum--about any links being seen. By 2002 when Dr. Omalu identified a link between Chronic Traumatic Encephalopathy (CTE) and football, the NFL should have reviewed the evidence with enlightened self-interest, rather than denying connections and intimidating Omalu. Not until 2009 did the NFL make any acknowledgement that concussions can have longterm effects. (Belson 2014) What has the NFL has risked by concealing information or denying links? Not only has it set itself up for lawsuits by injured players, it has risked the wrath of other stakeholders—for example, parents—who enroll their children in football and were unclear about its dangers. 3. If the concussion problem had been analysed using virtue ethics, what would the analysis have included and concluded? “[V]irtue ethics is concerned with the motivating aspects of moral character demonstrated by decision makers.” (Chapter 4) The analysis would have included an examination of the decision maker—the NFL–and virtues (see Chapter 4) we might expect from a virtuous organization, for example: •

Dutiful loyalty: The NFL was loyal to itself (shareholders and the corporation), but not to players.

•

Integrity and transparency: The doctor co-chairs of the NFL’s concussion committee from 2007 resigned in 2009 so that new members--“independent Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 161 sources of expertise and experience in the field of head injuries…”—could be hired. (Associated Press 2009) Releasing the doctors implies a lack of independence, and that the NFL acted in a selfish and non-transparent way in order to downplay the seriousness of concussions and to continue play. The NFL did not demonstrate the virtues of honesty, compassion, and fairness, because while hiding concussions is good for the NFL owners and revenues in the short term, it is not fair to the players or their families in the short- or long-term. Impartiality was not demonstrated at all until the presumably non-independent committee chairs were released. Denying all links between CTE and concussions suggests that NFL does not act with enlightened self-interest, but with selfishness. •

Sincerity and duplicity: When the NFL formed its “the Mild Traumatic Brain Injury [MTBI] committee” in 1994, it appointed as chair a doctor with no brain science experience (Ezell 2013), so the formation of the committee seems to lack sincerity. Duplicity, rather than sincerity seemed to be behind the MTBI’s studies published starting in 2003 (Ezell 2013) because the committee was not impartial, was part of the NFL, and studies seemed to deny the harm from concussions proposed by non-NFL studies.

•

Consistency: Because, in a virtuous organization, virtue should be consistently demonstrated, not just turned on like a light switch, an analysis of NFL suggests the organization has not been virtuous and its probable cover up of the health effects of concussions was not ethical.

4. Should the NFL continue to play football? Consider consequences, impacts on rights, and virtue ethics in your answer. Likely Consequences of Accepting the Long-Term Effects of Concussions: While health-wise, perhaps the NFL should not continue, it will continue, because it is big business with great demand and cultural status. But what will happen if the League loses more lawsuits? More research money will be used for research into preventing concussions (e.g., better helmets, better gear, new rules for the game), instead of into denying their long-term effects. Impacts on rights: To compensate for health risks, players’ salaries might go even higher; survivor benefits might increase; and players’ contracts will likely contain clauses about accepting the risks of the game while limiting NFL liability (read accountability). However, the league will still find players. Those that will take the risk for short-term glory will likely still exist. As in many high-risk sports (I.e. boxing), the economically disadvantaged will likely form the greatest pool of potential players, because while all parents might discourage their children from risking their futures for short-term gain, well-off parents are more able to offer an alternative. Virtue Ethics: The NFL, given the above paragraph, might say that it is demonstrating the virtues of honesty (by admitting to the long-term effects of concussions), compassion and fairness (by compensating —through contract—for the long-term effects of concussions), and loyalty (now to the players in addition to itself Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 162 and to the game as a cultural icon) by developing a risk/reward strategy to secure the future of the game. Are these actions ethical? The NFL and its audience and the players it recruits will justify as ethical a system that assigns a limited value to life and health. The risks and rewards will likely be accepted by many, but if success is limited in reducing the debilitating, life-threatening effects of concussion, the number of recruits will likely be reduced over time, because the dream of being a star will be offset by the nightmare of seeing stars and jeopardizing future success. Although it seems far-0fetched, without adequate help from the NFL, the game may, over time, assume the same kind of status of sumo wrestling in Japan, whose audiences today are over 50 years of age and whose recruiting success is dismal ("T.B." 2015), or chariot racing in ancient Rome. Useful Articles, Links, and Videos Associated Press. "Goodell Announces Two Resignations." ESPN, November 24, 2009. http://www.espn.com/nfl/news/story?id=4687088 (accessed October 31, 2016). Belson, Ken. "Brain Trauma to Affect One in Three Players, N.F.L. Agrees." New York Times, September 12, 2014. http://www.nytimes.com/2014/09/13/sports/football/actuarialreports-in-nfl-concussion-deal-are-released.html?_r=0 (accessed November 1, 2016). Ezell, Lauren. "Timeline: The NFL’s Concussion Crisis." Frontline, October 8, 2013. http://www.pbs.org/wgbh/pages/frontline/sports/league-of-denial/timeline-the-nflsconcussion-crisis/ (accessed October 31, 2016). Mangels, John. "NFL Efforts to Reduce Concussions." Cleveland.com, January 15, 2012. http://www.cleveland.com/science/index.ssf/2012/01/nfl_efforts_to_reduce_concussi.html . (accessed November 1, 2016). Reuter, Tim. "Americans Don't Like Big Business? Tell That To The NFL." Forbes, October 18, 2013. http://www.forbes.com/sites/timreuter/2013/10/18/americans-dont-like-bigbusiness-tell-that-to-the-nfl/#5c92b23b481c (accessed November 1, 2016). "T.B." "Why the Japanese Are no Longer on Top in Sumo Wrestling." Economist, March 17, 2015. http://www.economist.com/blogs/economist-explains/2015/03/economist-explains-13 (accessed November 1, 2016).

6. BP’s Gulf Oil Spill Costs (Chapter 4, page 239-242) What this case has to offer This case discusses the potential consequences of BP’s oil spill in the Gulf of Mexico. The costs derived from the spill could reach $80 billion, according to a Reuters’ estimate, or they could be around $40 billion, according to a BP’s estimate. This is a good case to discuss whether it is possible to estimate all the costs in a situation involving an ethical decision, including loss of life, health, environment, economic livelihood and reputation. Moreover, it may encourage the discussion about the ways to deal with uncertainty in determining expected total costs. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 163 This case is related to the following two other cases in the Text: •

BP’s Corporate Culture (Chapter 7), discussing the systemic problems with the company’s values; and,

•

BP’s Gulf Oil Spill Risk Management (Chapter 7), discussing the failures in the company’s operating controls and risk management process. Teaching suggestions

I start discussing this case by asking students to put together a list of all potential costs that BP could face after the oil spill. Then I ask students to rank each item in the list by degree of uncertainty involved in determining the total cost (i.e. high, medium or low). Next, I ask them to try to determine the actual dollar amount for each item. Finally, with or without using a discount rate, I compare the class’ estimate versus Reuters’ or BP’s estimate of total costs. It might be also useful to ask students how BP could convey to investors and other stakeholders the uncertainty of the loss estimates from the oil spill. Discussion of ethical issues 1. What are the costs to other stakeholders in society beyond those that Reuters included? How would these costs be estimated? The case describes the Reuter’s estimates. BP’s 2010 Annual Report describes the company’s calculation of the financial consequences of the oil spill (p. 38): “Consequences of the accident for BP and its shareholders: Financial consequences The group income statement for 2010 includes a pre-tax charge of $40.9 billion in relation to the Gulf of Mexico oil spill. This comprises costs incurred up to 31 December 2010, estimated obligations for future costs that can be estimated reliably at this time, and rights and obligations relating to the trust fund, described below. Costs incurred during the year mainly related to oil spill response activities, which included the drilling of relief wells and other subsea interventions, surface response activities including numerous vessels, and shoreline response involving deployment of boom and beach cleaning activities. Under US law, BP is required to compensate individuals, businesses, government entities and others who have been impacted by the oil spill. Individual and business claims are administered by the GCCF, which is separate from BP. BP has established a trust fund of $20 billion to be funded over the period to the fourth quarter of 2013, which is available to satisfy legitimate individual and business claims administered by the GCCF, state and local government claims resolved by BP, final judgments and settlements, state and local response costs, and natural resource damages and related costs arising as a consequence of the Gulf of Mexico oil spill. In 2010, BP contributed $5 billion to the fund, and further quarterly contributions of $1.25 billion are to be made during the period 2011 to 2013. The income statement charge for 2010 includes $20 billion in relation to the trust fund, adjusted to take account of the time value of money. The establishment of the trust fund does not represent a cap or floor on BP’s liabilities and BP does not admit to a liability of this amount.

P a g e | 164 BP has provided for all liabilities that can be estimated reliably at this time, including fines and penalties under the Clean Water Act (CWA). The total amounts that will ultimately be paid by BP in relation to all obligations relating to the incident are subject to significant uncertainty. BP considers that it is not possible to estimate reliably any obligation in relation to natural resource damages claims under the OPA 90, litigation and fines and penalties except for those in relation to the CWA. These items are therefore contingent liabilities. BP holds a 65% interest in the Macondo well, with the remaining 35% held by two joint venture partners. While BP believes and will assert that it has a contractual right to recover the partners’ shares of the costs incurred, no recovery amounts have been recognized in the financial statements.” Other costs, not included in the Reuter’s estimates may be: •

Reduction in sales due to the loss of reputation across all the company’s brands;

•

Managerial time and attention consumed dealing with regulators;

•

Loss of investor confidence and difficulty raising funds or increased cost of funds raised for future projects; and,

•

Increase probability of litigation against the company in the future.

2. Has the cost of lost reputation been included by Reuters? If not, how could it be estimated? The cost of lost reputation has been partially included by Reuters, as “Added regulatory scrutiny – 10% of operating costs” and “Ban from future drilling site auctions – lost new oil”. The U.S. Congress was discussing a seven year ban from Gulf drilling for BP, resulting mainly from the company’s loss of reputation. Nevertheless, it is difficult to estimate the overall impact of the loss of reputation accurately. 3. Since there are so many uncertainties involved in analyses such as Reuters presented, are analyses like this useful? Why or why not? There is a high degree of uncertainty in the Reuters’ estimates; however, as soon as the reader is aware of that, the analysis provided by Reuters is useful because it portrays a relatively realistic picture about the costs of this problem. The Reuters’ analysis is beyond the company’s estimates, and is limited by GAAP definitions about contingent liabilities. On the other side, the Reuters’ analysis could be improved by categorizing costs by different degrees of uncertainty. For example, the $20 billion put by BP in a trust fund for damages are very certain, the present value of the production losses from the Macondo are less certain, and the additional cost of regulatory scrutiny (calculated as 10% of operating costs) are very uncertain. 27):

BP’s 2010 Annual Report describes the potential effects of loss of reputation (p.

P a g e | 165 “Moreover, the Gulf of Mexico oil spill has damaged BP’s reputation, which may have a long-term impact on the group’s ability to access new opportunities, both in the US and elsewhere. Adverse public, political and industry sentiment towards BP, and towards oil and gas drilling activities generally, could damage or impair our existing commercial relationships with counterparties, partners and host governments and could impair our access to new investment opportunities, exploration properties, operatorships or other essential commercial arrangements with potential partners and host governments, particularly in the US. In addition, responding to the Incident has placed, and will continue to place, a significant burden on our cash flow over the next several years, which could also impede our ability to invest in new opportunities and deliver long-term growth.” 4. Calculate the discounted value of BP’s estimated lost production for an appropriate time horizon using reasonable assumptions for discount rate and price of a barrel of oil. Justify your assumptions. In order to determine the present value of lost production, it is necessary to determine the following four items: 1. Expected total annual production of the well in number of barrels: According to the “Final Report on the Investigation of the Macondo Well Blowout” prepared by The Deepwater Horizon Study Group (DHSG) in 2011 the size of the well’s reserve was between 50 and 100 million barrels (p. 20): “Initial drilling of the Macondo well began on October 6, 2009, and was spudded in a water depth of approximately 5,000 ft. BP originally estimated that the Macondo field contained approximately 50—100 million barrels of oil. However, BP later stated that the size of the field was undetermined because engineers had not completed the relevant tests before the explosion on April 20, 2010.” From the total reserves, BP was entitled to 65% of the production (p. 103): “The Macondo well was a joint venture including BP (65%), Anandarko (25%), and MOEX Offshore 2007 (10%). As the major shareholder, BP was the operator, in charge of overseeing operations of the well.” There are different ways to incorporate uncertainty. One way is to set a minimum and maximum loss. Using the minimum estimated loss, the well contained approximately 50 million barrels, from which BP was entitled to 65% of the reserves, equivalent to 32.5 million barrels over the lifetime of the well (50 million barrels times 0.65). 2. Number of years that the well was expected to be producing It is difficult to estimate the number of years the well will be producing. Assume that the well will be in operation for 20 years and will produce an equal amount every year. This is equivalent to 1.625 million barrels per year (32.5 million barrels/20 years). 3. Future oil prices

P a g e | 166 An estimate of future oil prices is provided in BP’s 2010 Annual Report. These estimates are used for valuing BP’s business subsidiaries for purposes of goodwill impairment tests (2010 Annual Report, p. 173): “For 2010, the Brent oil price assumption was an average $85 per barrel in 2011, $88 per barrel in 2012, $89 per barrel in 2013, $89 per barrel in 2014, $90 per barrel in 2015 and $75 per barrel in 2016 and beyond.” 4. Discount rate There are several ways to determine a relevant discount rate. The first alternative is to use the discount rate that BP itself uses for valuing its business subsidiaries for purposes of goodwill impairment tests, based on the company’s weighted average cost of capital (2010 Annual Report, page 173): “…The future cash flows are adjusted for risks specific to the cash-generating unit and are discounted using a pre-tax discount rate. The discount rate is derived from the group’s post-tax weighted average cost of capital and is adjusted where applicable to take into account any specific risks relating to the country where the cash-generating unit is located. The rate to be applied to each country is reassessed each year. Discount rates of 12% and 14% have been used for goodwill impairment calculations performed in 2010.” A second alternative is to use the 10% discount rate used in preparing the estimates disclosed in the “Supplementary information on oil and natural gas” disclosures on the BP’s 2010 Annual Report (p. 244-248). This is the same rate that Reuters used to prepare their estimates. A third alternative, applicable to firms with less detailed disclosures, is to estimate the company’s weighted average cost of capital using an estimate of the company’s cost of debt and equity. The cost of loss production is the present value of the future cash flow streams from annual production for the next 20 years (see following table): Y ear

Barrels (in mill.)

Price per Barrel

Cas h Flow (in mill.)

(Rate 10%)

(Rate 12%)

(Rate 14%)

1 1.625

85.00

138.13

125.57

123.33

121.16

2 1.625

88.00

143.00

118.18

114.00

110.03

3 1.625

89.00

144.63

108.66

102.94

97.62

4 1.625

89.00

144.63

98.78

91.91

85.63

5 1.625

90.00

146.25

90.81

82.99

75.96

6 1.625

75.00

121.88

68.80

61.75

55.52

7 1.625

75.00

121.88

62.54

55.13

48.71

P a g e | 167

8 1.625

75.00

121.88

56.86

49.22

42.72

9 1.625 1 0 1.625 1 1 1.625 1 2 1.625 1 3 1.625 1 4 1.625 1 5 1625 1 6 1.625 1 7 1.625 1 8 1.625 1 9 1.625 2 0 1.625

75.00

121.88

51.69

43.95

37.48

75.00

121.88

46.99

39.24

32.88

75.00

121.88

42.72

35.04

28.84

75.00

121.88

38.83

31.28

25.30

75.00

121.88

35.30

27.93

22.19

75.00

121.88

32.09

24.94

19.46

75.00

121.88

29.18

22.27

17.07

75.00

121.88

26.52

19.88

14.98

75.00

121.88

24.11

17.75

13.14

75.00

121.88

21.92

15.85

11.52

75.00

121.88

19.93

14.15

10.11

75.00

121.88

18.12

12.63

8.87

1,117.59

986.17

879.19

32.500

SU M

Present values of future cash flows in the last three columns are calculated using the equation: PV = CASH FLOWSt / (1 + DISCOUNT RATE)n In the above equation, n is the number of years in the future after which the cash flows will be received, and t is the cash flows in each year. Based on the above estimates, the total present value of loss in production is between $879 million and $1.12 billion. Even without discounting to the present, 32.5 million barrels at the current price of $85 per barrels amounts to $2.76 billion. Interestingly, the potential revenue from the Macondo well is very small compared with the total costs of BP’s oil spill. A way to convey uncertainty in these estimates is by computing the total costs varying different assumptions, such as total reserves, discount rate or number of years in production. Also, probabilities could be given to different alternatives to arrive to a single estimate.

5. Why were BP’s early estimates so low? After all, as Reuters reports, BP had experience with two other recent cases.

P a g e | 168 BP’s cost estimates are limited by the GAAP definitions of contingent liabilities. The $40 billion estimate provided by the company only includes those contingent liabilities that are probable and measurable. For example, BP considers that the cost of regulatory fines is too difficult to measure to include in that estimate. Moreover, the following items are not contingent liabilities under GAAP: •

Added regulatory scrutiny – 10% of operating costs

•

Lost production of 30,000 barrels per day

•

Ban from future drilling site auctions – lost new oil

BP’s 2010 Annual Report describes the uncertainty related to the company’s estimates as one of the company’s main risk factors (p. 27): “The Gulf of Mexico oil spill has had and could continue to have a material adverse impact on BP. There is significant uncertainty in the extent and timing of costs and liabilities relating to the Incident, the impact of the Incident on our reputation and the resulting possible impact on our ability to access new opportunities. There is also significant uncertainty regarding potential changes in applicable regulations and the operating environment that may result from the Incident. These increase the risks to which the group is exposed and may cause our costs to increase. These uncertainties are likely to continue for a significant period. Thus, the Incident has had, and could continue to have, a material adverse impact on the group’s business, competitive position, financial performance, cash flows, prospects, liquidity, shareholder returns and/or implementation of its strategic agenda, particularly in the US. We recognized charges totaling $40.9 billion in 2010 as a result of the Incident. The total amounts that will ultimately be paid by BP in relation to all obligations relating to the Incident are subject to significant uncertainty and the ultimate exposure and cost to BP will be dependent on many factors. Furthermore, the amount of claims that become payable by BP, the amount of fines ultimately levied on BP (including any determination of BP’s negligence), the outcome of litigation, and any costs arising from any longer-term environmental consequences of the oil spill, will also impact upon the ultimate cost for BP. Although the provision recognized is the current best estimate of expenditures required to settle certain present obligations at the Gend of the reporting period, there are future expenditures for which it is not possible to measure the obligation reliably. The risks associated with the Incident could also heighten the impact of the other risks to which the group is exposed as further described below.”

Useful Articles, Links, and Videos British Petroleum. Annual Report and Form 20-F2010. March 11, 2011. https://www.bp.com/content/dam/bp/businesssites/en/global/corporate/pdfs/investors/bp-annual-report-and-form-20f-2010.pdf Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 169 Bly, Mark. “BP Deepwater Horizon Accident Investigation Report.” BP. September 8, 2010. YouTube Video, 28:55. https://www.youtube.com/watch?v=zE_uHq36DLU. Deepwater Horizon Study Group (DHSG) “Final Report on the Investigation of the Macondo Well Blowout.” March 11, 2011. http://ccrm.berkeley.edu/pdfs_papers/bea_pdfs/DHSGFinalReport-March2011-tag.pdf

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7. Tylenol Recalls (2010): It’s Still About Reputation (Chapter 4, pages 243-245) What this case has to offer Johnson & Johnson (J & J) enjoyed a halo effect for many decades after their iconic precautionary recall of Tylenol capsules in 1982. That halo has now been lost due to the events that led to the company’s recall of children’s Tylenol and other children’s medicines in 2009 and 2010. Sadly, J & J executives seemed oblivious to the value of lost reputation due to the undermining of trust, and the real lost sales due to a government prohibition on sales. This case examines a number of weaknesses in the company’s internal control and a continuous disregard for safety practices. Teaching suggestions I ask students whether companies that act ethically in one significant instance will always continue doing so, and if so, why not? A good way to answer this question is discussing the J & J decision in 1982 and then discussing the recalls in 2009 and 2010, almost 20 years later. Two questions that are central to the discussion of this case are what happened and how did the company change its culture so drastically. Discussion of ethical issues 1. Who was really to blame for the lax procedures found? Although the U.S. FDA is partially responsible for not acting faster and tougher on J & J, it is the responsibility of the company’s top management to establish adequate internal controls. In this case, there were several operational controls that failed repeatedly. The internal control framework proposed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) explains that: “[i]nternal control is a process, effected by an entity’s board of directors, management and other personnel. This process is designed to provide reasonable assurance regarding the achievement of objectives in effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. •

Internal control is a process. It is a means to an end, not an end in itself.

•

Internal control is not merely documented by policy manuals and forms. Rather, it is put in by people at every level of an organization.

•

Internal control can provide only reasonable assurance, not absolute assurance, to an entity’s management and board.

•

Internal control is geared to the achievement of objectives in one or more separate but overlapping categories.”

Source: COSO, Internal Control – Integrated Framework, 1992, later revised. 2. How should this situation be remedied? A number of things have to change within the company:

P a g e | 171 •

Management needs to change its attitude towards internal control, including their views on product safety and quality. The company should not try to downplay the possible repercussions and seriousness of the recalls (McNeil has publicly stated that the recalls are a precautionary measure and that the risk of serious adverse medical events is remote).

•

J & J Management should make a strong statement that this situation will be resolved and take the necessary steps to clean the company’s reputation. Even when the drugs recalled where produced by the McNeil division, it is the parent company’s reputation that is at stake.

•

The company needs to invest in quality control and commit to meet or exceed the cGMP regulations.

•

The company should establish a strong foundation for monitoring of internal controls, including: o

Support from top management (part of what is known as “tone at the top”);

Assign monitoring roles to people with appropriate capabilities, objectivity and authority;

Set a starting point or “baseline” of known effective internal control from which ongoing monitoring and separate evaluations can be implemented (for example “meet the cGMP regulations”);

Design and implement monitoring procedures focused on key controls that mitigate risks; and,

Assess and report results, including the evaluation of the severity of any identified deficiencies and the reporting of the monitoring results to the appropriate personnel and the board for timely action and follow-up if needed.

It is not easy to remediate severe internal control weaknesses. It takes a cultural shift, managerial time, and significant economic resources. From the pure cost-benefit perspective, the company has already suffered significant economic losses as a result of the drug recall. The problems that motivated the 2009 and 2010 drug recalls did not cause any serious health issues, but without major changes the situation could happen again and possibly be worse. Finally, the company needs to revise its values and policies in place to deal with ethical issues. In a subsequent legal action started by the FDA on May 2010, McNeil was found guilty of illegally promoting a drug called Topamax and of causing false claims to be submitted to government health care programs. The drug was promoted for a variety of psychiatric uses that were not medically accepted indications and therefore not covered by those programs. The company was sentenced to pay a criminal fine of $6.14 million

P a g e | 172 3. How could the job done by the FDA be improved? In this case, the FDA failed to act quickly against the company. It also appears that the warnings from the Agency were not strong enough or did not come with tough enough penalties. For example, in the Warning Letter SJN-2010-01 sent to the company’s CEO in January 2010, after the inspection of the Las Piedras plant, the FDA states that: “It is your responsibility to ensure that your operations at this facility and all other facilities under your control are in full compliance with all applicable requirements of federal law and FDA regulations. You should take prompt action to correct the violations cited in this letter. Failure to promptly correct these violations may result in legal action without further notice, including, without limitation, seizure, and injunction. Other federal agencies may take this warning letter into account when considering the award of contracts. Additionally, FDA may withhold approval of requests for export certificates, or approval of pending new drug applications listing your facility as a manufacturer until the above violations are corrected. A reinspection may be necessary. Within 15 working days of receipt of this letter, please notify this office in writing of the specific steps that you have taken to correct violations. Include an explanation of each step being taken to prevent the recurrence of violations, as well as copies of related documentation. If you cannot complete corrective action within 15 working days, state the reason for the delay and the time within which you will complete the correction.” This warning was not enough to motivate the company’s management to take prompt corrective actions. The FDA followed up with inspections of other plants and found similar concerns. In February 2010, the FDA held an extraordinary meeting with senior executives of J & J. At that meeting, the Agency discussed a number of serious compliance problems at McNeil. In addition, the FDA confronted the company’s executives about whether McNeil's corporate culture supported a robust quality system to ensure the purity, potency, and safety of its products. 4. J & J had lived under a positive halo due to their earlier recall of tainted capsules of Tylenol. Why did J & J people behave differently, almost 30 years later? There could be several reasons behind the change in the company’s response: •

Lack of ethical leadership and clarity about the importance of product safety as a fundamental value for the company.

•

Management is narrowly focused on short-term profits: o

Stock market pressures to deliver short-term profits might be stronger now than 30 years before.

Executive compensation might be more short-term oriented now than 30 years before.

P a g e | 173 •

J & J outsourced the production of these drugs to a subsidiary and executives might have thought that outsourcing somehow shielded the parent company from reputational issues.

•

A misguided understanding of business and ethical immaturity.

•

Soft penalties or weak enforcement by the FDA.

5. How would the total cost of this debacle be estimated? There are direct and indirect costs for the company. The most obvious direct costs are: •

Litigation;

•

Fines;

•

Recall expenses; and

•

Cost of closing down plants to remediate quality issues.

On top of those direct costs, indirect costs may be very large, including: •

Reduction in sales due to the loss of reputation across all the company’s brands;

•

Managerial time and attention consumed dealing with regulators;

•

Loss of investor confidence and difficulty raising funds; and,

•

Increased length of time to receive FDA’s approval for new drugs developed by the company.

Some of these costs can be estimated by asking relevant executives, such as for the costs of recalls, remediation, loss of time taken dealing with regulators, and the increased cost of borrowing, etc. Studies could also be done of the lost sales and related contribution margin based upon the experience of other companies, or the estimates from marketing personnel (see the Ford Pinto Case Notes (11. Ford Pinto, ahead on page 33ff.) Articles, Links, and Videos COSO Definition of Internal Control, “Internal Control – Integrated Framework (1992),” later revised, see http://www.coso.org/resources.htm.

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8. Vioxx Decisions—Were They Ethical? (Chapter 4, pages 245-248) What this case has to offer This case offers the opportunity to apply ethical decision making approaches during their examination of some of the potential ethical issues related to Vioxx’s approval, marketing, and the decision to leave it on the market, as well as: How did Merck get into the dilemma? Could this have been prevented if Merck had and followed a stringent Ethical Decision Making (EDM) process? Did Merck drop the “ethical” ball? Court cases are being currently being decided which offer a rich opportunity for students to review the potential liability that can arise from hazardous products, particularly for manufacturers of pharmaceuticals and other products that can have a significant impact on life or health. It is interesting to speculate, as the students should, on whether there has been an overall net benefit to society and to Merck from its action in regard to Vioxx. Teaching suggestions There are many examples of the dangers of ignoring evidence of hazardous products or processes too long (Ford’s Pinto, Firestone tires, Union Carbide Bhopal, and Dow Corning’s silicone breast implant, to name a few) and Vioxx may be another of these. Students need to understand the dynamics facing management and directors during these decisions, and to learn from the mistakes made earlier. Consequently, it is useful to get the students to role play (say 2-3 students per side) a debate between Merck’s management and the representatives of patients who have begun a class action. The instructor can ask what the Merck directors would have said about issues debated when it has concluded. Following the debate, the analysis presented below can be discussed with the class. Alternatively, the two questions raised at the end of the case can be taken up using the analysis presented below. Discussion of Ethical Issues 1. Utilizing the information provided and available from web sources, use the ethical decisionmaking techniques discussed in the chapter to form an opinion about whether Merck’s decisions regarding Vioxx were ethical. Show your analysis. I have reproduced below Rahbar Rahimpour’s instructive analysis of the Vioxx case issues in the form of a response to question 1. Analysis of Some Ethical Issues Here we use a hybrid analysis of the Philosophical Approach and the Stakeholder Impact Analysis to suggest that Merck’s decision to market Vioxx had both quantifiable and non-quantifiable negative impacts on many of the stakeholders of the company. Initially, it appears that Merck may have neglected to ensure the fundamental interests of its stakeholders. Identification and prioritization of the stakeholders, and their respective interests (well-offness, rights, fairness), does not appear to have included patients and

P a g e | 175 their respective families as top priority. Merck’s decision making process appears to have been less than comprehensiveness. Tunnel vision profit maximization may have led Merck to making a decision that has negatively impacted the company for a long time. Merck’s decision to market and its subsequent decision to withdraw Vioxx negatively affected: 1) Merck’s Stockholders and investors, 2) Merck’s Management, 3) Merck’s employees, 4) physicians and patients, 5) general public, and 6) the regulatory agencies (FDA and Health Canada) and others as shown in Exhibit 3. In November 2000, Merck’s own VIGOR studies indicated a significant increase in the risk heart attack and stroke in patients taking Vioxx, in a 12-month period and as compared to those taking naproxen17. Despite knowing about these results it took Merck more than two years to withdraw Vioxx from the market. Were Merck’s decisions intended to benefit or harm any, or all, of the stakeholders? Are there lessons to be learned from what a seemingly improper decision to rush a drug to market only to withdraw later? Were the consequences of Merck’s decision beneficial to its stakeholders? Consequentialism view holds that whether an act is morally right depends only on the consequences of that act or of something related to that act. It is difficult to argue that any of Merck’s stakeholders are better off and have benefited in the long term. In the short run, Vioxx’s sales helped increase Merck’s revenues, benefited stockholders and management, as well as benefiting some patients. Through their short term vision, Merck’s management fell into ethical decision making pitfalls. Had Merck taken Pastin’s approach to re-prioritize its stakeholders and put patients first, and look at the long term consequences, the results may have been different. Merck’s decision to keep Vioxx on the market and not to present all scientific date to the FDA may seem unethical. However, Merck may argue that withholding scientific information from the regulatory authorities and marketing of Vioxx was based on its commitment to delivering better medicines to patients in need and with no treatment alternative. That is the greater benefit to patients was the ultimate desired consequence. Merck may also argue that Vioxx had a utilitarian impact on society and delivered a substantial health benefit to many patients and therefore its launch and marketing may be morally justified. However, the Company appears to have failed to minimize the net negative impact and harm to all patients. Merck was successful in delivering a high value medicine with tremendous utility to patients. But by apparent misrepresentation of selective data to the FDA it seems to have crossed the moral line. Furthermore, Merck had ample opportunity to withdraw Vioxx from the market (between 1999-2004). Merck’s decision to keep Vioxx on the market appears not to have been fair or right for the stakeholders. Though the legality of Merck’s conduct will be

“Cardiovascular Events Associated with Rofecoxib in a Colorectal Adenoma Chemoprevention Trial.” New England Journal of Medicine 352, no. 11 (March 17, 2005): 1092-102. Epub February 15, 2005. 17

P a g e | 176 decided in courts, it’s clear that short term consequences (profits) blinded Merck’s management to many long term moral and ethical issues. Were Merck’s decisions legal? Were Merck’s decisions fair, just, or right? Merck’s VIGOR data (1, 2) showed that Vioxx could cause death in some patients. Should Merck have withdrawn Vioxx from the market sooner that it did? If it is determined that Vioxx directly contributed to any death, and that Merck knowingly omitted certain data from its regulatory submissions or Merck held back information that could have prevented deaths, consequences may be enormous. Kant might argue that Merck’s omission of information would be deemed unfair, unjust, and unethical. Merck’s actions suggest that the company did not respect the rights and autonomy of individual patients. Merck might argue that staying in the market, for as long as they did might have maximized social benefits. In reality, Merck appears not to have attempted to minimize social injuries to those who did not benefit from Vioxx by issuing proper warnings about Vioxx. Pastin might argue that Merck thereby demonstrated a lack of social contract ethics, and hence was unfair. Transparency and information sharing of risks associated with Vioxx, would have allowed the physicians and patients to make a rational and informed decision thus respecting the autonomy of the patient. By Kant’s standards Merck used the patients to achieve an end (profits). Company profits clearly benefited some of the stakeholders. But many others suffered. Merck may contend that despite all transpired events the net benefit to society as a whole was worth the risks. The fact that Vioxx had serious adverse effects might have come into the risk-benefit analysis at Merck. As a result, some people were expected to develop complications or die. However, by Kant’s measures, an ethical decision should include the full respect of the individual’s right to choose, given all the information available. An increased level of transparency with scientific and clinical data would have had a different outcome. Overall, one may argue that the non-quantifiable impact of Merck’s decision has had a greater effect on the Company than those resulting from the drop in its market cap. Did Merck’s decisions demonstrate expected virtues? As a pharmaceutical company Merck’s reputation and public image had been built over many years. This reputation entailed implicit virtues of reliability, trustworthiness, compassion, caring, integrity, kindness, and responsibility. It does not appear that the decision to market Vioxx, or to stay in the market for much longer than expected, was based on the consideration of any of these expected virtues. In its attempt to satisfy the interests of a limited number of stakeholders, it appears that Merck failed to comprehensively examine, and therefore anticipate, all possible outcomes. Conversely, Merck might argue that its actions were the manifestation of its compassion for patients in need. However, in the public eye, this argument may not hold. One alternative option that would have resulted in securing Merck’s integrity might have been for Merck to be more transparent with the scientific findings and also to present sufficient warnings to the patients. Though Merck appears to have analyzed the profitability and legality of their decision, it seems unlikely that the Company had Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 177 considered its full duty to all stakeholders. Nor did Merck consider the rights of patients to live without worry. Summary In its decision-making process, Merck failed to identify and prioritize all stakeholders, and to address their respective interests and rights. By marketing Vioxx, not only did Merck appear to have ignored the basic rights of many of its stakeholders but also to have eroded the virtues expected from a pharmaceutical company. Merck’s focus on short-term financial gains created an unhealthy ethical decision making environment. Consequently, its decision on Vioxx failed to result in sustainable profits in the long run. Merck’s estimated cost of litigation has had a negative impact on majority of its stakeholders, including: shareholders, management, and employees. We found the following text on Merck’s website. “We believe our emphasis on ethics benefits our business. It motivates our people, and helps to inspire confidence and trust among doctors who prescribe our medicines as well as regulators who approve them. We care deeply about the results we achieve–the drugs we discover, our financial performance and our employees’ satisfaction–but we also care about how we achieve those results, both inside and outside the walls of Merck. No matter how tough the business environment, our ethics and core values will continue to guide our success.” However, it appears that the company continues to ignore its most important stakeholder, the patient, as the word “patient” is not mentioned here. Exhibit 2: Performance of Merck’s stock following withdrawal of Vioxx from the market

Exhibit 3: Merck’s stakeholders and their respective relationships

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In addition to Rahbar Rahimpour’s analysis, the students should appreciate the nature and structure of the court decisions that were appearing. At the early stage (May 2006), several decisions appeared. On April 12, 2006, a jury in New Jersey awarded John McDarby, a 77-year-old $4.5 million in compensatory damages and $9 million in punitive damages18 because “Vioxx had been a significant contributing factor to his heart attack and that Merck failed to warn adequately of the drug’s risks.”19 Punitive damage awards are capped at 5 times the compensatory damages in New Jersey. One analyst opined that the legal costs facing Merck might be “comparable to what Wyeth has faced with its withdrawn “fen-phen” diet drugs. Wyeth has already taken some $21 billion in charges.”20 It should be noted that the second plaintiff (Tom Cona) in the McDarby case received virtually no award. As at April 6th Merck had won two trials, and had been found liable in two others. About 10,000 lawsuits were still to be decided.21 2. In order to protect the public more fully, what should the FDA do given the Vioxx lessons? The FDA could consider: •

Requiring immediate notification by manufacturers and/or researchers of serious side effects

•

Immediate follow-up on such serious side effects

Driver, Anna. “Merck’s cost in Vioxx case increased to $13.5 million.” Toronto Star, April 12, 2006, E6. Ibid. 20 Ibid. 21 Smith, Aaron. “Merck stock tumbles after Vioxx verdict.” CNNMoney.com, April 6, 2006. .http://money.cnn.com/2006/04/06/news/companies/merck_outlook/index.htm (accessed April 6, 2006). See also Curran, John. “Jury finds Merck didn’t warn of Vioxx heart risks.” Toronto Star, April 6, 2006, C7. 18 19

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Immediate/very early public advisory about reports of and investigations of serious side effects

•

Sanctions for corporations and senior executives that: o

delay in reporting serious side effects

coerce researchers not to disclose serious side effects or edit or hold back data to avoid clear disclosure of potential such effects.

Note that, although the case does not speak to the issue of suppressing information on serious side effects, students will come across articles that allege such behavior. Update/Subsequent Events February 28, 2008 – In settlement of lawsuits in Federal, California, New Jersey and Texas courts, Merck obligated to pay $4.85 billion to 44,000 eligible U.S. claimants, see Official Vioxx Settlement (a website “website is sponsored by the Vioxx MDL Plaintiffs’ Steering Committee,”) at http://www.officialvioxxsettlement.com/ For the latest company news releases, litigation information, scientific Information and company statements/protocols see http://www.mercknewsroom.com/ and search for Vioxx. Useful Articles, Links, and Videos American Enterprise Institute. “The Vioxx Settlement,” C-Span video, 2:04:46, January 7 2008, http://www.c-spanvideo.org/program/TheVio. [Panel discusses the Merck settlement with Vioxx users. Although the panel is focused on legal aspects of the settlement, the panel raises some ethical concerns associated with the settlement.] John S. Martin Jr. Report of the Honorable Judge John S. Martin Jr. to the Special Committee of the Board of Directors of Merck & Company, Inc. Concerning the Conduct of Senior Management in the Development and Marketing of Vioxx. September 5, 2006. Debevoise & Plimpton LLP [“The Martin Report”]. [No longer available (2017) on www.merck.com through http://www.mercknewsroom.com/ .] “Merck Agrees To Vioxx Payout,” CBS News video, November 9, 2007, http://www.cbsnews.com/video/watch/?id=3482855n [No longer available. 2020.] Winstein, Keith and David Armstrong. “Top Pain Scientist Fabricated Data in Studies, Hospital Says." The Wall Street Journal, March 11, 2009). http://online.wsj.com/article/SB123672510903888207.html?mod=loomia&loomia_si=t0 :a16:g2:r1:c0.0270612:b22894832

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9. Just Make the Numbers! (Chapter 4, pages 248) What this case has to offer This mini-case conveys the scenario that has been acted out in countless CFO or CEO offices. It offers the opportunity to consider – while using an ethical decision making (EDM) framework – the: •

pressures and motivations that can come to bear on the CEO and CFO,

•

techniques that can be used to boost earnings and/or cash flow,

•

flawed prospect that manipulations will be self-cancelling when prospects improve,

•

consequences of manipulation on all the stakeholders,

•

professional accounting stance on manipulations, and why,

•

lessons learned from earlier manipulation cases, including: Enron, WorldCom, Waste Management, Sunbeam, Adelphia, Tyco, Nortel, HealthSouth, Parmalat, & Royal Ahold.

A most interesting aspect of the EDM discussion is the opportunity to reveal the value of adding deontological and virtue ethics perspectives to the basic consequential or utilitarian framework that most business folk and accounting professionals naturally use. Clearly the deontological issues of rights, fairness and justice are important for fiduciary, legal and reputational purposes, and for professional accountants taking virtue expectations into account is critical. It is not surprising that some corporations are thought to hire non-accounting professionals (MBAs) as their CFOs, in order that they will not feel the professional ethical pressures that a CPA or CA or CMA would. Teaching suggestions Although the case can be taken up by the instructor, it would be helpful for a group of students to present their case solution to the class. The presentation could then be critiqued by other groups of students who were allocated the roles or issues bulleted above, such as: shareholder and other stakeholder impacts, possible techniques and the flawed assumption of self-rectification, professional accounting concerns and expectations, appropriate use of EDM approaches, lessons learned from earlier cases, and why are deontological and virtue ethics important. Discussion of Ethical Issues 1. What should Ron consider in making his decision? Ron, the CFO, should employ a full EDM analysis before making his decision— but rarely would there be enough time or the inclination for this in real life–so using this case in class will prepare the students for future challenges. This full EDM analysis could be similar in framework to that used in the Illustrative Application of stakeholder analysis of a Proposed Audit Adjustment – Castle Manufacturing Inc. included in Chapter 4 of the Text. While the stakeholder impact analysis is necessary and useful to

P a g e | 181 make sure all issues are canvassed, I would suggest that the traditional ethical approaches not be short-changed. Here are some thoughts on the bulleted items listed above: •

•

Pressures and motivations that can come to bear on the CEO and CFO: o

incentives (greed), fear of losing one’s job, reputation erosion

it’s how the game is played – normal business practice (Ken Lay style)

Techniques that can be used to boost earnings and/or cash flow: o

•

Flawed prospect that manipulations will be self-cancelling when prospects improve: o

profits rarely rise as expected,

inventory and/or other profit boosts do not automatically cancel the next year – they are usually additive, and require higher levels of manipulation to hide.

Consequences of manipulation on all the stakeholders: o

•

see Illustrative Applications and cases earlier in this chapter.

Professional accounting stance on manipulations, and why: o

•

capitalize and/or defer expenses, off-balance sheet transactions, misrepresentation

code of conduct discussion, professionalism, reputation concern, lessons for other manipulation cases

Lessons learned from earlier manipulation cases, including Enron, WorldCom, Waste Management, Sunbeam, Adelphia, Tyco, Nortel, HealthSouth, Parmalat, and Royal Ahold:. o

Enron – off-statement deals, sham transactions

WorldCom – capitalization of line costs and other expenses

Waste Management – capitalized and /or failed to record expenses, overstated environmental revenue reserves, understated provisions for income tax, etc.

Sunbeam – channel stuffing, misrecording of fees, false sales, …

Adelphia – misrepresentation of transactions

Tyco – misuse of benefit plans, unauthorized bonuses and compensation, improper credits

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Nortel – misrecording the timing of revenue and expense, soft reserves (cookie jar accounting)

HealthSouth – recording of imaginary revenues

Parmalat – fake transactions

Royal Ahold – recording of non-existent commissions from suppliers

I would conclude with a discussion of the importance of deontology (duty, respect for rights, and fairness) and the demonstration of the virtue expected of senior company officials and the related director oversight. While it is easy to argue that a utilitarian analysis may indicate no significant net harm from an action, an assessment of fair treatment among stakeholders is not included, nor is a forward looking assessment of the expectations of stakeholders and what will happen if they are not met. In this regard, it does not matter if those expectations are beyond what is currently embedded in law, the future support of stakeholder groups is far more important to the success of the corporation and the CEO and CFO themselves, not to mention the directors.

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10. Smokers Are Good for the Economy – Really (Chapter 4, pages 248-250) What this case has to offer The Smokers are Good case offers the opportunity for students to appreciate that: •

•

Cost-benefit analyses (CBA) are useful, but they are susceptible to many flaws: o

Prices/costs are hard to find exactly, and rarely are equivalent to the value of specific items or impacts – consequently it is quite possible “to find the price of everything, but the value of nothing” and to be misled.

Frequently, CBAs do not capture the impact of an action on all stakeholders, particularly those on whom the impact is indirect.

What is incorporated in a more fulsome ethical analysis. Teaching suggestions I would recommend getting the students involved in the case by asking:

•

How many smoke now?

•

How many have recently quit? Then, to get at the issues of the case:

•

Why do people smoke?

•

Are these issues covered in the actuarial analysis (or CBA)?

•

What does a basic ethical analysis include?

•

What else would be covered in a full ethical analysis as opposed to a CBA?

•

What other issues beyond those in a full ethical analysis or a CBA should be continued?

•

Taking everything into account, is smoking good? Discussion of ethical issues

1. What does an ethical analysis add to Viscusi`s actuarial analysis? Using a stakeholder impact analysis framework, an ethical analysis: •

Identifies all the relevant stakeholder groups affected by the activity

•

Identifies all significant impacts on these groups

•

Prioritizes the impact on each stakeholder group

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Asks all the questions per Chapter 4 of the Text relevant to the nature of the problem/impact so as to cover: rights, fairness and well-offness

Viscusi’s analysis does not include the impact of smoking on all stakeholders affected, nor does it include all types of impact. For example, Viscusi does not include the impact on indirectly affected stakeholders, such as families (for example, of losing a loved one who is possibly a bread-winner), and there is no cost included for the pain and suffering of the family of the smoker. Nor is there a systematic and ranked consideration of the issues of rights, fairness and well-offness of all stakeholders. 2. Would an ethical analysis change the conclusion reached? Why? In this case, the product (cigarettes and cigars) is abnormal in that the nicotine included in it produces an addiction in the smoker, so it is difficult for a smoker to quit. Since the level of addiction is different and unknown for each smoker, the product may not be considered to represent a fair purchase and a continuing free choice even though a disclaimer “…harmful to your health” is printed on each package. Smokers smoke for relaxation and for satisfaction of their social or affinity needs. Leaving aside the craving for nicotine, what would smokers do if smokes were not available? Would they turn to drinking or drugs– with worse results? What would they do if taxes on smokes were increased significantly? Would this deprive low income families of money needed for sustenance? Is there really a good alternative to smoking? If not, is smoking not OK if not good?

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11. Ford Pinto (Chapter 4, pages 250-251) What this case has to offer The Pinto Case has become an icon in business ethics. It affords the opportunity to stress the importance of: •

Using a framework for decision making which considers both financial and non-financial factors such as impacts on life and health;

•

Estimating and balancing future impacts with and against short-term impacts, such as profit;

•

Recognizing that the social consciousness of society and executives has changed since the Pinto decision and will continue to do so; and

•

Considering cost-benefit analysis to be a realistic and valuable addendum to profit analysis.

Specifically, the case affords the opportunity to explore the following issues, among others, in a business context: •

Can/should a price be put on life?

•

Why was the cost-benefit analysis deficient? Consider the following: o

Estimates of lawsuit settlements

Lost reputation - how to measure it

Discounting - why and how

Didn't bring the future to the present

•

When is product risk normal or abnormal, acceptable or not acceptable?

•

Was disclosure an option?

•

What is the general trend in social conscience over time? Teaching suggestions

My approach to the Pinto Case depends on whether I use it to start a class on ethical decision making (EDM) frameworks, or to cement the framework issues that I have taught at the beginning of the class. Usually I use the Kardell Paper Case (Chapter 4) to introduce the "5question” or “5-box" framework in the first class on EDM. I begin the second with a discussion on the Moral Standards Approach (MSA) and cost-benefit analysis (CBA) which I cement with the Pinto Case. I then go on to deal with the variations in the MSA which are introduced in the Pastin Approach. Since the class has had a discussion on CBA, I launch right into the first question posed at the end of the case. This doesn't take long because the decision, in hind-sight, is so offensive Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 186 to human life and health. Sometimes there is a bit of debate, but generally the class agrees and we can shift to the second question about the CBA. Since Ford's CBA does not support the view that the decision was unethical, it is natural to dismiss CBA as useless or to look hard to see why. Therefore most of the class are relieved when the CBA is quickly shown to be flawed. During the discussion about the flaws, I make a special point to underscore how a properly crafted CBA would have most helpfully brought future cash flows into the EDM to allow a complete picture to be assembled and a balanced decision to be made. Ignoring the future can be a perilous short-coming. We finish with the last question which is designed to focus on the inappropriateness of thinking that disclosure of abnormal risks is practical or likely to be effective. In total, it usually takes about 30 minutes to deal with the case if it has been read in advance, which I require. Discussion of ethical issues 1. Was the decision not to install the rubber bladder appropriate? Use the 5-question/box framework to support your analysis. The 5-question framework suggests the identification and ranking of stakeholders and then employs the following challenges to proposed actions - in this case with the results indicated: Is the proposed action profitable? According to Ford's CBA - Yes Is the proposed action legal? Yes. But it is interesting to note that the Ford engineers knew that the Pinto would not pass 21 mph crash test which was expected to be introduced as the government's mandatory safety standard - an introduction which was "delayed" until the late 1970's after the bulk of the court work on this case was complete. Is the proposed action fair? No, certainly not to the people who died or were burned or to their families, provided it is decided that the product carried inherent risks which were greater than was reasonable for the buying public to expect. This sets up an interesting discussion of normal and abnormal product risk. Even baby's toys carry some risk to a user, but if there is a design flaw or a manufacturing flaw which presents some extra risk of significant harm, then that would be abnormal. Moreover, if this abnormal risk was known or should have been known to the company, its Directors or management, and they did nothing about it, then they can be considered negligent. In the Pinto case, the placement of the gas tank, etc., is usually considered, in hindsight, to create an abnormal risk. Can the executives be considered culpable? Most would say yes, but they forget that times were different when the decision was made. Social consciences were not as developed and executives were largely schooled to ignore personal matters in favor of financial ones. I usually play devil's advocate on the matter of culpability and force the class to argue their way through the normal/abnormal risk, cultural change issues. Sometimes this catches the traditionalists who side with me only to suffer the attention of their classmates. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 187 Is the proposed action right? No. It clearly offends the right to life, and to health, particularly if the abnormal risk/negligence argument goes against the Ford executives. Some people can't believe that anyone could make the trade-off of $11 for a life (actually I believe the real cost was only $5.50 or so), but the fact that Lee Iacocca did it lends a strange credibility to the case. Is the proposed decision sustainable development? In this case, the issue of sustainable development doesn't appear to be as important other matters, and so can be ignored for the purposes of class discussion. Overall, the proposed action is shown to be unethical based on two challenges at least, so the power of an EDM framework is seen to be greater than the limited financial analysis that Ford was doing. Of course, Ford's analysis was faulty which leads to a discussion of the next question. The ranking of stakeholder's interests does not appear to be needed to reach the above conclusion. 2. What faults can you identify in Ford's cost-benefit analysis? The most frequent observations made in response to this question are: how can anyone put a value on a human life, settlement costs look low, Ford's reputation suffered but this not valued, and there is no discounting of future cash flows. Here are some comments on each. Putting a value on human life and suffering: Gruesome though it may be, courts do it all the time in damage cases, generally as a function of lost future earnings plus damages for pain and suffering discounted at a reasonable rate of interest. Consequently, it the EDM approach will be complete only if we do the same. Unpalatable and inaccurate though it may be, it appears to be useful for EDM purposes to use similar valuation techniques. After all, a perfectly safe car would look like a tank and be more costly than most could afford, so trade-offs will have to continue to be made. Cost estimates look to low: True, but with hindsight everything is clearer. In fact, the total claims paid out ultimately was approx. $150 million. In the US judges are elected and, when the public learned more about the case it became outraged at Ford's conduct and the settlements skyrocketed. This is a pattern that has recurred since. No surrogate is included for lost reputation: We can't measure the value of lost reputation directly, but we can project the lost units of sales which might result from a poor decision. Having this number for each a series of future periods out to a time horizon of say 10 years, we can estimate the lost margin on each and discount the total for each year back to the date of our analysis at a reasonable rate (say 10%). If for example, Ford were to lose 200,000 units of sales for each of the 10 years, and each unit represented lost margin (sales price less variable manufacturing and marketing costs) of $100, then the first year's cost would be the present value of $20 million. Over the ten year time horizon, at a discount rate of 10%, the lost reputation valued on this basis would amount to $$122.9 million (see below).

P a g e | 188 Discounting is not employed: Ask your class whether they would be more willing to take their pay now or defer it for a year or two. Clearly, there is a time value of money which ought to be reflected in a proper CBA by discounting both costs and benefits. Correcting for these flaws, a recast CBA might look like that set out below: Cost-Benefit Analysis of not installing the gas tank gasket: Benefits of: Installation and material costs: ($137,500,000/2 since cost = approx. $5.50 not $11 ea.) (Assume cost incurred evenly over 10 years) (Present value of $6,375,000 annuity at 10%)........................$

39.174 mil

Costs of : Burn deaths, injuries, vehicles, and legal costs: (Assume total payout is $150,000,000 over 10 years) (Present value of $15, 000,000 annuity at 10%)...................... 92.175 Lost reputation: (Lost margin of $20,000,000 per year over 10 years) (Present value of $20 million annuity at 10%).......................…

122.900

Total costs 215.075 Net benefits-costs

($175.001)

Note: The income tax consequences of these cash flows have not be taken into account. If this picture of reality had been available to Ford executives, the decision would quite likely have been different. 3. Should Ford have given its Pinto customers the option to have the rubber bladder installed during production for, say $20? The impracticality of this suggestion is obvious, but it provides a jumping off point to discuss the common misperception that disclosure will make an unethical action all right. Somehow, telling a victim what is in store for him/her is expected to pass the from the manufacturer to the victim. However, when such communication can be done without severe consequences for the company's credibility, the victim can easily claim inability to understand, or not having the freedom to choose another alternate - in which case the manufacturer will still be stuck with the problem. Usually, asking the students how to compose the copy for the $20 option provides some levity at the end of the case. Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 189 Once again, the students will find the case invigorating and instructive, and will marvel at the changes in social conscience over time. Useful Articles, Links, and Videos Dowie, Mark. “Pinto Madness.” Mother Jones, September/October 1977. http://motherjones.com/politics/1977/09/pinto-madness Grimshaw v. Ford Motor Co., 119 CA3d 757 (Cal. App. 1981). http://online.ceb.com/calcases/CA3/119CA3d757.htm

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12. Kardell Paper (Chapter 4, pages 251-253) What this case has to offer The Kardell Paper Co. Case involves decisions around the necessity to introduce a very expensive "closed-loop" pollution control system in a pulp mill. This provides an excellent opportunity to: •

Introduce and illustrate the stakeholder analysis approach as it deals with financial and non-financial issues with impacts in both the long and short term;

•

Get the students to grapple with the need for decisions based on partial or uncertain information;

•

Examine how a board of directors works in governing organizations, and how it ought to be constituted or operated to insure that all stakeholder interests are considered;

•

Learn to anticipate functional fixation, conflicts of interest and other forms of bias from lawyers and other advisors or decision makers;

•

Appreciate what "due diligence" requirements decision makers must keep in mind to minimize the impact of charges of negligence with regard to the treatment of the environment and the handling of hazardous waste;

•

Confront the downside (whistleblowing, fines, jail, closure) of suppressing information or debate at the decision making levels (executive and board) of the organization; and

•

Appreciate the capacity of the stakeholder analysis approach to be used to refine a solution to produce a win/win, creative or better result. Teaching suggestions

I use the Kardell Co. Case either after developing the 5-question/box Approach (5QA) with the students, or after developing the Moral Standards Approach (MSA) and the Pastin Approach (PA) as well. I start the discussion with a short scene-setting statement which raises the reality of the case setting - actually it is an embellished real case with changed names, and with sonox really being dioxin, a suspected carcinogen produces in the pulp making process. Then I ask the following questions, in order: 1. Who are the stakeholders here and what are their interests? 2. What are the major issues and how are the interests of each stakeholder group affected by them? 3. Which ethical decision making approach should be used: 5QA; MSA; PA? Why? 4. What are the major decisions to be made? 5. How should the stakeholder's interests be ranked? Why? 6. What facts and analyses would we like to have? Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 191 7. What decisions would the students make? 8. What was wrong with the quality of the debate at the board of directors? 9. What is the downside if the right decision is not made - consider economic factors and also what Jack might do? The discussion moves along quite quickly, taking 30-45 minutes. At the end of the case, students feel quite good about the decision making approaches and their understanding of corporate governance. Discussion of ethical issues 1. Who are the stakeholders involved, and what are their interests? The discussion of stakeholders and their interests produces the expected list except that usually neither Jack, the technician who discovered the potential problem and who is most concerned with the impact of sonox, and the unborn, are mentioned. I usually have to probe for these, and sometimes I let the discussion proceed until the quality of debate at the board level comes up before asking who is going to raise their issues and argue for their interests. A satisfactory decision is unlikely unless they are recognized as stakeholders and their interests taken into account. You can delve into the issue of whether mothers can adequately represent the unborn or not, but remember that mothers may suffer from conflicts of interest in regard to the perceived short-term need for jobs for their families, etc. Similarly, the issue of whether the environment should be accorded status as a stakeholder in its own right, or simply as an extension of known human needs, is an interesting one. Pointing to the 1992 movie "Medicine Man" in which Sean Connery was trying to find a cure for the cancer in the Brazilian rain forest, but was prevented from doing so by efforts to clear for grazing cattle, is helpful here. 2. Which stakeholders and interests are the most important? Why? The ranking of stakeholders interests can be done after or in conjunction with the identification of the major decisions to be taken. Provided sonox is considered a health risk, the usual ordering of concerns by the public would be: life, health, quality of life, financial. I usually find that there is quite a debate in class over the primacy of shareholders concerns (financial) vs. those related to life and health. In the end, it usually boils down to how serious a health risk the student thinks that sonox is. This is an issue that is unresolved in the case due to lack of information (the same as in real life - dioxins are very harmful to monkeys, but science has not been able to make the same case for humans yet). Choosing an ethical decision making approach: Because the case involves the environment, most students want to use the 5QA which features the sustainable development question. It also appears to be the most simple and logical since the decisions appears to lies outside the confines of the organization. However, the students should be reminded that the profit challenge in the 5QA it deficient because it is often short run in focus and fails to consider externalities like harm to the environment. These issues call for the supplementation of the 5QA with cost-benefit Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 192 analysis as in the MSA. Also, the issues of discovering Kardell's internal ground rules and employing social contract ethics may be helpful in shaping recommendations and encouraging decision makers to consider the downside of the health concerns. Since numbers are not available, augmenting the profit challenge with the concept of CBA usually proves to be desirable and reinforces the idea of fashioning a hybrid system where advisable. What decisions ought to be considered? What facts/analyses would we like to have?: Obviously the decision of whether to shut down and install the closed-loop system is before the board. However, the class should realize that there are a number of variants which should be investigated, time permitting, with the ultimate decision depending on more information. For instance: •

Is sonox really a problem?

•

Are we polluting in sufficient quantities to cause a problem?

•

Are there alternative and less costly process modifications which would reduce, but not eliminate, our sonox discharge?

•

The closed-loop shut down and costs appear high: are their less disruptive/costly approaches?

•

What are the costs of delay?

As a result, an alternate decision would be to defer the closed-loop decision and seek more info on one or more of the above. In the interim, several decisions arise: •

Should the community be informed of the possible health risks? When?

•

Should bottled water be brought in? When?

•

Should the other competitors be brought into the discussions?

Getting the class to make decisions: I usually force the class to vote on the closed-loop decision right after the choice of ethical decision making approach. They resist doing so, and I ask why - then the other questions come out. I keep asking for a decision and this forces the group to think through each stage of the process. Ultimately the class is usually split between those wanting to take the ethical "high road" and install the loop right away, and those who what to move more slowly. 3. What was wrong with the quality of the board of directors’ debate? At this point, it is easy to see that the board was not sufficiently representative of the stakeholders to meaningfully present and understand the important issues facing the company. Moreover, there was no one with sufficient technical expertise to appreciate the significance of the health issues or the biological impact on the environment. The lawyer may have felt a conflict of interest, in that he was both a director and a paid counsel. In any event, his view was limited to current and past legal precedent, not to the future, or to non-legal perspectives. This is functional fixation which can mislead a corporation into short-range thinking. The result of this analysis Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

P a g e | 193 should be the realization that to properly govern a company, the board should have effective representation from all important stakeholder groups, and/or effective access to and information from representative groups or ethics experts. This analysis will highlight the value in appointing "outside" directors (who don't rely on the organization for their livelihood) and also women directors to insure that all aspects of an issue will be understood and argued effectively. 4. What is the downside if the right decision is not made? Consider economic factors and also what Jack might do. Jack might blow the whistle if he thinks that the wrong decision is made or if the process is suppressed or if too much delay is involved. This would (did) involve regulatory sanction including fines, shut down, loss of market, loss of profit, and ultimately loss of control to creditors. If Jack doesn't blow the whistle, costs of ultimate clean-up and new process installation could rise. If the decision by the board is just to wait and see what happens, they will not be able to argue that they took "due diligence" measures to keep abreast of the health risk unless they initiate some research into the sonox problem, even if it is a periodic literature search or a retainer arrangement with a researcher to keep them advised. Similarly, they should continue to take readings in the river to monitor their discharge and try to identify other polluters. I finish the case by asking whether the interests of certain stakeholders can be examined to refine or produce better decision. Sometimes one of the more astute students will speculate on the possibility of arranging with government for support as a test project for the closed-loop system, or to offset the cost of a shut down. Also, the approach to other competitors on the river can be examined, since they are likely to be in the same boat...as it were.

Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn

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Chapter 5—Corporate Ethical Governance & Accountability Chapter Questions and Case Solutions

Chapter Questions..................................................................2 Case Solutions........................................................................9

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Chapter Questions 1. Must a company be incorporated as a benefit corporation in order to legally consider actions other than those in pursuit of profit? No. All publicly traded corporations must meet governance requirements. Given the ability of non-shareholder stakeholders to exert pressure on corporations, that may include taking stakeholders’ interests into account, and in some jurisdictions, this is a legal requirement. Therefore, corporations have legal accountability to shareholders, but strategic accountability also to stakeholders. Because gaining the support of nonshareholder stakeholders may be in the best interest of a company, choosing a course of action may involve trade-offs between shareholders and other stakeholders in order to gain in the long-term, rather than just the short-term. Also, a company can apply for designation as a Certified B Corporation (B Corp) after incorporation as long as it meets requirements of transparency and social and environmental performance. 2. If Lynn Stout is correct, that the drive for shareholder value is a myth, why do so many companies continue to use it as a goal? Stout asserts that U.S corporate law does not require corporations to maximize share price, shareholder wealth, or shareholder value; thus, the myth. But many lawyers, board members and executives have been living in a world where they only needed to be concerned that a proposed action was legal, and was intended to produce a profit (and that was usually only a short-term profit that was needed). They have found those to be a rather easy set of tests to consider and to meet. Longer term considerations usually involve measurement difficulties that many of these individuals consider to be problematic, so they naturally were reluctant and therefore slow to embrace them. In addition, historically companies have been classified as “for-profit,” “not-forprofit,” or “non-profit,” so the continuing rubric for monikers contributes to the myth. The myth is also perpetuated by common compensation schemes that focus only on profit or return on investment, not on the contribution to stakeholders. For example, when executives, directors, and shareholders stand to gain from short-term, rather than long-term thinking under the banner of shareholder value (for example, at Valeant Pharmaceuticals), they may see little incentive to change, because they may be motivated by greed. Increasingly, however, enlightened directors and executives realize that recognizing stakeholders--other than just shareholders--and gaining their support, may be in the best long-term interest of the corporation. In some jurisdictions, corporate statutes are changing so that directors can act in the best interest of stakeholders, not just shareholders, especially if that increases long-term benefits for a corporation, even at the loss of short-term gains. 3. What is the role of a board of directors from an ethical governance standpoint?

P a g e | 196 The board is responsible for the actions of the corporation, both with regard to the achievement of the corporation’s strategic objectives to enhance shareholder value and maintain the support of the company’s stakeholders to achieve those objectives. This means that the board must build into the company’s governance framework such objectives as growth, profitability in the short- and long-run, compliance with laws, and respect for the rights of the primary stakeholders. The board must set or approve policies that will achieve these objectives, hire executives and monitor their performance in accord with those objectives, and make corrections where required. The directors must oversee the governance system, monitor it and take responsibility for it as the agents of the shareholders. 4.

Explain why corporations are legally responsible to shareholders but are strategically responsible to other stakeholders as well. Corporations are created under the laws of a particular jurisdiction (Country, state, province …) and the directors, as agents of the shareholders’, must account to those shareholders and must follow the laws of the jurisdiction in which they are incorporated as well as where they operate. In addition, according to stakeholder theory, corporations need the support of their stakeholders to reach their strategic objectives on a continuing and sustainable basis. This support can best be obtained it the corporation take into account the interests of stakeholders when building and implementing its strategy. Consequently, corporations are legally responsible to shareholders and strategically responsible to a broader set of stakeholders.

What should an employee consider when considering whether to give or receive a gift? An employee should be aware that giving or receiving a gift may raise conflicts of interest (COI), and should understand the COI discussion in this chapter, including the material to be considered specifically, which is in Table 5.6 (Conflicting Interests— Causes of Judgment Bias).

When should an employee satisfy his or her self-interest rather than the interest of his or her employer? An employee’s self-interest, should be satisfied first, if satisfying the employer would be unlawful or harm society, or harm the employee or other employees or other people physically or mentally, or in the case of a professional would offend the professional’s code of conduct. Use of an ethical decision making approach such as those discussed in Chapter 5 could be helpful.

P a g e | 197 7. Can an apparent conflict of interest where there are adequate safeguards to prevent harm be as important to an executive or a company as one where safeguards are not adequate? Yes, because an apparent conflict of interest can be perceived as real and actions triggered in response, whether or not safeguards are present, it can be a risk with the potential to do significant harm. An apparent conflict of interest can damage reputations, so avoiding conflicts of interest is ideal; managing them is second-best. 8. How can a company control and manage conflicts of interest? See the discussion in Chapter 5 of the Text (section, Conflicts of Interest, page 272). Employees must be constantly made aware of potential COI and their consequences through training and reinforcement. There must be a mechanism provided for clarification and guidance including codes and counsellors. Monitoring and sanctions are essential. Table 5.5 (Ethics Risk Management Principles) provides a list of helpful management techniques and issues to consider. Table 6.13 (Conflicts of Interest Examples—2015 AICPA Code Section 1.110.010.04) provides safeguards that are available in the accounting firms and profession, which may be of some use in corporations to manage the risk of COI problems. 9. What is the role of an ethical culture and who is responsible for it? An ethical culture provides continual guidance to executives and other employees with regard to appropriate patterns of behavior, standards of conduct, and how decision are to be made. It is a vital part of the dissemination of company policies and of the internal control compliance mechanism required by SOX of directors, the CEO and CFO. External auditors have long relied upon an organization’s internal controls for assurance that transactions, records and reports are handled properly. Without an effective ethical corporate culture, directors, executives and auditors are very much at risk. A corporation needs an ethical corporate culture to guide employees to do what the directors and senior officers have decided to be appropriate behavior. Codes of conduct are not always read or understood well, nor comprehensive, so employees usually consider and emulate what they believe to be appropriate norms or actions from informally observing their bosses and colleagues. An ethical culture is one where those informal observations are intentionally integrated with formal ethics program objectives and guidance. The informal signals given by senior executives are so important to good ethical governance that directors are now expected to continually assess the ethicality of the “tone at the top”, and to hire/fire/encourage good role models. Consequently, the corporation’s directors are ultimately responsible for the ethical culture, and in turn so are the senior executives, as are auditors to some extent (for not finding obvious flaws). In turn, executives and managers at lower levels are expected to be supportive. A corporate ethics officer or advisor can be quite helpful.

P a g e | 198 10. What is the most important contribution of a corporate code of conduct? Guidance to ensure minimum standards of behavior and protect the reputation of the person, profession or organization, so that no one can later say: "No one ever told me...", or "I though that's what top management wanted.” 11. Are one or more of the fundamental principles found in codes of conduct more important than the rest? Why? I would argue that all of the ethical principles named at the start of Table 5.17 (Subjects Found in Codes)—honesty, fairness, compassion, integrity, predictability and responsibility–are very important and each is essential in specific situations. However, integrity is perhaps the over-reaching principle. 12. Why should codes focus on principles rather than specific detailed rules? Principles are susceptible to interpretation to give guidance on complex or newly emerging issues. They are far easier to remember and therefore understand and use than an exhaustive, detailed listing of rules. Few people would read, or could remember what they have read of such a list. 13. How could you monitor compliance with a code of conduct in a corporation? The internal auditor should be charged with testing to see if employees have complied with the code. Tests could involve surveys, annual sign-offs, interviews, whistle-blower comments, review of HR complaints and lawsuits, and reporting of disciplinary actions. The annual sign-off process can be broadened to include a statement that each employee has done nothing to contravene the code in letter and in spirit, nor do they know of anything they haven't reported that anyone else has done. An annual report should be made to the Audit Committee in addition to more frequent communication if required. 14. How can a corporation integrate ethical behavior into their reward and remuneration schemes? Rewards could be offered for outstanding performance, such as for assistance in revealing fraud. The recognition could take the form of paper medals (certificates for the office /factory wall), publicity of good deeds, cash payment on a percentage of recovery/cost avoidance basis, or an increment of base salary. Sanctions should be applied for wrongdoing, including disciplinary interviews, reduction of raises, fines, dismissal etc. Management-by-objective (MBO)-type goals may be employed to provide the appropriate basis for positive recognition. 15. Other than a code of conduct, what aspects of a corporate culture are most important and why? See the discussion beginning on Chapter 5, page 279 of the Text. Tables 5.10 (Ethical Culture: Important Aspects) and 5.11 (Ethical Programs Usual Dimensions) are specifically instructive, as are Tables 5.12 (Presence of Ethics & Compliance Program Elements per KPMG Forensic Integrity Survey 2013), 5.13 (Ethics and Compliance

P a g e | 199 Program Effects on Behaviors & Perceptions, per KPMG Forensic Integrity Surveys), and 5.14 (Development & Maintenance of an Ethical Corporate Culture). 16. Is the SOX-driven effort being made to check on the effectiveness of internal control systems worth the cost? Why and why not? The SOX governance reforms, and the ensuing SEC internal control certification by the CEO and CFO, and audit thereof, have triggered costly Section 404 reviews of internal control and subsequent improvements that were overdue in many cases. Without sound internal control systems, accurate financial statements are very unlikely. Lynn Turner, former Chief Accountant at the SEC, has indicated that the aggregate cost of all the Section 404 reviews by SEC registrant companies is well below the amount lost by Enron’s investors, and that is only one such bankruptcy. It is also clear that many companies have good systems of internal control and do not need the motivation and cost of Section 404 compliance. Their costs, however, should be less than for the offending firms. See also the answer to question 17. 17. Why should an effective whistle-blower mechanism be considered a “failsafe mechanism” in SOX Section 404 compliance programs? No matter how good a company’s internal controls are, frauds will still occur because systems cannot prevent and/or catch everything—they can only lower the risk of wrongdoing. It is likely; however, that someone has seen or become concerned about an individual’s behavior or a transaction. If that person can be induced to become a whistle-blower, then the whistle-blowing mechanism could be considered a “fail-safe” mechanism or add-on to normal internal controls and/or Section 404 compliance programs. 18. If you were asked to evaluate the quality of an organization’s ethical leadership, what would the five most important aspects be that you would wish to evaluate, and how would you do so? Linda Treviño and others, in 1999, identified five important aspects of a company’s ethical leadership. Beside each are some questions of many that could be asked to test a corporation’s adherence to each. •

Ethical leadership by executives and supervisors: Do they espouse the values of the organization? Support and promote ethical decision making? Are decisions made in stakeholders’ best interests, rather than to benefit corporate leaders? Are realistic goals set that do not exert undue pressure on employees to meet those goals whatever the cost? Are product problems corrected when they are found or covered up?

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Reward systems that incorporate ethical considerations: Are rewards systems tied to values espoused by the corporation (for example, to reducing tailings in a mining company espousing sustainable development or increasing organic content of offerings in a health-espousing grocery chain or putting patient health first at a pharmaceutical company)?

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Perceived fairness, fair treatment of employees: Does the company offer living wages? Benefits? Reasonable working conditions? Flexible working hours? Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn, ©2021, 2018 Cengage Learning, Inc.

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Open discussion of ethics in the organization: Do leaders walk the talk? Do people consider ethics in decision making? Do employees sign off on a code of ethics?

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Authority structure that emphasizes an employee’s accountability and responsibility to question his or her own actions and an obligation to question authority when something seems wrong: Are top executives willing to be corrected? Can employees disagree with management without fear of reprisal? Can employees present poor company results without being pressured to disguise them? Are employees encouraged to provide input to improve operations?

19. Why is it suspected that corporate psychopaths gravitate to certain industries, and what should corporations within those industries do about it? Among other traits, corporate psychopaths pursue their own objectives, rather than others’, and lack empathy and conscience. When working in the finance industry, in areas such as investment and banking, they are thinking about the game or wealth (their own), but are not concerned with how their actions might affect people or their or corporations. Corporations in those industries need to conduct personality tests on prospective employees and ensure that people fitting the profile, if hired, have limited power and little unchecked autonomy in their work. The corporation should constantly be on watch for individuals who display poor motivation or judgement that reflects a negligible respect for what is right based on the projected impacts on other stakeholders. 20. Descriptive commentary about corporate social performance is sometimes included in annual reports. Is this indicative of good performance, or is it just window dressing? How can the credibility of such commentary be enhanced? Sometimes CSP reporting indicates good performance, while at other times it is window dressing. The credibility of such disclosure can be enhanced by: •

the inclusion of negative performance or results

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review and attestation by an independent reviewer/auditor/committee

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comparison with benchmarks now available for similar companies

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comparison with ethically screened companies or inclusion in ethically screened investor databases – Domini, EthicScan or FSTE4Good Indices or lists.

P a g e | 201 21. Should professional accountants push for the development of a comprehensive framework for the reporting of corporate social performance? Why? Yes, such a framework will assist in making directors and executives aware of what they should and can do to develop and ethical culture, manage risks and ensure a sound system of internal control. All of these will assist greatly in maintaining trust, credibility, and accurate reporting of ethical transactions that external auditors must certify. Professional accountants working within corporations will find that their professional responsibilities will be much easier to discharge if they are working in an ethical culture. 22. Do professional accountants have the expertise to audit corporate social performance reports? They have an understanding of audit and reporting principles. However, they usually lack specific knowledge of the accountability frameworks and key indicators involved. These can be learned as readily as for any other management control system. From time to time, expert engineers or environmentalists may need to consult with professional accountants to ensure that such frameworks and indicators are appropriate. Students will increasingly be aware of the developments that are taking place worldwide in regard to such reporting. For an up-to-date picture of developments, see the references in Table 5.22 (Emerging Public Accountability Standards and Initiatives), and refer to the discussion of CSR reporting and audit in Chapter 7.

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Case Solutions Cases on Ethical Corporate Culture 1. Hospital Governance Challenges (Chapter 5, pages 312-313)

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What this case has to offer Hospitals can be for-profit or non-profit, and they answer to many stakeholders. Where health is concerned, many ethical issues arise, and good governance and an ethical corporate culture can reduce ethical risk. This case looks at Wolfson General Hospital (WGH) that has an opportunity to save itself from the reputational damage neighbouring hospitals have suffered because they lacked ethical corporate culture and good governance. In this case, a former nurse, Kelly, has been asked by the Chair—a dear friend—to accept the nomination as ViceChair. Teaching suggestions This case can be used to examine board structures, director nomination, roles and responsibilities, in addition to the variety of ethical issues that hospitals face. The hospital context makes tangible a discussion of risk management, crisis management and ethical risk. Discussion of ethical issues Kelly has asked you to give her advice on the following matters: 1. What major governance problems does WGH face? Which problems are the most important and need to be fixed as soon as possible? Major governance problems Kelly has a board of directors whose members have… •

•

little independence on the board: this is one of most important issues and needs to be addressed o

inappropriate recruiting methods (e.g., the current Chair—“her dear friend”-- has asked her as a friend to accept a nomination for Vice-Chair) ➔ There should be an impartial process for recruiting potential board members; otherwise, the board could be composed of cronies whose independence to think or act could be compromised by conflicts of interest and like-mindedness or group think.

the CEO chairs the Fiscal Advisory Committee (the closest to an audit committee that Wolfson General Hospital (WGH) has): a non-executive member of the board, an independent lead director should serve in this role

limited knowledge and understanding of board functions: this is one of most important issues and needs to be addressed. o

The directors have medical, but not financial knowledge, and may not have governance or ethics training.

The directors have poorly defined roles, since they “preferred to leave financial matters and administrative detail to others.” ➔ When roles are defined and understood, directors perform the duties required of the

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P a g e | 204 role, rather than deciding they don’t like some duties and passing them off.

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The Chair “had just dealt with a serious crisis and wanted [Kelly’s] answer before he could discuss the details confidentially.” ➔ For the Chair to act alone to deal with a crisis—instead of invoking a wellrounded crisis management response with feedback from the directors, stakeholder advisors, etc.–is inappropriate.

No internal financial controls and reporting to the board (equivalent of an audit committee) takes place.

No whistleblowing channel and reporting system (to address accounting and medical or personnel issues) are present to help support a culture of integrity.

limited time for hospital matters. Kelly would have a hospital with…

•

Ethical Risk: this is one of most important issues and needs to be addressed, because of: o

a moribund mission statement and code of conduct: no review in many years, no associated training, no commitment from employees to agree with the mission or abide by the code; likely no mission or values that reflect the code.

unknown culture: want a culture of integrity, but neighbouring hospitals seem to lack one.

no whistleblowing mechanism to help support a culture of integrity.

no stakeholder analysis or risk assessment and management.

reputation risk in the form of association with other area hospitals known for a lack of integrity.

2. What are the most important ethical problems faced by a general hospital? How could these ethical problems best be managed? Ethical Problems Useful reference: (Der Bedrosian 2015) •

Fair and safe treatment of stakeholders, for example, patients and staff. For example: o

providing care without prejudice or judgement (even to a suspected criminal or murderer or …)

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fair treatment of staff (work hours, work shifts, burden of care; compensation)

access to drugs and opportunities for misuse (may relate to perceived unfair compensation or workplace conditions or hiring practices)

end-of-life care; care for the vulnerable

errors/malpractice (may arise when current practices are unchallenged and people fear speaking up and when a corporate culture is one of organizational secrecy/covering up rather than one of organizational learning and continuous improvement)

Quality versus Efficiency o

Quality care versus inexpensive care or faster care (the latter due to staff shortages, for example)

Staff issues that could compromise care, for example: staffing levels (e.g., shortages);

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burnout; post-traumatic stress disorder

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staff compensation

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violence and harassment in the workplace, especially because of power hierarchies

Access to health care o

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hospital personnel as gatekeepers (including access to limited resources, which might be organs or blood or medical procedures)

Access to information (honesty; transparency; privacy) How to Address Ethical Problems

Table 5.14 (Development & Maintenance of an Ethical Corporate Culture) in Chapter 5 outlines how to develop and maintain an ethical corporate culture. By stating a set of values and a mission, and developing a supportive ethical corporate culture that employees must review, ascribe to, and be trained in, the likelihood increases that clearer, decisions can be made when staff are faced with ethical dilemmas. With clearer procedures and reporting, fewer crises may arise. Understanding stakeholders and their issues and expectations can reduce conflict. 3. Should WGH introduce a crisis management process? If so, what should its objective be? How could that best be achieved? Yes! Its objective should be to prevent crises, if possible, by anticipating and planning for risks--internal and external--that could affect the hospital. Crisis management should stem from risk analysis and management, and understanding stakeholders--their issues and expectations and how those might impact the hospital and vice versa--is a place to start. Developing and maintaining an ethical corporate richard@qwconsultancy.com

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P a g e | 206 culture can reduce the number of issues that develop into crises, and management must include an ethical reaction to the crisis. The source of externally driven crises—for example, a new pandemic—may not be controllable, but management of the crisis would include: •

Anticipation and planning

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Assignment of responsibility

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Responsible flow of information to the public and to hospital employees

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Ethical reaction through the ongoing nurturing of an ethical corporate culture

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Consideration of ethical risk (this might include human resources policies and compensation, work hours and employee safety)

Because crisis management stems from good risk management, see Table 5.4 (Areas of Corporate Risk Assessment) in Chapter 5, which outlines areas of corporate risk management (e.g., governance and objectives; areas of impact (e.g., reputation; assets, revenues, costs; performance; stakeholders); sources of risk (e.g., environmental, strategic, operational, informational); specific hazards; degree of control over the risk; and documentation). 4. Why should WGH introduce a protected whistleblower program? Who should administer it, what factors would make it successful, and how should it report? A protected whistleblower program is necessary, especially in a hospital setting, where power hierarchies—and, therefore, the risk of intimidation—exist. Medical and financial improprieties are possible in a hospital setting (see ethical problems in question 2). In fact, the “cone of silence” practice of medical staff means that problems may never be reported without a protected whistleblower program. The program should be administered by an ethics officer (or more than one) so that medical and monetary issues can be confidentially reported. It would include whistleblower protection and possibly an obligation to report and more than one avenue for reporting (e.g., website, hotline, etc.). The ethics officer would report to a subcommittee of the board, for example, an audit committee and a medical-oriented committee, neither of which would have management present. WGH seems to have many (too many?) advisory committees, so the latter might be a Quality of Care Committee. Other key factors—to eventually make whistleblowing a last resort—would include a code of conduct with associated training and sign-off; effective internal controls; effective risk and crisis management programs; and an ethical corporate culture; a fair hearing process so that whistleblowers do report; a board review of ethical concerns so that remedial actions can be taken. 5. Are there any other governance issues that Kelly should consider? Should the Vice-Chair automatically become the Chair in two years’ time, or should a chair be recruited, nominated and voted for by shareholders (for a for-profit hospital) or stakeholders (including government funders for a non-profit hospital)?

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P a g e | 207 Should the committees of the board be restructured so that directors can properly fulfill their roles? (See Table 5.1 (Directors Functional Responsibilities) in Chapter 5). Should the hospital board have some duties that for-profit boards would not have? (For example, community liaison, fundraising?) Would non-profit boards have adequate budget to support their compensation and roles? (e.g., financial oversight; quality of care; developing and maintaining an ethical corporate culture…) 6. Should Kelly accept the nomination as Vice-Chair? Table 5.1 (Directors Functional Responsibilities) in Chapter 5 outlines the roles of directors, of which the Chair is one. Independent directors or an independent Chair should not be employees of the hospital. The Chair (and in this case, the Vice-Chair who succeeds the Chair) needs leadership skills to steer the corporation and guide its building of an ethical corporate culture (and the CEO must play a conspicuous role here, too). They will lead the rest of the directors and will put together the subcommittees. They will be responsible for independent actions and must have clear knowledge of their responsibilities. They will have top-level accountability and will need to manage a budget for the work they do. They must monitor and oversee the corporation and the board must hire the CEO and set her/his compensation. They require experience, because good intentions will not limit their liability. Although Kelly no longer works as an employee of the hospital, she has close ties there.* She “had been a nurse before leaving to raise her family, and now enjoyed participating on the Board to make the healthcare provided by Wolfson General (WGH) as good as possible for her community,” so she seems to be a very good candidate as a director to represent the local community. She seems to have limited budgetary and governance experience, but she recognizes that both need improvement at her hospital. With the experience she gains as a community liaison director, and with increased governance and financial training, she may one day be eligible to apply to be Vice-Chair or Chair of one of the boards of neighbouring hospitals. She should not accept the nomination as Vice Chair of this hospital at this time unless there is no better option available. * Kelly has many friendship ties that may cloud her judgement even if they may not be challenged as creating potential and/or apparent conflicts of interest. She will be lonely at the top, and she needs to get buy-in from everyone to act with integrity and to leave behind personal biases or favor. If she were eligible to serve as Vice Chair in the future, and if she can leverage her friendships to generate loyal personnel to help promulgate the code and values and what they stand for, she may consider the ViceChair position. But she needs to “walk the talk” and to recognize that she can’t do personal favours for those same friends.

Useful Articles, Links, and Videos American Hospital Association, “AHA Trustee Services [website],” 2020, https://trustees.aha.org/. richard@qwconsultancy.com

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P a g e | 208 See sections on governance. Der Bedrosian, Jeanette (Summer 2015). "Nursing is hard. Unaddressed ethical issues make it even harder." Johns Hopkins Magazine, http://hub.jhu.edu/magazine/2015/summer/nursing-ethics-and-burnout/ (accessed November 4, 2016).

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2. Siemens’ Bribery Scandal (Chapter 5, pages 313-315) What this case has to offer This case focuses on the ethical governance implications of bribery to obtain or maintain business opportunities. Several recent worldwide initiatives have recently been mounted to change the rampant regime of bribery that has existed for centuries. In 1998, 34 countries signed the Organization for Economic Cooperation and Development's "Convention on Combating Bribery of Foreign Public Officials in International Business Transactions," requiring the signing countries to implement laws like the U.S. Foreign Corrupt Practices Act prohibiting bribery of foreign officials to gain a business advantage. In 2004, more than 140 countries signed the UN's "Convention against Corruption," requiring member states to return assets obtained through corruption to the country from which they were obtained. In the U.S., the Foreign Corrupt Practices Act (FCPA) enacted in 1977 prohibits directors, officers, employees and agents of U.S. companies, as well as foreign companies with securities registered with the SEC, from making payments to foreign officials to obtain or retain business. Teaching suggestions It would be useful to explore bribery with the class, particularly the forms it can take and the history noted above. The discussion can move on to the governance issues behind the questions posed at the end of the case. There are several interesting questions related to bribery that help to start the discussion, for example: •

What is the purpose of a bribe?

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What forms can a bribe take?

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What is the difference between a bribe and other types of discretionary payments made to facilitate business in a given country?

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How can a company’s internal control system detect bribes?

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What should a company do when an employee is discovered bribing other company’s employee or a government official; and

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How can a company react in a timely fashion to changes in stakeholders’ expectations about what are acceptable or ethical business practices? Discussion of ethical issues

1. The senior executives at Siemens’ spent most of their working environment that condoned bribery outside Germany but not inside. However, they failed to take notice of the changes that Transparency International—championed by a German who was embarrassed by the double standard of his countrymen–was proposing, and that ultimately resulted in a new worldwide anti-bribery regime. Why did they ignore the change? There are several potential reasons why Siemens’ executives ignored the changes in public expectations about bribery:

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P a g e | 210 •

Wrong-headed incentives, pushing executives to obtain more contracts but disregarding or even encouraging unethical methods required to win contract bids;

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Lack of financial reporting transparency, including secret discretionary spending accounts or unidentified transactions without proper authorization;

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Lack of recognition of anti-bribery environmental changes;

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Considering bribery ethical just because it was not illegal at the time, or because everyone was doing it;

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Lack of ethical corporate values against bribery;

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Weak governance/control environment, no sanctions, no encouragement for ethical behavior and deficient ethics programs.

2. If you were Löscher, the new CEO, how would you show the employees and external stakeholders that you actually have a zero tolerance policy concerning corruption? The new CEO could make a public statement regarding the company’s views on bribery and should establish policies and procedures aiming to prevent and detect this practice. There are a number of possible controls that may help to detect and prevent bribery, for example: •

Board members and senior executives should verify that the company has an effective anti-bribery program that includes identification and training of employees and agents who interact with foreign officials;

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The company should have a reporting mechanism for violations, with sanctions, and an effective whistle-blower program;

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Management could require an ethics audit of contract bids by the company’s internal auditors; and,

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The company should keep strict control of discretionary spending accounts.

Useful Articles, Links, and Videos Schubert, Siri & Christian Miller (February 13, 2009). “At Siemens, Bribery Was Just a Line Item.” Frontline, http://www.pbs.org/frontlineworld/stories/bribe/2009/02/at-siemens-briberywas-just-a-line-item.html Nicholson, Chris (December 2, 2009). “Siemens to Collect Damages from Former Chiefs in Bribery Scandal.” New York Times, http://www.nytimes.com/2009/12/03/business/global/03siemens.html Jameson, Angela (November 16, 2007). “Siemens bribes reached around world.” Sunday Times, https://www.thetimes.co.uk/article/siemens-bribes-reached-around-world727rbhgwtgd

Cases on Ethical Leadership 3. Salary Equity at Gravity Payments (Chapter 5, pages 315-316)

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P a g e | 211 What this case has to offer This case explains how the founder and CEO of the company raised the minimum wage for all employees to $70,000 and the positive and negative reactions to his arbitrary decision. Teaching suggestions I begin by asking the students to identify factors that should influence salary levels. Normally they mention: education and training; work experience; level of responsibility; past performance; number of people who report to you; and industry (investment bankers are paid more than grade school teachers). I then ask the students to think about the following three questions (taken Nash 1981): 1. What is your intention in paying the employee? 2. How does your intention compare with the likely results? 3. What is the symbolic potential if compensation is misunderstood? As we take up the case, we constantly refer back to these three questions. Stakeholder analysis involves understanding who a corporation’s stakeholders are— including employees and competitors and understanding their issues and expectations. In this case, the salary announcement that the CEO expected would be received happily by all gets surprising reactions because of what looks, initially, like unilateral decision making and a lack of stakeholder analysis. Discussion of ethical issues 1. Do you think that Dan Price’s decision to raise the minimum salary to $70,000 represented ethical leadership? Dan seems to have characteristics of an ethical leader, which, from Chapter 5, include integrity, trustworthiness, honesty, sincerity, and forthrightness. He shows compassion and that a company's purpose is not solely about profit. Indeed, in 2016, the company’s mission says, “Our mission is to change the way business is done by putting purpose and people above profit,” (Gravity Payments 2016) so Dan seems to be “walking the talk.” He seems to be "doing the right thing, [have] concern for people, [and have] personal morality." Another factor for ethical leadership is "being open and approachable for discussion of concerns," (Text, Chapter 5, page 300), and we’re not told if Dan Price is open to discussion, though he seems to have other characteristics of an ethical leader by "holding to desired values; being objective and fair; exhibiting concern for society; following reasonable ethical decision rules." (Text, Chapter 5, page 300) One criticism is that although Dan Price’s motives were noble, he acted unilaterally without input from other stakeholders. If we look at hypernorm values— those which are very widely held–we could say that Price acted with honesty, and he believed he acted with utmost fairness. And he acted in keeping with his own value set— with integrity. But despite his good intentions, some stakeholders, for example, employees and customers may feel that Dan did not act with respect, because he did richard@qwconsultancy.com

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P a g e | 212 not consult with them. Dan may have acted predictably for him, but given the financial services industry he is in, some stakeholders—competitors–would say he did not act predictably for the industry. He showed compassion for lower-paid employees, but might have failed to realize that the motivation to work well and with effort might be different for different people and different for different types of jobs, so some people might actually feel resentment or a lack of fairness in his action. Also, the contribution made to the welfare of the company, and/or to society may differ, so paying equally may not be regarded as being fair. Initially, business critics might say that personally secure, wealthy, careerfulfilled, successful Dan failed to realize that his actions reflect his own security and, perhaps, ego, guilt or boredom, and that the action was attention-grabbing marketing. In order to overcome cynicism--especially because he was proposing a disruptive action -one not expected and certainly very different from the norm—one might expect that he really would want buy-in from his stakeholders—clients in particular, who might wonder if their rates would rise to pay for the salary changes. However, in this case, Dan was proposing something radically different in the industry, so he may have wanted to be purposely provocative to competitors in order to show that corporate responsibility can still be profitable. 2. Do you think that Price should have arbitrarily increased the minimum salary to $70,000? Initially, no. A company survives, thrives, or dies because of its many stakeholders. By acting unilaterally, Dan ignored all others and acted as a friendly dictator. Had he identified his stakeholders and analyzed their expectations of the company, he may have acted differently. Or would he? Employees - People develop beliefs often stem from values learned through people at home or work—for example, by rules or motivational systems at work. Beliefs motivate people to act. (Text, Chapter 5, page 266) So, surprisingly, not all employees may have welcomed the $70,000 minimum salary. For example, employees in information technology (IT), financial and legal services, as examples, have industry-based expectations that the training required of their jobs, the importance of their work—for example, in keeping computer systems running or in recruiting and maintaining clients or in generating revenue for the company, or in contract law--will result in big salaries or bonuses. Giving lower-paid employees $70K per year might reduce motivation for professional employees to work hard—or, more likely, increase resentment that employees with lesser training, responsibility or stress, will have higher-than-average salaries for their job class. The case tells us that two employees in this group did quit. Lower paid employees may initially rejoice at receiving $70,000 per year, but might wonder what is expected of them to receive it. For example, are they expected to work a great deal of overtime? Will the heretofore casual corporate culture change? (See also question 4 and employee motivation.) From the Text, Chapter 5 (page 266): “The identification, assessment, and ranking of stakeholder interests should help develop a comprehensive set of values for an organization. In the face of competing value systems for the motivation of personnel, corporations should consider which set of values most aligns with those of their richard@qwconsultancy.com

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P a g e | 213 shareholders, and of their most important stakeholders—those that can most influence their largest consumer and capital markets, and their ability to achieve their strategic objectives.” So after some consideration, Dan may have believed that his most important stakeholders were his employees (“Take care of your team, and they’ll take care of your clients” (Gravity Payments 2016)) and the independent business owner clients to whom he provides credit-card services: something that other companies say but do not demonstrate. He may have also believed that he would get only negative reactions from other stakeholders—namely competitors. Because his minimum salary concept was so radical—but so good in intention—and because his company is not publicly held, he could do something radical, disruptive, be an example to other corporations, and gain free marketing through media attention. One can infer that Dan was purposely radical from a video (Gravity Payments [n.d.]) posted on the website in which he says, “The company operates on one principle: we never want to make ‘screw-you money’ like the rest of the financial services industry …. Our industry has a culture and a set of rules that everyone pretty much plays by…and I think the idea of the industry is: ‘Don’t rock the boat…We’re all going to get rich.’ And…why would you challenge that?” Well, Dan Price did, and his company is still successfully operating in 2016. 3. Should he have increased everyone’s salary, even those who were earning more than $70,000? Those earning more--who didn't get more -- may, unfortunately, wonder why they need work hard or take more stress...if they could do a lesser job and make the same. Price's actions were noble, but not everyone will think the same way. When people are consulted or included in the process of decision making, they may feel ownership or involvement with the decision. From Chapter 5 (page 266): “People make things happen, so it is essential that their motivations are aligned with stakeholder expectations, which can only be reliably accomplished only by ensuring that the values underlying corporate motivational elements (i.e., elements (i.e., corporate culture, codes, policies, etc.) are similarly aligned.” For some -- particularly higher-paid employees not seeing raises -- the increase of some salaries may have been demotivating. Dan Price may have actually expected this, and may have selected for employees with a sense of corporate responsibility by allowing them to leave and by attracting new employees with the same beliefs. His actions may have changed the corporate culture positively, despite some “cons” identified in question 4. (See also question 2.) 4. Do you think that this plan will motivate the Gravity employees to work harder? The motivation to work well and with effort might be different for different people and different for different types of jobs. Low-pay employees: Because leaving a clerk’s job at that salary would be difficult, employees who would otherwise undertake training for more and more richard@qwconsultancy.com

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P a g e | 214 challenging jobs may not do so, because their Gravity salary would be unrealistic at other companies. In the short term, these employees might feel very loyal and work hard in order to feel as though they deserve the high salary. Or, they might feel no need to work hard when their salaries are so large and, in the long term, $70,000 might act as golden handcuffs that prevent self-realization. In the long term, the latter might be detrimental for the company, because as people lose interest in their work, but stay with Gravity because of pay, they may focus on petty things that lessen the happiness and efficiency of the workplace. Outside stakeholders who understand behavioural psychology might also agree, and worry about the long-term and the rates they pay for Gravity’s services. Has Dan factored in a way of dealing with employees who underperform? Professional employees: Employees in information technology (IT), financial and legal services, as examples, have industry-based expectations that the training required of their jobs and the importance of their work—for example, in keeping computer systems running or in recruiting and maintaining clients or in generating revenue for the company, or in contract law-- will result in bigger salaries or bonuses. Motivation for these employees might be competition or status. So with Price giving everyone $70K per year, they might feel resentment that employees with lesser training, responsibility or stress, earn too much. We know from the case that two employees in this group left the company. If more leave, Dan’s plan may weaken the company’s ability to compete or deliver on its mandate. Dan Price: Financially secure, Dan has a driven personality type and will look for challenges that are not monetary. His behaviour might suggest that he has achieved great success and that he is looking for other motivators and ways to “give back.” Customers and employees might worry that he losing interest in his company and might sell it to move on to other ventures. Others might believe the move to be pure marketing; others, socialism at work. (Newman 2015) 5. Should Price have consulted with his customers and his employees before he made the decision to increase the minimum salary to $70,000? Consultations lessen surprise--and often people like stability, not surprise. Consultation would help in thinking out all aspects of the plan--like how to reward or reprimand employees; how employees feel about the change; how customers feel; finding out whether the changes will result in rate increases, and finding out what some unexpected consequences might be and how to measure expected benefits. In the future, will the right fit of people be hired into the company, or will a different person than expected apply? Will morale be positively or negatively affected? Will he be able to track and measure changes in productivity, morale, revenue, etc.? (For reviews by current or former employees of Gravity Payments, see the Glassdoor website (Glassdoor 2016). Most reviews are very positive, with a recurring negative being, ironically, media attention.) Useful Articles, Links, and Videos Glassdoor. Gravity Payments Reviews. 2016. , at https://www.glassdoor.ca/Reviews/GravityPayments-Reviews-E697633.htm?countryRedirect=true . (accessed November 14, 2016). [Link active in 2020; reviews are current.] richard@qwconsultancy.com

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P a g e | 215 Gravity Payments. [About]: Unique & Innovative Company Culture. 2016. https://gravitypayments.com/about/ (accessed November 14, 2016). —. About. 2016. https://gravitypayments.com/about/ (accessed November 14, 2016). —. "CEO Dan Price: How Gravity Payments is Different [Video]." Gravity Payments. [n.d.]. https://gravitypayments.com/ (accessed November 14, 2016). Nash, Laura (November 1981). “Ethics without the sermon.” Harvard Business Review. Newman, Jonathan (August 12, 2015). "How Did Gravity’s $70K Minimum Wage Work Out?" Four States News, https://fourstatesnews.us/2015/08/12/how-did-gravitys-70k-minimumwage-work-out/ (accessed November 17, 2016).

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4. Merck and River Blindness (Chapter 5, pages 316-317) What this case has to offer This case concerns a company that follows its values and provides a life-enhancing drug for free to those who cannot afford the drug. Teaching suggestions I begin the discussion by talking about organizational values. For the MBA students, I ask them to think about the values of the firms where they’ve been employed. How did they learn these values? Were they written down anywhere? How important is it for a firm to have a set of values? Then we take up the questions. Often, at the end of the discussion, students comment that they like this case because it is the opposite of most of the cases we discuss. Almost all the cases involve bad situations, i.e., ethical lapses. The students like this case because it is so positive. This case shows that positive results—and goodwill—can result from doing good and acting in accordance with stated corporate values. Rather than shelve a drug that otherwise had little commercial value--since those who needed it could not afford it--Merck entered into a partnership with the World Bank, many African countries, and non-governmental developmental organisations (NGDOs) to cure river blindness. While Merck may have shrewdly limited its own risk and financial expenditure, it created a partnership for drug donation that benefits millions of people and is held up as a model for others to emulate. Discussion of ethical issues 1. Pharmaceutical companies have to spend millions of dollars and years of research to find just one successful drug. Merck spent time and money developing and then distributing Mectizan for free. Is it possible for Merck to justify, to its shareholders, making a sizable investment in a product and incurring ongoing costs in the distribution of that product when the product generates no revenue for the company? The donation generates reputational good will for the corporation and the price of that good will, it could be argued, is probably much less than the marketing campaign for other drugs in the company’s stable. (Hanson 2015) The company shows ethical leadership, as well as a strategic acknowledgement of stakeholders other than shareholders in keeping with the company’s values and George Merck’s 1950 comment that “Medicine is for the people...profits follow.” (Merck & Co., Inc. [USA] [n.d.]) Because of the program, the company has “greatly benefited from being seen as a 'good corporate citizen’” and has seen “enhanced employee satisfaction” and, in addition, “The U.S. tax benefits that Merck has received on account of the Mectizan Donation Program have substantially reduced the net financial cost of the program to the company.” (Coyne and Berk [2002], 16) In Merck’s case, the donation keeps on giving…back to Merck as continued publicity over the program... From Merck (2016): In 1994, then-President Jimmy Carter and former Merck Chairman Dr. Roy Vagelos announced a new World Bank grant richard@qwconsultancy.com

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P a g e | 217 program to expand the Mectizan program; in 1995, Merck unveiled a bronze statue of a boy leading a blind old man that symbolizes the fight against river blindness, and the World Bank announced a new 12-year program to fight river blindness using Mectizan; in 1999, Merck and the Gates Foundation each gave $56.5M and joined with Botswana to form the African Comprehensive HIV/AIDS Partnerships (ACHAP); in 2012, the Mectizan Donation Program was 25 years old; and as the case states, in 2015, Dr. William Campbell was awarded the Nobel Prize in Medicine for his work in discovering ivermectins while working for Merck & Co. In case anyone is cynical about the Mectizan donation program, it has “…become a paradigm for successful public-private partnership in the international health arena.” (Coyne and Berk [2002], 26) And, to prevent unwanted or substandard donations, the World Health Organization, together with pharmaceutical companies, and non-governmental developmental organisations (NGDOs), developed core principles of donation that require that product donations (Coyne and Berk [2002]): • • • •

are of maximum benefit to the recipient respect the wishes and authority of the recipient strictly avoid any double standards in quality are based on effective communication between the donor and the recipient.”

Even so, there have been criticisms of the program, for example (Coyne and Berk [2002], 20): • • •

whether the US government should have allowed the tax deductions given to Merck whether Merck or other drug companies would be pressured to provide similar donations (although this is considered to have a net positive benefit) whether drug companies would reduce R&D on tropical drugs if they might expect no revenue from them. Limited R&D may be true, but other sources of funding (e.g., the Gates Foundation) may stimulate more.

2. Did Merck have an ethical obligation to develop and distribute Mectizan for free? While it may have had no legal obligation to distribute the drug for free, the program was in keeping with Merck’s values, and George Merck’s 1950 comment that “Medicine is for the people...profits follow.” (Merck & Co., Inc. [USA] [n.d.]). If shareholders and other stakeholders (such as employees) at the time also believed in those values, then Merck may not have felt resistance from those stakeholders; indeed, good acts may have been expected. Because of its value statements, Merck would have a self-imposed ethical obligation to provide medicine, although with the strategical intention that profits (not necessarily from that program) would follow. With tax breaks offsetting the cost of the program and Merck just providing the drug, but not the costs or logistics of administering it, doing good became very good for the company. 3. Do you think that Roy Vagelos, Merck’s CEO and chairman, demonstrated ethical leadership? What value did it have/create?

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P a g e | 218 Yes! Ethical leadership was demonstrated and showed that the company’s stated values were not just words people wanted to hear, but truly had intention and impact. Even if the company never intended the program to last as long as it has, benefits were likely realized at its start. As stated in the answer to question 1, the company “greatly benefited from being seen as a 'good corporate citizen’” and has seen “enhanced employee satisfaction” and, in addition, “The U.S. tax benefits that Merck has received on account of the Mectizan Donation Program have substantially reduced the net financial cost of the program to the company.” (Coyne and Berk [2002], 16) 4. Based on the river blindness example, how would you describe the organizational culture of Merck in the 1980s? The organizational culture would seem to have been values-based and someone had responsibility for meeting with the World Bank to at least discuss philanthropy and, perhaps, with U.S. federal tax officials to discuss the possibility of tax breaks. Notably, Merck donated Mectizan, rather than just supplying it at a reduced rate. It was this act that made the program exceptionally successful from the point of view of NGDOs who might otherwise have been unable to afford the drug or have been able to distribute it as broadly. “A number of organizational and health-related arrangements, made to suit or reassure Merck…also contributed importantly to the success of the program.” For example, the choice of who would receive the drug deliveries and distribution were not its responsibilities. In addition, “…a system of monitoring adverse effects served to preserve Merck's reputation and limit its risks.” (Coyne and Berk [2002], 22) Finally, “… market and financial features of the program…served to prevent any loss of business for Merck and to minimize or even offset entirely its net expenditures for the program. The human drug distribution did not interfere with Merck's existing or future markets for the well-established veterinary form of the drug. There was also little prospect of a future commercial market for the human form of the drug, as Merck had already discovered at the beginning...Finally, whatever Merck's real manufacturing, administration, and shipping costs were and are, it has taken advantage of U.S. tax deductions to minimize its net costs.” (Coyne and Berk [2002], 22) So the corporate culture of Merck in the 1980s was such that someone realized that some benefits could come from a drug that otherwise had little commercial value on the African continent, since those who needed it there could not afford it. Rather than shelve the drug, Merck entered into a partnership that limited its risk and financial expenditure while benefitting millions of people and creating a template for private/public partnerships in delivering healthcare.

Useful Articles, Links, and Videos Coyne, Philip E., and David W. Berk [2002]. The Mectizan (Ivermectin) Donation Program for Riverblindness as a Paradigm for Pharmaceutical Donation Programs 31570. [Washington, DC]: [World Bank]. Available at http://documents.worldbank.org/curated/en/116611468204860193/The-Mectizanivermectin-Donation-Program-for-Riverblindness-as-a-paradigm-for-pharmaceuticalindustry-donation-programs. richard@qwconsultancy.com

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P a g e | 219 Hanson, Karmen (July 1, 2015). "Marketing and Direct-to-Consumer Advertising (DTCA) of Pharmaceuticals." NSCL: National Conference of State Legislatures, http://www.ncsl.org/research/health/marketing-and-advertising-of-pharmaceuticals.aspx (accessed November 4, 2016). [Link active in 2020, but content is current.] Merck & Co., Inc. [USA]. "Our Values and Standards: The Basis of Our Success [Code of Conduct Edition III]." View Our Code of Conduct (Our Values and Standards). [n.d.]. http://www.msd.com/about/how-we-operate/code-of-conduct/pdfs/OVS_v2_EN-US-CA.pdf (accessed November 4, 2016). Merck. Our History [Timeline]. 2016. https://www.merck.com/about/our-history/home.html (accessed November 4, 2016).

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5. Lululemon’s Questionable Leadership (Chapter 5, pages 317-318) What this case has to offer This case describes what happened to the founder and the CEO after they made several gaffs and the company unintentionally manufactured transparent yoga pants. Teaching suggestions I begin by asking how many students wear Lululemon clothing and why they like Lululemon products. Normally, people talk about: the quality and durability of the products; the fact that they look good; that they’re fashionable; and that they’re comfortable. Then we talk about the importance to the firm of delivering quality products. This makes the discussion more personal because most of the students have Lululemon clothing. Then I ask the students to define some of the responsibilities of the CEO of an organization. Normally, they talk about developing and executing strategy; overseeing the firm’s financial and operational performance; supervising employees and building a culture; managing risks. This help to set the stage for addressing CEO responsibilities when there are product failures. Inflammatory statements by both former owner and Chair Chuck Wilson and CEO Christine Day contributed to Lululemon Athletica’s negative press in 2013. After a company becomes publicly traded, the entrepreneurial founder often finds it difficult to adapt to greater challenges of management and/or accountability, and ends up by leaving. Lululemon is an example of a company that outgrew its founder, but the founder wouldn’t leave. Not leaving resulted in poor corporate governance because of the former owner’s lingering control over the board, voting plurality, and staggered board tenure, which contributed to poor risk management, including poor crisis management and ethical and reputational risk management. The company is also an example of a “first”: the first to make attractive clothes to sweat in. It had/has a cult following, and sold a lifestyle, not just a brand—a characteristic that early competitors lacked. It was also a company that expanded incredibly rapidly, a factor in its operational issues. Discussion of ethical issues 1. Do you think that the executives at Lululemon demonstrated ethical leadership? Could it have been improved? Chip Wilson became a liability—a reputational risk–to his own company, because it outgrew his vision, and his management ability. The company became a feelgood illusion, and cult fashion and yoga place for women. It came to have a “you can do it and look great!” aura, but Chip Wilson may not have understood that. Lululemon is a perfect example of a company that had outgrown its founder-owner. By blaming women’s bodies for the Luon pants problem, Chip Wilson was throwing darts at the illusion*—the bubble that made store “guests” feel special about the clothing. His comments did not live up to hypernorms: they did not show integrity (living up to the company’s perceived values and celebration of health and wellness and feeling better about self), compassion (for all customers and their feelings), responsibility to his retail employees who very much believed in the values aura, his ambassadors, et al. richard@qwconsultancy.com

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P a g e | 221 [*“Competitors were slow to catch on to the fact that Lulu wasn’t selling workout clothes so much as they were selling membership to a club with a very appealing uniform.” (Nelson 2011)] Christine Day increased the number of stores and increased stock value gain 250% year-over-year from 2008 to 2011 (Taylor 2011) before she resigned in 2013, so was in the bad books with loyal Lululemon followers who believed in the company’s manifesto (lululemon athletica 2011): a series of pithy slogans written over its shopping bags, one of which is, “Friends are more important than money.” Christine seemed to be all about making money. And expanding too quickly resulted in a number of operations issues, including colour dye bleeding from pink and red clothing in 2012; transparent pants and pilling and seam problems in 2013; and also intentional product scarcity to increase demand in 2011. (Bhasin 2013) In 2013, Day blamed the transparent pants on the company’s supplier (who claimed the pants were made to specification approved by the company) (Strauss 2013a), and sounded dismissive and lacking responsibility to customers by saying, in effect, that transparency wasn’t seen as a problem until a wearer bent over. (Strauss 2013b) Day seems to ignore the fact that Lululemon had “… [earned] fans not just for its high-end athletic wear but also for its commitment to yoga’s high-minded principles” (Lee 2014) and those fans would expect higher quality control. Blogger “Lululemon Addict” said of Day, “’Day has ruined everything special about Lululemon. The bullet proof quality, the fit, the femininity, the lululemoness of the product…She is a one-trick pony who grew the company through expansion.’” (Business Insider 2013) So Day’s actions did not live up to the hypernorms of fairness or responsibility, since she incorrectly blamed manufacturers for the problem; nor compassion, since she didn’t apologize for causing embarrassment to wearers of the transparent pants; nor predictability, since customers will doubt the quality of Lululemon clothing and the CEO’s veracity. 2. Does a CEO have an ethical responsibility to step down as CEO when there is a production and marketing disaster that requires a product recall? Theoretically speaking, a CEO would not, ethically, need to step down if problems were handled differently than those at Lululemon. The CEO needs to accept responsibility for the problem and apologize to those affected and commit to fixing the problems. The CEO, as a leader, must reflect the values of the company and guide its corporate culture. In the case of Lululemon, however, CEO Day does, ethically, need to step down because she did not act ethically (see question 1) and did not do those things. 3. Does the chair of the board of directors have an ethical responsibility to step down as chair of the board when there is a production and marketing disaster that requires a product recall? Theoretically speaking, a Chair would not, ethically, need to step down if problems were handled differently than those at Lululemon. But in the case of Lululemon, the Chair is part of the problem, and was a reputation risk and did damage to the Lululemon brand. The Chair needs to accept responsibility for the corporate richard@qwconsultancy.com

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P a g e | 222 culture and ethics of a corporation, and must reflect those. In the case of Lululemon, however, Chair Chuck Wilson does need to step down because he did not act ethically (see question #1); he does not understand or relate to how customers view the company; he does not take responsibility for his disparaging comments, nor apologize to customers, and his feeble apology to employees. (Petri 2013) 4. Does the board of directors have an ethical responsibility to reprimand the chair of the board if the chair makes controversial statements and comments to the press? Yes! One of the responsibilities of a board is to imbed hypernorms in the corporate values system (Text, Chapter 5) and to guide corporation into develop and maintain an ethical corporate culture (Text, Chapter 5). It is the responsibility of the board to manage risk, including ethical and reputation risk, and the CEO and Chair at Lululemon both represented reputation and ethical risks. Usually, the board can hire a CEO and Chair; so reprimanding and firing them are also responsibilities. At Lululemon, however, in June 2014, Chair Wilson held nearly 27% of the company shares, and threatened to use that stake to oppose the election of two directors. (Lee 2014) This imbalance in shareholder power may have contributed to Lululemon problems, because it raised obstacles to achieving an independent board able to control Wilson. Ironically, Wilson said he lacked confidence in the board, a PR gaff hours before a shareholder meeting (Friesner 2014).

Useful Articles, Links, and Videos Bhasin, Kim (June 10, 2013). "Christine Day Steps Down as Lululemon CEO." Huffington Post, http://www.huffingtonpost.com/2013/06/10/christine-day-steps-down-lululemonceo_n_3417495.html (accessed November 7, 2016). Business Insider. "Lululemon fanatics call for CEO to be fired after see-through pants blunder." (March 20, 2013). Financial Post, http://business.financialpost.com/businessinsider/lululemon-see-through-pants-recall-ceo (accessed November 7, 2016). Friesner, Zach (June 26, 2014). "It's Time to Look at Lululemon's Corporate Governance Policies." Motley Fool, http://www.fool.com/investing/general/2014/06/26/it-is-time-to-look-atlululemons-corporate-governa.aspx (accessed November 7, 2016). Lee, Adrian (July 11, 2014). "Lululemon boardroom fight part of a corporate culture war: Lululemon isn’t the only company being accused of selling out its principles for short-term gain." Maclean's, http://www.macleans.ca/economy/business/lululemon-a-growing-culture-war/ (accessed November 7, 2016). lululemon athletica. Lululemon manifesto. 2011. http://static.lululemon.com/about/manifesto (accessed November 7, 2016). [Link in 2020 does not give access to 2011 Manifesto. Current Manifesto can be found at https://info.lululemon.com/about/our-story/manifesto.] Nelson, Jacqueline (April 29, 2011). "Loco for Lulu." Canadian Business, http://www.canadianbusiness.com/lifestyle/loco-for-lulu/ (accessed November 7, 2016). Petri, Alexandra (November 12, 2013). "How not to apologize, with Chip Wilson of Lululemon." Washington Post, https://www.washingtonpost.com/blogs/compost/wp/2013/11/12/howrichard@qwconsultancy.com

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P a g e | 223 not-to-apologize-with-chip-wilson-of-lululemon/ (accessed November 7, 2016). [Imbedded video of Wilson's apology.] Strauss, Marina (March 19, 2013a). "Supplier of too-sheer yoga pants insists it stuck to Lululemon design." Globe and Mail, http://www.theglobeandmail.com/globe-investor/supplier-of-toosheer-yoga-pants-insists-it-stuck-to-lululemon-design/article9948948/ (accessed November 7, 2016). — (March 21, 2013b). "Lululemon backs off supplier blame." Globe and Mail, http://www.theglobeandmail.com/globe-investor/lululemon-backs-off-supplierblame/article10053046/ (accessed November 7, 2016). Taylor, Timothy (November 24, 2011). "CEO of the Year: Christine Day of Lululemon." Globe and Mail, http://www.theglobeandmail.com/report-on-business/rob-magazine/ceo-of-theyear-christine-day-of-lululemon/article4252293/ (accessed November 7, 2016).

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Cases on Bribery 6. SNC-Lavalin Missing Funds Topples CEO & Triggers Investigation (Chapter 5, pages 318-319) What this case has to offer The SNC-Lavalin case illuminates the challenges of doing business in many foreign jurisdictions where bribery is the normal practice and many businesses and businesspeople have come to believe that they cannot operate successfully in those jurisdictions without bribing directly or through agents, foreign officials, and many other individuals with influence. Sadly they forget or minimize the bigger picture of: loss of reputation in other jurisdictions, legal prosecution, financial consequences, jail, loss of job, and the diminishment of opportunities to garner business in the future. Perhaps they are unaware of the changing view on the legitimacy of bribery, and the new statutory and enforcement regimes that are coming into place. This case also gives the opportunity for students to understand: (1) the roles expected of executives, the board of directors, and (2) the purpose and function of company policies, and potential shortfalls of circumvention and the omission of key operational considerations such as the duty to report wrongdoing to an effectively placed and mandated representative of the board. Obviously, SNC-Lavalin did not have an ethical tone at the top. Teaching suggestions To get the class thinking about bribery, and to make the subject relevant, I ask if anyone has seen or heard of a case of bribery, and we discuss several of those so that they understand the issues: can business be done without bribes, what is a facilitating payment, are bribes good, etc. I then have a member of class introduce the case details, and then we work through the case questions. These questions provide a platform to discuss what the new legislative and enforcement framework is, and why and how it should be proactively dealt with. Discussion of ethical issues 1. From a governance perspective, what can the Board of Directors do to make sure that the company’s policies and procedure are adequate to ensure ethical and legal conduct by its employees? While the Independent Review (see case) concluded that the company’s codes had provisions identifying bribery as bad, there was no requirement to report bribery to an official who could investigate and whose role included informing the board of directors. The existence of these weaknesses should have been picked up by a periodic review commissioned by the board at an earlier date. However, the board seemed unaware that there was a shift from considering bribery unethical to making it illegal, and that the hardening of concern against bribery would make consideration of old cases of bribery prosecutable retroactively. A periodic review of policies by outside experts would have identified this trend in concern, and would have recommended the institution of a proper reporting and investigation system, reporting to either the Audit Committee of the Board, or the Governance Committee on an ongoing basis. As part of richard@qwconsultancy.com

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P a g e | 225 the system, there should be a system of ethics code training which should have introduced the values of the company, and which should have been supported and reinforced by the CEO and senior executives. It is the responsibility of the board to ensure that the anti-bribery policy of the company is up-to-date and effective as part of their risk management responsibility. The company policy should indicate that consultation is required when an action might be considered unethical or illegal. In addition to the institution of strong policies, the board should ensure that internal audit or some other group is mandated to endure that the policy is being followed, and that problems are being followed up, brought to the attention of the board, and punished. 2. Mr. Aissa and Mr. Duhaime were not demonstrating strong ethical leadership. What can a firm do to improve its ethical tone at the top? A company should screen senior employees for their ethical values as indicated from penetrating questions, reactions to scenarios posed, and reference checks, not only as to their own actions but also with respect to their support for reporting and whistleblowing. Internal audit should report instances to the board where senior executives are not supporting the company policy, and an assessment of ethical performance should be an important component of remuneration and promotion decisions. 3. Is it appropriate for a company to do business in a country with an oppressive regime? Why and why not? It depends upon whether the company’s activities can be conducted in an ethical manner, and whether the support given to the citizenry as a whole outweighs the favourable impact on the oppressive regime. At some stage, it may be ethically responsible to withdraw services from the country if to do so would serve a greater purpose. This was the considered the case during apartheid in South Africa. However, some companies remained in South Africa to do good according to the Sullivan Principles (downloadable at http://www1.umn.edu/humanrts/links/sullivanprinciples.html). The board of directors of a company doing business with a repressive regime must reconsider their involvement on a continuing basis in order to assure it is responsible.

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P a g e | 226 4. If the decision is made to do business in a country with an oppressive regime, what limitations that should be put in place by the company to guide its employees against unethical involvement? There should be an effective statement of policy, plus clear guidelines and rules where necessary. A training session should be undertaken. In any case of uncertainty, a consultation regime should be mandated where employees would have to consult an advisor for direction. To minimize risk taking, actions should be judged by what would be acceptable in the most rigorous jurisdiction the company faces or intends to face in customer or capital markets in the future. Update on charges Useful Articles, Links, and Videos The Fifth Estate (April 3, 2013). “Mission Improbable—Preview [video].” CBC, http://www.youtube.com/watch?v=maYrZc1yVzY&feature=youtu.be Preview of the CBC-TV’s Fifth Estate documentary described in the CBC Media Centre press release, (below), which aired April 5, 2013. For a synopsis of the documentary and link to the video, see CBC Media Centre (April 4, 2013). “On CBC News’ The Fifth Estate: SNC Lavalin’s Gadhafi Connection and One Woman [Cyndy Vanier] Caught in The Middle.” http://www.cbc.ca/mediacentre/press-release/on-cbc-news-the-fifth-estate-snclavalins-gadhafi-connection-and-one-womanNagel, Edward (January 2014). “Taking a bite out of corruption, one bribe at a time.” Chartered Professional Accountants of Canada (CPA): Conversations about Forensic Accounting, accessed at http://www.cica.ca/focus-on-practice-areas/forensicaccounting/conversations-about-forensic-accounting/entries/item77750.aspx on September 23, 2014. [Link not active in 2020.] Though not directly related to SNC-Lavalin, the article discusses the first conviction under legislation under which SNC-Lavalin has been scrutinized. The author of the article discusses “…one of the big stories from 2013-at least from the perspective of forensic and investigative accounting…the first trial and conviction that occurred under the Canadian Corruption of Foreign Public Officials Act (“CFPOA”). The case which is known as R. v. Karigar 2013 ONSC 5199, involved Mr. Nazir Karigar, who in his capacity as an agent for an Ottawa-based technology company, Cryptometrics Canada, was convicted of conspiring to bribe foreign public officials at Air India and India’s Minister of Civil Aviation.”

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7. Rio Tinto’s Bribes in China (Chapter 5, pages 320-321) What this case has to offer Bribery cases often involve a company making illegal payments to government officials in order to land lucrative contracts. Sometimes, however, bribery can be between two or more companies, as it was the case involving Rio Tinto, the Anglo-Australian mineral company, and several Chinese steel companies. Rio Tinto executives received bribes from Chinese steel manufacturers in exchange from giving these steel manufacturers preferential business treatment. Moreover, the same Rio Tinto executives bribed Chinese officials to receive confidential information that led their company to increase the price of iron ore sold to Chinese steelmakers. Teaching suggestions There are several questions related to bribery between companies that may help to start the class discussion, for example: is a bribe between companies the same as a bribe given to a government official, would a bribe given to other company just be “part of doing business, and how is a bribe different from a gift. Finally, it is useful to discuss the importance and benefits of a strong ethical culture to deter unethical behavior. Discussion of ethical issues 1. The culture of giving and receiving payments is ingrained in China. On the other hand accepting and paying bribes is a violation of Rio Tinto’s code of conduct. When does a payment stop being a gift and turn into a bribe? It is sometimes difficult to determine whether a gift is really a bribe. The following questions should help to separate gifts from bribes. •

Is it nominal or substantial?

•

What is the intended purpose?

•

What are the circumstances?

•

Is the person who receives the payment in a position of sensitivity?

•

What is the accepted practice?

•

What is the firm/company policy?

•

Is it legal?

Several of these questions address the issue of whether or not a gift has an intention to “unduly influence” or “obligate” the recipient to reciprocate by giving preferential treatment to the giver. Similarly, Rio Tinto’s Code of Conduct, a document named “The Way We Work” (Rio Tinto 2009), states that: “There are several questions that we should ask ourselves when confronted with a business decision: richard@qwconsultancy.com

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P a g e | 228 •

Is it legal?

•

Are my actions consistent with The Way We Work and associated Rio Tinto policies and standards?

•

Will there be any direct or indirect negative consequences for Rio Tinto?

•

What would my family, friends or neighbours think of my actions?

•

Would I prefer to keep this secret?

•

Would I want my actions reported on the front page of the newspaper?

If you do not feel comfortable with any of the answers, then the best response is not to do it.” Moreover, the company’s Code of Conduct explicitly prohibits bribery: “Rio Tinto prohibits bribery and corruption in all forms, whether direct or indirect. We do not offer, promise, give, demand or accept any undue advantage, whether directly or indirectly, to or from: •

a public official;

•

a political candidate, party or party official;

•

a community leader or other person in a position of public trust; or

•

any private sector employee (including a person who directs or works for a private sector enterprise in any capacity.”

Finally, the company’s policy on gifts and entertainment is: “Gifts and entertainment given and received as a reward or encouragement for preferential treatment are not allowed. In certain circumstances, the giving and receiving of modest gifts and entertainment is perfectly acceptable. A business meal, for example, can provide a relaxed way of exchanging information. Nonetheless, depending on their size, frequency, and the circumstances in which they are given, they may constitute bribes, political payments or undue influence. The key test we must apply is whether gifts or entertainment could be intended, or even be reasonably interpreted, as a reward or encouragement for a favour or preferential treatment. If the answer is yes, they are prohibited under Rio Tinto policy. Exchanges of gifts and entertainment, including the payment of travel expenses, must be in accordance with Rio Tinto’s Business integrity standard.” 2. The smaller Chinese steel companies bribed the Rio Tinto executives because of Rio Tinto’s policy of only dealing with large state-run steel companies. Can a business policy, such as giving priority to only one set of firms, be unethical? Is Rio Tinto ethically responsible for the bribes that were given to its employees because of its policy? A business policy to give preferential treatment to some clients is not necessarily unethical. Nevertheless, the company should think about whether the policy encourages its employees to behave ethically or to behave unethically. Rio Tinto richard@qwconsultancy.com

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P a g e | 229 is responsible not only for having a policy on bribing and a code of conduct, but also for having a comprehensive internal control system. As stated in the OECD recommendations for internal controls, ethics and compliance with anti-bribery regulations (OECD 2010): “Effective internal controls, ethics, and compliance programmes or measures for preventing and detecting foreign bribery should be developed on the basis of a risk assessment addressing the individual circumstances of a company, in particular the foreign bribery risks facing the company (such as its geographical and industrial sector of operation). Such circumstances and risks should be regularly monitored, re-assessed, and adapted as necessary to ensure the continued effectiveness of the company’s internal controls, ethics, and compliance programme or measures.” The company has to be aware that China’s two-tiered system for purchasing iron ore may encourage corruption. While big steel mills are allowed to negotiate long-term fixed price contracts, most small and medium-size steel mills are supposed to buy from the spot market, the more volatile open market. The system creates arbitrage opportunities, allowing big steel mills with fixed contracts to buy far more supplies than they need and then profitably sell excess supplies to smaller mills on the black market. 3. Why were these bribes prosecuted? It is not entirely clear why these bribes were prosecuted. Several Australian officials criticized the detention of the Rio Tinto employees and suggested that Beijing was retaliating against Rio Tinto for calling off a $19.5 billion deal that would have given a Chinese state-owned company, called Chinalco, a large stake in the mining giant. On the other side, the Chinese government argued it was an isolated case of espionage that seriously harmed the country’s economic security and interests.

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P a g e | 230 4. What lessons should be taken from these convictions: a. For foreign governments? Foreign governments should warn their companies and citizens of the business conditions in China, encourage them to behave ethically, and to strengthen their internal controls when dealing with Chinese companies. b. For corporations trading in and with China? Companies trading in and with China should be careful and strengthen their internal controls. Moreover, these companies have to be aware that businesses operate in China under strict control of the government and that political events may influence the way business have to be conducted there. The Rio Tinto case happened shortly after Google decided to pull its search engine out of China. Both cases highlight several issues that foreign companies have to consider when doing business in China. In addition, companies have to be aware that it might be hard to fight against the Chinese government in court. Rio Tinto’s employees were prosecuted largely in closed-door proceedings. The trials appeared to favor the prosecution and deny the defendants due process. c. For individual employees? Employees should be aware that even when they appear to be acting in the best interest of their companies, they may be acting unethically and illegally. If they obtain business opportunities through bribes, then they can face the direct consequences of their actions, without the support of their companies. Initially, Rio Tinto stated that the allegations of bribery of officials at Chinese steel mills were wholly without foundation; however, later on the company blamed the employees and denied any corporate responsibility for the bribes. d. For possible investors in China? Investors in China have to be aware of the potential ethical and reputational issues involved in doing business there. These include dealing with state-controlled entities, corruption, limited civil rights, etc. 5. Should Rio Tinto have been charged? The bribes were given over a number of years from 2003 to 2009. It is hard to believe that the bribes, and particularly the ones paid by Rio Tinto employees, were totally unknown to the company. Although this case might serve as a warning for the company, it seems that the company should also have been punished in this case. Moreover, the company failed to have adequate internal controls to prevent the bribes. Useful Articles, Links, and Videos OECD (2010). Good Practice Guidance on Internal Controls, Ethics, and Compliance. http://www.oecd.org/dataoecd/5/51/44884389.pdf richard@qwconsultancy.com

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P a g e | 231 From the cover: “This Good Practice Guidance was adopted by the OECD Council as an integral part of the Recommendation of the Council for Further Combating Bribery of Foreign Public Officials in International Business Transactions of 26 November 2009.” Rio Tinto (2009). The way we work. Our global code of business conduct. http://www.riotinto.com/documents/The_way_we_work.pdf [Link not active in 2020; document available at https://contractors.kennecott.com/sites/contractors.kennecott.com/files/uploads/The_ way_we_work.pdf.]

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8. Daimler Settles U.S. Bribery Case for $185 Million (Chapter 5, pages 322-324) What this case has to offer This is a good case to discuss the implications from bribery, the need for an ethical culture within a company, the role of whistleblowers in raising red flags about bribery, and the prospect of bribery charges arising from U.S. and U.K. legislation even though the bribery occurred in other jurisdictions. A company employee, David Bazzetta learned in July 2001 at a corporate audit executive committee meeting in Stuttgart Germany, that DaimlerChrysler had secret bank accounts to bribe foreign government officials. As a result, he filed a whistleblower complaint under the U.S. Foreign Corrupt Practices Act (FCPA) that ultimately led to a multiyear investigation of surprising scope and U.S. charges against a company headquartered in Germany, for bribes made to foreign officials around the world. Teaching suggestions I start this case asking students how a bribe can be detected by a company or by the government. Arguably, detecting bribes could be difficult in a large company such as DaimlerChrysler, with worldwide operations, a large number of bank accounts and a complex financial reporting system. In these circumstances, the best possible control is a strong ethics program, discouraging employees to act unethically and giving whistleblowers the means to report these actions within the company. Moreover, the U.S. government incentives to report bribes within the FCPA constitute a strong incentive to report bribery activity outside the U.S. This case also represents a good example of a change in perceptions about bribery, and in the real legal consequences that now can flow from it. This case can foster the discussion about the measures that a company should take to timely react to changes in stakeholders’ expectations about acceptable or ethical business practices. Discussion of ethical issues 1. Apparently Daimler executives were not concerned enough with personal sanctions to change the company’s bribery practices to comply with German and U.S. statutes. How can these attitudes be changed? Daimler executives have to be made aware of the potential consequences of giving a bribe. The U.S. FCPA (q.v.) includes the following sanctions for bribing a foreign official: “CRIMINAL: The following criminal penalties may be imposed for violations of the FCPA's anti-bribery provisions: corporations and other business entities are subject to a fine of up to $2,000,000; officers, directors, stockholders, employees, and agents are subject to a fine of up to $100,000 and imprisonment for up to five years. Moreover, under the Alternative Fines Act, these fines may be actually quite higher -- the actual fine may be up to twice the benefit that the defendant sought to obtain by making the corrupt payment. You should also be aware that fines imposed on individuals may not be paid by their employer or principal. CIVIL: The Attorney General or the SEC, as appropriate, may bring a civil action for a fine of up to $10,000 against any firm as well as any officer, director, richard@qwconsultancy.com

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P a g e | 233 employee, or agent of a firm, or stockholder acting on behalf of the firm, who violates the anti-bribery provisions. In addition, in an SEC enforcement action, the court may impose an additional fine not to exceed the greater of (i) the gross amount of the pecuniary gain to the defendant as a result of the violation, or (ii) a specified dollar limitation. The specified dollar limitations are based on the egregiousness of the violation, ranging from $5,000 to $100,000 for a natural person and $50,000 to $500,000 for any other person [i.e. a corporation]. The Attorney General or the SEC, as appropriate, may also bring a civil action to enjoin any act or practice of a firm whenever it appears that the firm (or an officer, director, employee, agent, or stockholder acting on behalf of the firm) is in violation (or about to be) of the anti-bribery provisions. OTHER GOVERNMENTAL ACTION: Under guidelines issued by the Office of Management and Budget, a person or firm found in violation of the FCPA may be barred from doing business with the Federal government. Indictment alone can lead to suspension of the right to do business with the government. The President has directed that no executive agency shall allow any party to participate in any procurement or non-procurement activity if any agency has debarred, suspended, or otherwise excluded that party from participation in a procurement or nonprocurement activity.” 2. What internal controls could have been usefully introduced to prevent bribery at Daimler? The OECD (OECD 2010) has published a document listing 12 recommendations for internal controls, ethics and compliance with anti-bribery regulations, including: 1. Strong, explicit and visible support and commitment from senior management to the company's internal controls, ethics and compliance programs or measures for preventing and detecting foreign bribery; 2. A clearly articulated and visible corporate policy prohibiting foreign bribery; 3. Compliance with this prohibition and the related internal controls, ethics, and compliance programs or measures is the duty of individuals at all levels of the company; 4. Oversight of ethics and compliance programs or measures regarding foreign bribery, including the authority to report matters directly to independent monitoring bodies such as internal audit committees of boards of directors or of supervisory boards, is the duty of one or more senior corporate officers, with an adequate level of autonomy from management, resources, and authority; 5. Ethics and compliance programs or measures designed to prevent and detect foreign bribery, applicable to all directors, officers, and employees, and applicable to all entities over which a company has effective control, including subsidiaries on the following areas: •

gifts;

•

hospitality, entertainment and expenses;

•

customer travel;

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P a g e | 234 •

political contributions;

•

charitable donations and sponsorships;

•

facilitation payments; and

•

solicitation and extortion;

6. Ethics and compliance programs or measures designed to prevent and detect foreign bribery applicable, where appropriate and subject to contractual arrangements, to third parties such as agents and other intermediaries, consultants, representatives, distributors, contractors and suppliers, consortia, and joint venture partners (hereinafter “business partners”), including the following essential elements: •

Properly documented risk-based due diligence pertaining to the hiring, as well as the appropriate and regular oversight of business partners;

•

Informing business partners of the company’s commitment to abiding by laws on the prohibitions against foreign bribery, and of the company’s ethics and compliance program or measures for preventing and detecting such bribery; and,

•

Seeking a reciprocal commitment from business partners;

7. A system of financial and accounting procedures, including a system of internal controls, reasonably designed to ensure the maintenance of fair and accurate books, records, and accounts, to ensure that they cannot be used for the purpose of foreign bribery or hiding such bribery; 8. Measures designed to ensure periodic communication, and documented training for all levels of the company, on the company’s ethics and compliance program or measures regarding foreign bribery, as well as, where appropriate, for subsidiaries; 9. Appropriate measures to encourage and provide positive support for the observance of ethics and compliance programs or measures against foreign bribery, at all levels of the company;

10. Appropriate disciplinary procedures to address, among other things, violations, at all levels of the company, of laws against foreign bribery, and the company’s ethics and compliance program or measures regarding foreign bribery; 11. Effective measures for: •

Providing guidance and advice to directors, officers, employees, and, where appropriate, business partners, on complying with the company's ethics and compliance program or measures, including when they need urgent advice on difficult situations in foreign jurisdictions;

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P a g e | 235 •

Internal and where possible confidential reporting by, and protection of, directors, officers, employees, and, where appropriate, business partners, not willing to violate professional standards or ethics under instructions or pressure from hierarchical superiors, as well as for directors, officers, employees, and, where appropriate, business partners, willing to report breaches of the law or professional standards or ethics occurring within the company, in good faith and on reasonable grounds; and

•

Undertaking appropriate action in response to such reports;

12. Periodic reviews of the ethics and compliance programs or measures, designed to evaluate and improve their effectiveness in preventing and detecting foreign bribery, taking into account relevant developments in the field, and evolving international and industry standards. 3. What should Dieter Zetsche do to ensure the highest compliance standards? The change of a company’s culture is a long process that takes time and a strong commitment by top management to promote and enforce high ethical standards. It is important to make sure employees at all levels of the company know that bribes and other similar unethical actions will not be tolerated. The recommendations outlined in the answer to the previous question may be a good way to start developing a strong compliance program. Whatever steps Mr. Zetsche takes, he must speak out actively in support of the anti-bribery policy and its enforcement – in other words he must provide strong ethical leadership – or his employees will not take notice of the new policies. 4. Whistleblowers on FCPA matters are eligible for up to 25% of the settlement and/or fine that results depending on a hearing by a tribunal on the import of their evidence (see Chapter 1, page 17 for a discussion of this). How much of the $91.4 million restitution payment would you award David Bazzetta if you could make the decision? Provide your reasons for the choice you advocate. Whistleblowers providing “original information” leading to a successful enforcement action resulting in monetary sanctions exceeding $1,000,000 may be paid between 10 and 30 percent of any money the government collects as a result of the provided information. In this case, if the evidence provided by Mr. Bazzetta becomes central to the prosecution of this case, he deserves the maximum possible award. 5. Did David Bazzetta do what was expected of him as a professional accountant? A professional accountant has the responsibility to not be associated with misleading or false information. Mr. Bazzetta acted ethically in this case; however, it is debatable whether he should have gone public right away or he should have reported this matter within the company first. Mr. Bazzetta could have attempted to reach the Board of Directors before filing a complaint with the U.S. Department of Justice. It may have been a reasonable judgment on his part that, at the time, his internal report would have been ignored, or that he might have been discriminated against or prosecuted. Useful Articles, Links, and Videos richard@qwconsultancy.com

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P a g e | 236 OECD (2011). Bribery in International Business. http://www.oecd.org/document/13/0,3746,en_2649_34855_39884109_1_1_1_1,00.html [Link in 2020 is active. but content is current.] U.S. Department of Justice. Foreign Corrupt Practices Act of 1977 (15 U.S.C. §§ 78dd-1, et seq.) http://www.justice.gov/criminal/fraud/fcpa/docs/fcpa-english.pdf OECD (2010). Good Practice Guidance on Internal Controls, Ethics, and Compliance. http://www.oecd.org/dataoecd/5/51/44884389.pdf U.S. Department of Justice (2011). Lay-Persons’ Guide to FCPA. http://www.justice.gov/criminal/fraud/fcpa/docs/lay-persons-guide.pdf [Link not active in 2020.]

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9. HP Bribery for Russian Contract with Anti-Bribery Prosecutor’s Office (Chapter 5, pages 324-325) What this case has to offer This case describes how Hewlett Packard bribed officials at the government office that is responsible for prosecuting bribery cases in Russia. It is a good case to discuss the implications of giving a bribe in a foreign jurisdiction based on the assumptions that it is OK since everyone is doing it, or that since bribery is OK at the time of the bribe, it not result in charges and/or convictions forever. Teaching suggestions I start this case by asking students how is it possible for a company to bribe a government official without being discovered. This case is interesting because HP tried to bribe officials within the anti-bribery office itself. Furthermore, I discuss whether a company that bribes officials in a given country has to worry about penalties in its home country. The Daimler’s Settles U.S. Bribery Case for $185 million Case is a useful companion case on this matter. Also, the new U.K. Bribery Act includes an extra-territorial reach. Discussion of ethical issues 1. Why would HP bribe think they could get away with bribing an employee in the Russian antibribery prosecutor’s office? There could be several reasons, for example: •

HP used several bank accounts and indirect money transfers that would make difficult to trace back the money to HP;

•

The bribe could have been masked as a legitimate payment; and,

•

HP’s executives may have thought that the Russian authorities were so corrupt that they would never be prosecuted in Russia, without considering that they were subject to the Foreign Corrupt Practices Act (FCPA).

•

Actually, under German law HP could not be charged, so senior officials may have induced other employees to bribe to benefit the company thinking erroneously that problems, if any, would fall on the individual, not HP.

2. Why was it done through a series of companies in different countries? It was done in that way to try to make it difficult to trace the money back to HP and probe that these payments were bribes. 3. What has changed to now allow investigators to unravel such a series, whereas in the past they would have found it almost impossible? The following changes have enabled the prosecution under the FCPA: •

On November 21, 1997, the 29 member nations of the Organization for Economic Cooperation and Development ("OECD") and five non-member nations adopted the "Convention on Combating Bribery of Foreign Public

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P a g e | 238 Officials in International Business Transactions." The OECD Convention, which was signed on December 17, 1997, and ratified by the U.S. Senate on July 1, 1998, sets forth the essential elements of a Foreign Corrupt Practices statute that each country should enact into a law. •

New whistleblower provisions will motivate insiders to provide evidence aiding the prosecutors. Whistleblowers providing “original information” leading to a successful enforcement action resulting in monetary sanctions exceeding $1,000,000 may be paid between 10 and 30 percent of any money the government collects as a result of the provided information. Whistleblowers will also be paid if their information leads to successful “related actions,” i.e., administrative or judicial actions brought by other agencies, including the U.S. Department of Justice, federal and state regulatory authorities, and foreign law enforcement agencies.

•

The passage of the International Money Laundering Abatement and Anti-terrorist Financing Act of 2001 has made international money transfers more transparent to regulators and easier to trace back to the original source.

4. If a company decides to bribe, how many years need to go by so that they are safe from prosecution? The violations to the FCPA can be prosecuted anytime, regardless of the number of years that have passed since the bribe was given. Moreover, if a company acquires another company, the parent company is responsible for the past actions of the acquired company. 5. Even though German law does not allow companies to be charged, what are the possible consequences of the alleged bribery for HP? HP may face the following consequences: •

Loss of reputation and future government contracts in Germany and other countries;

•

Increased time dealing with regulators in several jurisdictions as this incident may cause other similar investigations; and,

•

Possible prosecution in the U.S. under the FCPA.

Useful Articles, Links, and Videos OECD (2011). Bribery in International Business. http://www.oecd.org/document/13/0,3746,en_2649_34855_39884109_1_1_1_1,00.html [Link in 2020 is active. but content is current.] U.S. Department of Justice. Foreign Corrupt Practices Act of 1977 (15 U.S.C. §§ 78dd-1, et seq.) http://www.justice.gov/criminal/fraud/fcpa/docs/fcpa-english.pdf

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Cases on Corporate Governance & Managerial Opportunism 10. Spying on HP Directors (Chapter 5, pages 325-328) What this case has to offer This is a good case to discuss the ethical implications from obtaining and using information from the company’s employees in general. It also illustrates the perils of conducting secret investigations of board members. In addition, the HP case highlights the importance of ethical guidance for the board of directors and the need for limits to the power of the chairman of the board. The board of directors exists to monitor management and it is appointed to act in the best interest of the company’s shareholders. Nevertheless, there are few internal mechanisms that are needed to ensure the proper functioning of the board. On one side, it was the responsibility of the chair to investigate the origin of the leak of confidential information and keep the investigation secret in order to discover the person who was leaking the information; however, on the other side the investigation should have been conducted within ethical and legal boundaries. On September, 2006 the press revealed that the chairwoman of Hewlett-Packard (HP), Patricia Dunn, had hired a team of independent electronic-security experts that later spied on HP board members and several journalists, to determine the source of leak of confidential details regarding HP's long-term strategy in January, 2006. The independent consultant obtained phone call records of HP board members and nine journalists, including reporters for CNET, The New York Times, and The Wall Street Journal using an unethical and possibly illegal practice known as pretexting. Patricia Dunn claimed she did not know the methods the investigators used to determine the source of the leak and resigned after the scandal. George Keyworth, the director responsible for the leak, resigned from HP’s board after 21 years of service. Teaching suggestions I start the class asking the students who should be in charge of monitoring the CEO, and then follow up by asking who should monitor the board of directors, and how? This sets up the questions at the end of the case for further discussion in order. Discussion of ethical issues 1. Should the chair of the board of directors be allowed to initiate investigations into weaknesses in a company’s internal control systems? The investigation of internal control weaknesses is usually a management function; however, as stated in the COSO integrated framework “Management is accountable to the board of directors, which provides governance, guidance and oversight. A strong, active board, particularly when coupled with effective upward communications channels and capable financial, legal and internal audit functions, is often best able to identify and correct such a problem.” The provisions of SOX Section 302 require CEOs and CFOs to certify that they are responsible for internal controls and have evaluated the company’s internal controls. Nonetheless, in this case it seems that the chair had the responsibility to richard@qwconsultancy.com

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P a g e | 240 investigate the leak of strategic information given that some of the suspects were members of the board of directors. Under the circumstances, it would have been prudent for Ms. Dunn to share her plan with the Executive Committee of the board and get their guidance and blessing. 2. Is the strategy of pretexting an acceptable means in order to obtain critical information that will strengthen a company’s internal control system? The legal opinion given to HP on pretexting is a masterpiece of doubletalk, and of little value. As it turned out, using pretexting is/was definitely not acceptable from several different points of view: •

It involves misrepresentation designed to get information by deceit, which is quite unethical as it is unfair and violates the rights of the subjects involved.

•

Patricia Dunn herself recognized in her resignation letter (Chapter 5, page 327 in the case) that “The unauthorized disclosure of confidential information was a serious violation of our code of conduct”;

•

HP settled a State lawsuit paying $14.5 million in fines and promising to improve its corporate governance practices;

•

HP agreed to a financial settlement with The New York Times and three BusinessWeek magazine journalists; and,

•

Pretexting invades privacy and is a questionable practice involving the impersonation of somebody in order to trick phone companies into handing over the calling records of that person’s personal phone accounts.

3. Should the reasons for resignations from a board of directors always be made public? In general, a policy of transparency and full disclosure should be in the best interest of the company’s shareholders. Without complete information it would not be possible for shareholders to effectively monitor agency problems within the company. Some people may disagree with this position and could argue that shareholders would be worse off if information that impacts stock prices negatively is made public. In this case, HP made Perkins resignation public without disclosing the reasons for his departure. HP reported Perkins’ resignation to the SEC four days later, again giving no reason for his resignation. In practice, most resignations are accompanied by boilerplate statements that are uninformative to the public; however, in a full disclosure environment, the impact of full disclosure on director’s reputation should be an incentive to act in the best interest of the company’s shareholders. Useful Articles, Links, and Videos “HP’s Boardroom Drama” (May 8, 2007). CNET News Special Coverage, http://news.cnet.com/HPs-boardroom-drama/2009-1014_3-6112817.html To access the article, use the search feature on the website. This website provides current and previous coverage. At the time of the issue, coverage was provided on the internal investigation into media leaks at HP. It provided links to the legal investigation and highlights congressional hearings, press conferences, commentary and video footage across the scandal. richard@qwconsultancy.com

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P a g e | 241 Committee of Sponsoring Organizations of the Treadway Commission (COSO). (2004). “Enterprise Risk Management —Integrated Framework.” http://www.coso.org/guidance.htm [Link in 2020 is active, but content is current. The 2004 document is available at https://www.coso.org/Documents/COSO-ERM-Executive-Summary.pdf. ] “Feds charge investigator in H-P boardroom case.” (Jan 11, 2007). Market Watch, http://www.marketwatch.com/story/feds-charge-investigator-in-h-p-pretexting-case [Link not active in 2020. Article is accessible at https://www.marketwatch.com/story/guid/09b86183-1c6f-4197-8ef1-aced2cb92a67. ] Helft, Miguel (September 30, 2006). “H.P. Read Instant Messages of Reporter.” New York Times, http://query.nytimes.com/gst/fullpage.html?res=9D04E0DB1730F933A0575AC0A9609C 8B63&sec=&spon=&pagewanted=1 Hewlett-Packard (September 22, 2006). “News release: Patricia Dunn Resigns from HP Board.” http://www.hp.com/hpinfo/newsroom/press/2006/060922a.html [Link in 2020 active, but content is current.] Hewlett-Packard (September 12, 2006). “News release: George Keyworth Resigns as HP Director.” http://www.hp.com/hpinfo/newsroom/press/2006/060912b.html [Link not active in 2020. News release is accessible at http://www.nytimes.com/packages/pdf/business/20060913_HEWLETT/gp_keyworth.pdf .]

richard@qwconsultancy.com

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11.Lord Conrad Black’s Fiduciary Duty? (Chapter 5, pages 328-332) What this case has to offer This is an excellent case to discuss: •

the conflicts of interest risks arising when management or a dominant owner has effective control of a public company, and

•

appropriate governance controls needed to safeguard the interests of other shareholders and stakeholders.

Conrad Black effectively controlled Hollinger International, Inc. without a majority of the corporation’s equity, through special Class B shares that carried a 10-1 voting preference over class A Shares. Using his controlling privileges, Conrad Black and other executives obtained from Hollinger payments alleged to be self-dealing without fully and properly informing the board of directors whom he had personally selected. The case highlights the importance of an independent, objective, courageous board of directors, with active and knowledgeable committees (i.e. audit, compensation and corporate governance). It provides an opportunity to discuss ethical decision-making when a legal transaction might be ethically dubious. It also highlights the importance of the fiduciary duty owed to the company – to all shareholders, not just a select few – by managers and directors, acting as trustees of the shareholders’ wealth. Teaching suggestions To start out, students can be asked three central questions on corporate governance: •

why companies have a board of directors,

•

who should appoint the members of the board, and

•

what is the duty that these members owe to the company’s shareholders?

One of the board’s most important roles is to oversee the company’s management for the good of the company (on behalf of all the shareholders). Otherwise, managers will be tempted to line their own pockets as did Black and misrepresent facts and earnings to suit their own interests. Since it is rare that anyone can effectively monitor themselves, there needs to be a separation of management from ownership. It is not surprising, therefore, that boards of directors have the following basic objectives, as well as several others: •

To ratify management’s strategies and monitor their performance and progress;

•

To hire, fire and compensate management; and,

•

To ensure that complete and accurate information to assess the company’s performance is publicly disclosed.

The students can then be asked what problems may arise if the selection of directors is left to the discretion of the parties whose behavior the board is supposed to monitor, especially when the company is controlled by a small group of investors that also hold executive positions in the organization.

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P a g e | 243 The details of the case can then be reviewed, questioning the role of the board in authorizing management’s regular compensation and one-time payments. Finally, it is useful to ask if all forms of management’s compensation authorized by the board of directors, even when perfectly legal, are ethical and in the best interest of the company’s shareholders. Discussion of ethical issues 1. What conflicts of interest may have been involved in Black’s activities? Conrad Black was, through a structure of holding companies, the controlling shareholder of Hollinger International Inc. even though he did not own the majority of the corporation’s total equity. Black’s potential conflicts of interest included: •

with a partner, he negotiated deals selling company-owned newspapers to other entities but included non-competition payments directly to himself and other executives.

•

paid personal expenses and bought an apartment with company’s money.

•

selected the members of the board of directors, who were supposed to oversee his activities.

The conflicts of interest are evident. Black was CEO of the company, controlling shareholder without a majority of shares, and the person in charge of appointing members of the board. He could and did choose people who were his friends or admirers, or who were unlikely to challenge him objectively and independently. 2. Were Black’s non-compete agreements and payments unethical and/or illegal? These payments seem to be on the borderline of legality. If the board of directors approved the payments (there is some doubt about the quality of information provided them) and Conrad Black is able to prove that he did not conceal self-dealing causing damages to other shareholders, the payments might be deemed legal. [In fact, he was convicted on some, but not all of the deals. Even if the payments are considered legal, they are unethical. Black was receiving remuneration as CEO of the company selling the newspapers and should be acting in its best interests. All proceeds of the sale should have gone to Hollinger unless the directors knowingly approved a change in his remuneration. The fact that he and his partner wanted to be paid for not personally competing with the newly sold newspaper conflicts with their role as officers of Hollinger. They should have been acting in the interest of the company, not of themselves. If the company buying the newspapers wanted personal protection from Black and his partner, that should have been a separately negotiated contract.22 By including the non-compete payments, the rights of other shareholders were negatively affected, and since the disclosure to the board was not timely or transparent, the interests of the board and other shareholders were dealt with unfairly. While it is possible to argue that Black and his partners were shareholders, 22

In fact, two of the three fraud convictions were in cases where the buyers first refused to pay Black and his partner, but were coerced to do so in order to make the deal go through. The third conviction was for a case (if you can believe it) where Black and his partner arranged the sale of a newspaper to themselves, but decided to include non-compete payments to themselves in the deal so that they wouldn’t compete later with themselves.

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P a g e | 244 so they were in a sense short-changing themselves, that argument overlooks the injustice done to the other shareholders who did not receive direct payments. Black and his partners were clearly self-dealing. He appears to have had the perspective that he built the company and could do what he liked with it and its resources. While this may be fine if he was the sole owner, when equity is raised from public shareholders, their interests need to be recognized and protected. 3. What questions should have been asked by International’s directors? Directors should act in the best interest of all the company – of all its shareholders. They should have: •

discovered the non-competition payments and other expenses,

•

asked how they could possibly increase the overall company’s value,

•

ensured that the company’s internal auditors should have been reporting to the Audit Committee on these issues,

•

verified that that non-compete payments were actually received by Hollinger International, or have arranged for internal auditors or counsels to do so, and

•

if reporting on the non-compete agreement payments was opaque, the directors should have demanded a full and transparent accounting.

Obviously, the directors were used to leaving such matters to Black and his managers, and did not exercise independent and objective judgment, or have the courage to confront Black. 4. If the boards of directors of his various companies approved these non-compete agreements, are the board members on the hook and Black off? Not necessarily. The directors’ liability will depend on the kind and quality of information they received from Black and how they validated such information in approving the non-competition fees. Directors can raise a "good faith reliance" defense to many of the liabilities to which they are subject. This defense allows directors to point to a reliable source of information as justification for their actions. However, it does not permit them, in the absence of that specific justification, to show that they acted reasonably. Therefore, it is not clear if the directors will be completely responsible, thus leaving Black free of guilt. Conrad Black can still be charged if the non-controlling shareholders can prove that he breached fiduciary duties owed to Hollinger by him as an employee through unfair use of the company’s assets. It is also important to note that several provisions in securities legislation are intended to protect minority shareholders from executive managers’ self-dealing. Definitely, he can be still “on the hook” for these payments. 5. Black controlled key companies through multiple voting rights attached to less than a majority of shares. Was this illegal and/or unethical? Differences in voting rights and shareholding structures are common practice in public companies. This practice is not illegal, provided it is properly disclosed.

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P a g e | 245 Public companies are usually subject to the Market for Corporate Control Principle. Stockholders have no loyalty to incumbent managers and, if the wish, they can usually chose to sell their shares in a given company at the market price at any point in time. This sale will drive the stock price down, attracting potential buyers and eventually cause a corporate takeover leading to changes in executive management. However, when the primary controlling shareholder is also the top executive, the market for corporate control might not be effective enough to dislodge him. It is then the responsibility of the board of directors to act for all shareholders with independence and objectivity in overseeing management’s performance. However, it would be unethical, and perhaps illegal in some cases, for a controlling shareholder to use such majority voting rights to appoint the members of the board who are not likely to represent all shareholders. Unfortunately, it has been known to happen, and is a governance flaw that investors must consider prior to purchasing shares in such a company. 6. What risk management techniques would have prevented Black’s potential conflicts from becoming harmful?

A strong control environment constitutes the most pervasive means to deter fraud. An appropriate control environment includes a culture of ethical values such as integrity, honesty, fair-dealing, and competence; as well as a management philosophy and operating style that reflects those values, and the reinforcing oversight, attention and direction provided by a supportive board of directors. The awareness of company personnel, and internal controls that correspond to this culture should provide reasonable assurance that fraud will be prevented or detected. Some elements of the control structure that might prevent or early detect conflicts of interest include legal, accounting, and internal audit departments, as well as an independent board of directors. The legal department, or office of the general counsel, typically plays a key role in reviewing disclosure documents for compliance with applicable laws and regulations. The internal audit function performs a supervisory function within the company to examine, analyze, and make recommendations on matters affecting the company's internal controls. The audit committee of the board of directors has a responsibility to the company's shareholders to oversee management's performance. Subsequent events On December 10, 2007, Judge Amy J. St. Eve of United States District Court sentenced Lord Black to six and a half years in prison on three fraud charges involving self-dealing, noncompete payments and one charge of obstruction of justice for removing 13 boxes of documents from the Toronto offices of Hollinger International. Instead of keeping a low profile after his conviction, Mr. Black became even more voluble. He managed to publish and publicize a 1,152-page biography, “Richard M. Nixon: A Life in Full”. He spends his time in a Florida penitentiary teaching history to overflow classes of inmates, and writing newspaper columns.

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P a g e | 246 Useful Articles, Links, and Videos Heritage Institute (2007, 2008). “Conrad Black Trial Background.” http://www.heritageinstitute.com/governance/black/background.htm This website provides information under many headings, including: accusations, criminal charges, the trial and the trial in depth. The Heritage institute also provides a link to a report from the internal committee at Hollinger that initially accused Black and his partner David Radler of operating a "corporate kleptocracy" and allegedly stealing more than $400 million from the corporation. Waldie, Paul (July 23, 2010). “Black can’t return to Canada yet.” Globe and Mail, https://www.theglobeandmail.com/report-on-business/black-cant-return-to-canadayet/article1318571/ “Conrad Black Trial Excerpts.” (March 21, 2007). CBC News In-Depth Coverage, http://www.cbc.ca/news/background/black_conrad/trial-excerpts-cramer.html [No longer available in 2017.] “Conrad Black: Where did it all go wrong?” (Feb. 27, 2004). BBC World News, http://news.bbc.co.uk/2/hi/business/3276689.stm

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12.Manipulation of MCI’s Allowance for Doubtful Accountants (Chapter 5, pages 332-333) What this case has to offer This case illustrates the problems an employee can get into when the firm develops a high-paced culture of growth at any cost and will not tolerate any dissention, even if the dissenting opinion is the voice of reason and prudence. It also illustrates that employees must have the courage to be forthright when communicating bad news to their superiors. Teaching suggestions I would suggest that students in the class outline generally accepted accounting principles with respect to accounts receivable. Any student who has audit experience can explain the steps that auditors follow in order to satisfy themselves that the net accounts receivable and the bad debt expense are reasonably stated. Generally accepted accounting principles require that accounts receivable be stated at the amount that will ultimately be collected. This is the gross amount, less the allowance for doubtful accounts. Although the true allowance cannot be predicted in advance, a reasonable provision can be estimated based on the available facts. These would include: •

the firm’s credit policy,

•

the age of the outstanding accounts, and

•

the history of collection and write-off rates over a number of periods.

In the case of MCI, the credit policies were too lenient, and had not been reviewed or changed as a result of economic conditions and sales volumes. The aging was being artificially manipulated because there were inadequate internal controls to prevent Walt Pavlo and his team from: •

converting delinquent accounts receivable to promissory notes,

•

accepting common stock instead of cash, and

•

lapping payments. Discussion of ethical issues

1. After being told that the guideline for bad debts for 1996 was $15 million, what should Walt do? Walt should have been more forceful in his presentation to his boss. If his boss would not acknowledge the problem, then he should follow the chain of command and report the issue to his boss’ boss. At the extreme, if all else fails, then Walt should consider becoming a whistle-blower. He should raise the issue directly to the audit committee or to the auditors. The consequences of this could be dire, but not as severe as the $150 million write-off that MCI eventually recorded after it was taken over by WorldCom. By accepting the $15 million guideline, Walt contributed to his own downfall and eventual penitentiary sentence. 2. What are the risks for MCI in setting an unrealistic allowance for doubtful accounts? richard@qwconsultancy.com

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P a g e | 248 The allowance is simply today’s estimate of the amount of receivables that will not be collected in the future. The actual amount of the uncollectibles remains the same, regardless of the amount of the estimate. So, by setting the allowance too low, the firm is simply pretending that a further loss recognition problem does not exist. The firm can bury its head in the sand, but the reality of the uncollectibles will become apparent when the firm does not receive the cash from those customers in later periods. The major risk of not having a reasonable allowance is that a controllable problem can go unchecked and thereby increase to become a major issue. In the case of MCI, approximately $180 million was not going to be received (this is the amount of the eventual write-down). But setting the allowance at only $15 million the firm was not being honest with itself nor its investors. The problem was not being acknowledged and therefore not being addressed on a timely basis. If investors and/or the government believe that the firm deliberately overstated net income by understating the bad debt expense by understating the allowance for doubtful accounts, then the firm can be sued for fraudulent financial reporting.

richard@qwconsultancy.com

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P a g e | 249

13.Stock Options and Gifts of Publicly Traded Shares (Chapter 5, pages

333-334) What this case has to offer This allows the students to discuss a variety of issues, including: •

when does the exercise of CEO discretionary power become opportunistic,

•

the ethics of a variation of the classic pump and dump strategy, the scheme whereby an investor will artificially increase a firm’s stock price with false or misleading information, in order for the investor to sell a price much higher than the purchase price of the shares, and

•

the professional and fiduciary responsibilities of accountants working within an organization. Teaching suggestions

This is a good opportunity to review the major ethical theories and apply them to corporate charitable donations, redirecting donations to stem cell research and managerial opportunism. Utilitarianism. Currently Revel Technologies donates to a variety of charities. Moving the funds from many charities to only one charity may not be of the greatest benefit to the largest number of people. However, this argument implies that the social benefits of the recipient agencies can be measured. Students should be asked why they think that a cure for MLD will not result in other benefits to society, greater than perhaps the benefits of curing cancer. It is important to stress with the students that utilitarianism is a simple theory to articulate but is very difficult to measure social costs and benefits. Deontology. This theory argues that we should not treat others as means to our personal ends. Is redirecting donations, to a charity that the CEO has a personal interest in, using Revel Technologies as a means to the personal goal of the CEO? Does it violate the principles of justice and fairness that the CEO is allowed to make arbitrary decisions? On the other hand, if the shareholders are prepared to have Revel Technologies make charitable donations, then it may not matter to them where the donations are directed, as long as they go to legitimate charities. As such, the redirection does not violate any understanding that the shareholders have with the organization. Virtue Ethics. Many people have strong views on the subject of stem cell research. Is it acting virtuously to allocate funds to a form of research that may be contrary to the religious convictions of some of the firm’s shareholders? If the firm is adopting a more holistic approach, should they be balancing their donations based on the religious and social attitudes of their relevant stakeholder groups? Discussion of ethical issues 1. Is it right that a CEO can direct the charitable donations of his company to the charity of his choice? There is a separation between ownership and control. The shareholders own the firm, but they delegate running the business to the CEO. As such, the shareholders give richard@qwconsultancy.com

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P a g e | 250 a great deal of discretionary power to the CEO to run the business as the CEO sees fit. The CEO in turn reports to the board of directors who must assess whether the CEO has, in fact, been acting in the best interest of the shareholders. The board is to assist in strategic planning and providing advice and counsel on critical issues. They leave the rest of the decision-making to the CEO. As long as the CEO does not use this discretionary power opportunistically, then there is no problem. A problem only occurs when the CEO makes choices that are in the best interests of the CEO and that may not be in the best interests of the firm. In this case, is re-directing donations opportunistic or not? 2. Comment on the ethical aspects of Pierre’s stock option/stock donation strategy. There are two different strategies in this case: one quite legal and the other unethical, and perhaps illegal. Stock Donations Many wealthy CEOs have little surplus cash, but quite a lot of very valuable, in the money, stock options. Many charities receive large gifts from wealthy business executives. However, the charities were concerned that their cash receipts might decrease because these executives did not have a lot of surplus cash. The Canada Revenue Agency plan created a win/win scenario. An executive can exercise stock options without incurring any capital gains tax as long as the executive donated the shares to a registered charity. The executive would also receive a tax receipt for the amount of the donation. The charity would receive common stock in a publicly traded company that the charity could immediately sell for cash or hold and receive dividend revenue. So, this was a win/win situation. The charity receives a marketable asset and the taxpayer claims a charitable deduction for tax purposes. Pump and Dump Strategy The pump and dump strategy involves artificially inflating the price of a stock, normally by releasing false information (pump), in order to be able to sell the stock (dump) at a price higher than the initial purchase price. This case is a reverse of the technique. By withholding the release of the financial statements that contain bad news, Pierre is artificially keeping the stock price at $19, higher than it would be if the investors knew the bad news. He will only release the bad news after he donates his stock to the charity and receives a tax receipt at the artificially high price of $19. Then the financial statements will be released and the stock will drop to about $17. Pump and dump is an unethical strategy because it capitalizes on information asymmetry. Pierre has information that is useful to the marketplace, but he withholds that information for personal gain. Pierre is using his insider information to take advantage of all the other investors. As such he is acting opportunistically, using the other investors as a means to his own personal advantage. 3. If you were Gloria, what should you do? Would you change if you were a donations specialist, a lawyer, or a professional accountant? As a professional accountant, Gloria cannot be associated with any information that is false or misleading. She may consider that delaying the release of the financial richard@qwconsultancy.com

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P a g e | 251 statements is misleading to the other investors on the basis that if they had that information then the stock would be trading at the $17 level rather than the current $19 level. If so, then she has a professional responsibility not to go along with Pierre’s schemes, and instead to report her concerns to the audit committee, or to the board of directors. If Gloria is in-house counsel, then as a lawyer she has a fiduciary responsibility to look out for the best interests of the firm, which may not necessarily be the best interests of her boss. In this case, Gloria should raise her legal concerns with Pierre. If that does not convince him to eschew the strategy, then she should report her concerns to the board of directors. As a loyal employee Gloria has a duty as the donations officer to adhere to both her job description and the requests of her superior. One of the functions of a job description and standard operating procedures is to protect employees from doing questionable actions. Gloria should, once again, remind Pierre that Revel Technologies has standard operating procedures, and that if he wants the donations to be re-directed then he should make that request to the donation committee, not to her. If this does not work, then she should follow the chain of command, and report the issue to the donation committee. The committee has the responsibility for deciding whether or not they concur with Pierre.

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14. The Ethics of Repricing and Backdating of Employee Stock Options (Chapter 5, pages 335-336) What this case has to offer This is a good case for addressing agency theory, executive compensation and stock options. Given that, for many executives, there is a huge discrepancy between their cash compensation and the stock options they receive, it is important for students to understand that when cash, bonuses and stock options lose their proportionality, they may no longer be strong motivation techniques for enhancing the long-term value of the firm. Teaching suggestions Consider bringing in a chart with the names of the highest paid executives, the amount of their cash compensation, their bonuses, their stock options and their total pay. These data are available from many periodicals, including Forbes, Business Week, and the Report on Business. The following data are from USA Today on the 10 highest paid executives in 2007. Na

me Thain

L. Moonves R. Adkerson L. Ellison B. Simpson L. Blankfein K. Chenault J. Mack G. Murphy E. Breen

ny Lynch

Compa Merrill

Sala ry 0

Bon us 15.0

Optio ns 68.0

CBS

5.3

18.5

43.5

2.1

5.4

55.0

1.0

8.4

50.1

1.3

35.5

19.5

0.6

27.0

26.0

1.2

6.5

41.3

0.8

40.2

0.8

2.2

35.8

1.6

3.2

28.3

Freepor t-McMoRan Oracle Energy

XTO

Goldma n Sachs Americ an Express Morgan Stanley Gap Tyco

Tot al 83. 1 67. 6 65. 2 61. 2 56. 6 54. 0 50. 1 41. 4 39. 1 34. 1

(http://www.usatoday.com/money/companies/management/2009-02-05-executivecompensation-2007_N.htm)

After reviewing the table, there can be a general discussion about compensation, its form and its purposes. Compensation can be given through salary, bonuses, stock options, allowances and non-pecuniary perks such as vacation time, and large offices with large staffs. Compensation is used to hire and acquire employees, to motivate them, to reward them for good performance, and to punish them for poor performance. The problem with compensation is untangling the relationship between each part of compensation and the various purposes. richard@qwconsultancy.com

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P a g e | 253 Salary is used to acquire people, but does it motivate them to work hard? Is a bonus a reward for past performance, or a motivation for future performance? The students should realize that the term ‘compensation’ is multifaceted and multilayered. Next, consider discussing the fundamentals of agency theory. There is a separation between ownership and control. Those who own the firm want a reasonable return on their investment, but they do not want to operate the firm. Management is hired to operate the firm and is paid compensation to do so. However, the interests of management may not be aligned with the interests of the investors. Management may not want to take risks on behalf of the investors lest the risky venture fails, and the manager is fired. So, compensation schemes are set up to align the interest of the manager with the investors by giving the manager an ownership interest in the firm through stock options. Because they are now owners of the firm, their interest should be aligned. This is the basic rationale of agency theory. Discussion of important issues 1. Do you think that stock options actually motivate employees to work for the long-term good of the company? Stock options are an attempt to align the interest of managers with those of the investors. Investors are interested in a reasonable return on their investment; as result, they are risk takers. Managers are assumed to be interested in compensation and are risk averse. Stock options allow the manager to acquire an ownership interest in the firm. By having an ownership interest in the firm, the manager should be inclined to adopt an investor perspective, i.e. the manager should work towards having the stock price increase thereby generating a reasonable return for both the investor and the manager. So, according to agency theory, stock options should align the interests of the manager with those of the investor. The premise is that investors have a long-term perspective. However, if management can exercise their stock options and then immediately sell their shares, then management may have only a short-term perspective. As such, management may make decisions that have only a short-term advantage, but no long-term benefit of the firm and the investors. Furthermore, if management is risk averse, then managers would not want to hold shares in only one company. Instead they would want a diversified portfolio, in order to minimize their portfolio risk. This also contributes to short-term thinking by the manager. The manager exercises the stock options to receive enough money to buy a long-term diversified investment portfolio. 2. Do you think that stock options inadvertently encourage manager to engage in questionable accounting activities, such as earnings management, to artificially increase the company’s net income and thereby the value of the executives’ stock options? Stock options are a means of transferring risk onto the manager. Managers will take on risky projects so as to increase net income and have the stock price rise. As the stock price increases, the value of the options increase. When the options are exercised and the shares are then sold, the manager receives cash, an indirect form of compensation. Managers know that if the risks they take on behalf of the investor fail, then they will probably be fired, and receive no more compensation. Since managers

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P a g e | 254 normally have a short-term orientation, and they fear losing their compensation, this encourages many managers to engage in earnings management. Earnings management is a technique to artificially increase net income, and hopefully stock price, through accounting and operational strategies. For example, management may artificially increase earnings by changing the allowance for doubtful accounts, the inventory obsolescence reserve, the estimated warranty provision and/or a pension cost estimates. None of these strategies alters cash flows but they do alter reported earnings. Other strategies, that will alter cash flows, include changing credit terms and approvals, shipping goods before they are ordered, altering the level of research and development and/or reducing advertising expenditures. All of these are designed to reduce expenses, increase net income and increase stock price so that the stock options become more valuable to the manager. The students can then discuss the pros and cons of each strategy. Some aspects of the accounting strategies include the following. •

Net income is altered without changing cash flows.

•

Accounting estimates reverse in the next period, so the strategies are normally short-term.

•

These accounting estimates are not disclosed in the financial statements, and so they are not readily apparent to the investor. Aspects of the cash flow strategies include the following.

•

Net income is reduced, and short-term cash is saved.

•

These strategies may have a long-term detrimental effect because important activities such as R&D and advertising are reduced or eliminated.

3. Do you agree or disagree with the four ethical arguments summarized above and contained in more detail in the article by Raiborn et al.? Explain why. 4. Should a board of directors approve repricing or backdating stock options for outstanding executives whose current stock options are underwater due to uncontrollable economic factors, and who will be lured away unless some incentives to stay are created? What other incentives might work? Stock options are a means of transferring risk onto the manager, and risk means that there is the possibility of both success and failure. If the firm is unsuccessful, then net income falls as does the stock. In this situation the investor has lost money and the value of manager’s options fall and may be underwater (below the strike price). If the manager can have the options rewritten, so that they are no longer out of the money, then the manager has won while the investor has lost. This is not fair. If both parties are at risk, then they should both reap the benefits when the venture succeeds, and both share the losses when it fails. To do otherwise is not treating equals equally. Stock options are a form of executive compensation. Compensation can be used to reward good performance. By re-writing stock options, the firm may be rewarding poor performance rather than good performance.

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P a g e | 255 Some will argue that stock options need to be rewritten in order to prevent good managers from leaving and joining another firm. Managers are to be responsible for their decisions, both the successful and unsuccessful ones. Managers with integrity admit their mistakes and take the consequences of their actions. Irresponsible managers will attempt to blame others while moving to another firm in order to minimize their financial losses. Also, if the managers made decisions that led to the losses of the firm, the decrease in stock prices, and the options become worthless, then these may not be the managers that the investors want to have operating the firm. It is best to not rewrite the stock options and instead let the managers leave.

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Cases on Fraudulent & Questionable Financial Reporting 15. Satyam Computer Services—The Enron of India (Chapter 5, pages 336-338) What this case has to offer This case resembles several of the large accounting scandals in the U.S. It highlights several failures within the company’s corporate governance mechanisms and the negative consequences of excessive power concentrated in the hands of the company’s Chairman, who allegedly perpetrated the fraud alone. Satyam is a company whose principal business is outsourcing, and the company relies highly on reputation to attract clients. This case also raises concerns about the extent to which a company that outsources operations to a third party should make sure that the third party behaves ethically and has strong corporate governance and internal controls. The outsourcing company must ensure that ultimately the outsourced information is processed safely and without any business interruptions. Finally, this case is an example of a successful turnaround after a large scandal. With the help of the government of India and new investors, the company took several commendable actions to clean its reputation and continue operating. Teaching suggestions The first questions that come to mind in this case are what happened with the company’s controls over financial reporting and who was responsible for the fraud. As it has been the case with previous accounting scandals, the fraud scheme seems to be relatively easy to identify but nobody noticed it or reported it. I go through the list of people that could have raised a flag but did nothing, for example: directors, accountants, internal and external auditors. I highlight that it was unlikely that Mr. Raju perpetrated the fraud by himself without the knowledge of anybody else within the company. I also discuss the measures taken by the company after the fraud and whether or not they would be effective at restoring the company’s reputation and avoiding a similar fraud in the future. Discussion of ethical issues 1. Will the Satyam fraud damage India’s reputation as a reliable provider of information technology outsourcing? Given the size of Satyam and its importance as an outsourcing company, serving over one third of the US Fortune 500 companies, this fraud could cause a major disruption of India’s enormous outsourcing industry and may force many large companies to investigate and perhaps revamp their back office operations in India. Before the company was acquired by Mahindra Group there was a high level of uncertainty about the outsourcing operations of Satyam. The government of India’s speed and decisive nature of actions in the aftermath of the crisis helped to stabilize the richard@qwconsultancy.com

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P a g e | 257 company’s operations during the first months of 2009. At the same time, a new board of directors nominated by the government quickly identified Mahindra as strategic investor for the company, which infused funds and helped to restore confidence among Satyam’s stakeholders. 2. How long will it take to restore Satyam Computer’s reputation, and how would you recommend that the restoration be facilitated? The recovery of the company’s reputation is going to be a long process that will take several years. In the Chairman’s Letter, published together with the Annual Report 2008-09 -- 2009-10 (Mahindra Satyam 2010), the new Chairman notes that: “As you may be aware, the Mahindra Group has always been known for its value system, which uncompromisingly applies to all the Group Companies: •

Be responsive to customers

•

Zero tolerance on unacceptable standards for ethics and governance

•

Uphold the dignity of all associates

•

Provide an environment that values professionals

•

Make quality our mantra in all aspects of work”

In addition, the Letter highlights the importance of strengthening internal controls: “Strengthening our internal controls and reporting systems has acquired its own piquancy and urgency in the current context. We would wish to ensure that financial irregularities and frauds of the nature which the Company has gone through, can never happen again. Measures have been initiated for making the financial systems robust, tamper proof and transparent.” The company seems to have taken a number of good steps to recover from the loss of reputation after the fraud. Several actions, already taken by the company, included: •

Changing the composition of the board of directors to have a majority of independent directors;

•

Appointing independent and financially savvy directors to serve in the audit and compensation committees of the board of directors;

•

Initiating a review of compensation policy, performance management system, sales incentive policy, recruitment policy, travel policy, etc.;

•

Adopting a whistleblower policy;

•

Adopting a revised code of conduct and ethics policy for the board of directors and employees of the company;

•

Nominating a Corporate Ombudsman to monitor the implementation of the code of ethics, including the whistleblower policy;

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P a g e | 258 •

Strengthening the internal audit function by appointing a reputed and independent external agency as its internal auditor, under the oversight of the company’s audit committee; and,

•

Performing a company-wide internal control evaluation and strengthened several weaknesses in controls over financial reporting.

Beyond these measures, the company must maintain high ethical standards for many years before its reputation will be fully restored. As a company whose principal business is outsourcing, Satyam relies highly on reputation to attract clients that need their back-office information safely processed and without business interruptions. 3. Mr. Raju did not commit this fraud on his own. What types of individuals probably assisted him either actively or by keeping quiet about what they knew he was doing? In a fraud of this magnitude, several individuals probably assisted Raju or kept quiet about the fraud. This would include, for example, the company’s CFO, the Chief Auditor, and other accounting and internal audit personnel. Moreover, the board of directors and the external auditors were also partially responsible for failing to exercise proper due care in overseeing the company’s financial reporting. 4. To whom should potential whistleblowers have complained? A potential whistleblower could have gone through the following steps to complain: •

Talk to an immediate superior or relevant company officials in the accounting or internal audit department;

•

Notify the audit committee of the board of directors;

•

Communicate with the external auditors;

•

Present a formal complaint to the Indian Securities and Exchange Board; and,

•

Go public as a last resource (after seeking appropriate legal counsel).

5. Mr. Raju likened his fraud experience to “riding a tiger, not knowing how to get off without being eaten.” This is an aspect experienced by some people trapped on a slippery slope from small to ever larger fraudulent acts. If Mr. Raju had come to you for advice during the tiger ride, what would you have advised him? Mr. Raju has to understand that sooner or later the fraud will be uncovered and that accounting fraud is a crime. As time goes by the size of the fraud and its consequences will be bigger. He has to think about the consequences for his family, colleagues, and the thousands of employees working for the company. He also has to learn from several other large corporate frauds that ended badly for their perpetrators. He could avoid a larger disaster by acting sooner. 6. Should PwC worldwide have to pay any investors for their losses caused by faulty audit work of personnel in PW India? It depends on the type of agreement between the affiliate of the accounting firm in India and the global partnership. In principle, just by sharing a common name, PwC richard@qwconsultancy.com

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P a g e | 259 has already been affected by the fraud. Furthermore, the global partnership is liable if it failed to ensure that the audit conducted by its affiliates in India complied with the firm’s global audit standards and procedures. In general, external audits are not designed to detect fraud, but it seems that relatively straight forward audit procedures such as thorough bank confirmations and reconciliations, as well as other forms of asset verifications, would have uncovered the fraud. Useful Articles, Links, and Videos Mahindra Satyam (2010). Annual Report 2008-09 -- 2009-10. http://www.techmahindra.com/sites/resourceCenter/Financial%20Reports/mahindrasatyam-annual-report-2008-09-and-2009-10.pdf [Link not active in 2020. Report available at https://cache.techmahindra.com/cache/investors/2010.pdf. ]

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16. Nortel Networks’ Audit Committee Was in the Dark (Chapter 5, pages 338-347) What this case has to offer Nortel Networks is one of the most notorious companies to emerge from the 1990’s dotcom stock bubble that burst spectacularly. Nortel’s own stock – which accounted for more market capitalization than any other stock in Canada – went from $124.50 to $0.63. Following the collapse of its Internet business, Nortel entered into a dramatic restructuring process focusing on containing losses and returning to profitability. The company’s downsizing and restructuring efforts lowered morale and motivated Nortel’s management to manipulate profits by recording and releasing inappropriate accruals/provisions. Even though these provisions were not material in an individual basis, their aggregate value made the difference between a profit and a reported loss. Achieving profitability triggered rewarding bonuses to all Nortel employees and significant bonuses to senior management. The inappropriate provisioning was discovered after the Audit Committee of Nortel’s board of directors hired a legal firm to review a restatement of $900M of liabilities in the third quarter of 2003. These inadequate practices began in early 2002, when the company started its restructuring efforts. The case offers several interesting points for discussion, including: •

Nortel’s loss of its earlier strong ethics reputation, and its ethical culture,

•

Audit Committee processes and how they might have avoided finding themselves in the dark, unaware of the fraudulent “cookie jar” accounting manipulation going on,

•

Techniques for accounting manipulation, and the role of provisions and contingencies as “cookie jar” reserves,

•

Audit processes and why the auditors were unaware of the fraud,

•

The potential negative impact of a management compensation scheme strongly tied to pro forma profitability,

•

Management of an investigation into fraudulent accounting manipulations. Teaching suggestions

I start the case with a brief background of Nortel, giving the students a sense for the company's size, operations, and significant market changes that drove its share price up to C$124.50 and eventually down to less than one dollar in 2002. In light of these events, I ask the students what actions could have been taken to restructure the company and build back Nortel’s share value. I also ask what the implications of the Internet’s business downturn were. My objective here is to show that the company needed a thorough strategic change including a new compensation scheme tied to strategic milestones beyond pro forma earnings. Then I ask my students to what extent they believe a company's success is a direct result of its top executives' performance. Later I inquire who should be setting the top executives' incentive package. I tie their answers to the role of the board of directors and the responsibilities of its committees. The board needs independent and objective members with strong industry, strategic, governance and financial skills. In order to fulfill specific purposes, richard@qwconsultancy.com

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P a g e | 261 the board appoints specialized committees such as audit, conduct review, compensation and corporate governance. Nortel’s board and its audit committee did not exercise enough due care asking enough questions, in a timely manner, regarding the provisioning process and overall control structure. Nor did they – like the Enron board – have any whistleblowers tipping them about the manipulations going on; probably due to a failure to create an ethical corporate culture that encourage such openness. I then deal with the questions posed at the end of the case, which follow below, stressing the role of the various players and pieces of an ethical culture. All are required to ensure that problems are minimized. Even when they are all operating effectively – a due diligence requirement of the board – unethical problems cannot be eliminated entirely. Discussion of important issues/questions 1. Why would Nortel Networks, a Canadian company, hire a U.S. law firm to undertake an independent review of factors that led to restatement of accounting reports? The choice of an investigator was multifaceted. A law firm was probably chosen so that any findings not reported publicly could be held in confidence due to the attorney-client privilege that is not available with accounting, consulting, or investigative firms. This would prevent other findings from being used against the directors in a lawsuit. The law firm could (and did) employ an investigative firm and their findings would similarly be protected. In addition, hiring a well-known U.S. firm with contacts and standing with the SEC – the most aggressive regulator facing Nortel – would add credibility to the exercise and lend support to the stock valuation during the investigation. 2. Why did the independent review focus on the “establishment and release of contractual liability and other related provisions” (also called accruals, reserves, or accrued liabilities)? The legal review mandated by the audit committee expected to verify the company’s liability restatement of $900M. The audit committee wanted to gain understanding of the events that caused significant excess liabilities to be maintained on the balance sheet. These contractual liabilities were a result of previous years' provisioning process, based on judgments made of the company's obligations. 3. How did the failure to follow U.S. GAAP permit the manipulation of Earnings before Taxes (EBT) and lead to fraudulent behavior? As per general accounting principles, accrued liabilities arise from recognition of expenses for which payment of cash or other assets will be made in a future period (i.e., interest, taxes, and payroll payable). Sometimes the amount of a future payable is uncertain due to future conditions and/or external factors, and the amount of the liability has to be estimated using the best information available at the time. In such cases a provision is made for the estimated amount, thus charging an expense against profit. When the actual event occurs (creating a triggering event), any unused provision is supposed to be reversed, creating a credit that enhances profit. Nortel executives chose to add to and reverse or draw down its reserves arbitrarily without regard to a proper triggering event, thus manipulating profit up or down to qualify for bonuses based on pro forma profit targets. richard@qwconsultancy.com

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P a g e | 262 Contingent losses are one type of these estimated liabilities. A contingent loss is a possible loss (or expense), derived from past events, which will be resolved as to existence and amount by some future event confirming or rejecting the loss. Nortel overstated contingent contractual agreements (debit in the liability side) and losses (credit expenses) in 2002 and subsequently released or reversed these accruals (estimates) increasing revenue and decreasing liabilities. The contractual liabilities acted as “cookie-jars, overstating losses in a bad year and then reversing these losses into income in the following periods. 4. Describe the Nortel Return to Profitability (RTP) and Restricted Stock Units (RSU) bonus plans. What did the board of directors expect these plans to achieve? The board intended to motivate employees to stop losses and generate profits, while motivating employees to stay with Nortel. The bonus plans also were intended to motivate executives over time to maintain a profit trend. •

The RTP bonus plan contemplated a one-time bonus payment to every employee, save 43 top executives, in the first quarter in which Nortel achieved pro forma profitability. The 43 executives were eligible to receive 20% in the first profits quarter, 40% in the second, and 40% upon four following quarters of cumulative profitability. Pro forma profits had to exceed or equal the total cost of the bonus in that quarter.

•

The RSU bonus plan made a significant number of share units available for award by the board of directors to the same 43 executives in four installments tied to profitability milestones.

5. Were the misstatements of EBT and bonuses paid material in an accounting sense? Materiality – measured by the ability of a change to affect the decision of an informed lay reader of financial statements – refers to a threshold that varies somewhat depending on the circumstances. In a normal audit, for example the aggregate materiality threshold may be set as a percentage of net income (i.e., 5%). However in this case, given the importance of the tipping point turning a loss into profit, and its connection with bonus payments, the draw downs of provisions (reversals) would have been less than 5% of profit, but since they turned a loss into a profit – an important tipping point – they were definitely considered to be material. The company released $361M in Q1 2002, and $370 in Q2 2002.

6. Why didn’t Nortel’s auditor discover the misstatements? At the time of writing, we do not know why the auditors did not discover the cookie jars or there fraudulent use. Provisioning involves significant judgment on the part of company executives. Auditors review and challenge the provision estimates but rarely have more expertise than client personnel, and do not hire outside valuation experts unless there is reason to suspect misrepresentation. Nortel’s finance executives apparently stretched the judgment inherent in the provisioning process to create a flexible tool to achieve EBT targets. Making accounting estimates frequently requires management to develop models and assumptions richard@qwconsultancy.com

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P a g e | 263 regarding possible outcomes, including timing, transactions or events that are uncertain at the time of the estimation. Guidance on audit procedures for validating accounting estimates, including materiality and restatements, remains unclear and dispersed throughout different sections of the Auditing Standards. However, auditors should ensure that the client is using an appropriate model and considering reasonably accurate assumptions. In some cases, auditors may opt for consulting with legal or actuarial experts to review very material estimates. Sometimes auditors are too concerned with the present year and place too much confidence on previous years’ judgment. If the auditors deem a liability to be valid because it was reviewed in previous years, they may only ask management for current explanations to validate the liability’s reversal. Auditors should also verify the validity of the original liabilities when they were subsequently reversed. It is conceivable that the auditors did not thoroughly review the end-of-period adjusting entries related to the cookie jar reversals because they were unaware of them, or considered them to be not material. 7. Why did the audit committee or the board as a whole, not anticipate the manipulations? The audit committee should have queried management regarding the components of the income statement, including the accrual reversals, particularly when the financials triggered the pro forma based bonus plans. It appears that Nortel's directors did not ask the appropriate questions or did not receive straight answers. Nortel’s audit committee did not demonstrate enough accounting expertise and savvy to direct internal auditors to review and report on end-of-period and other discretionary adjustments (where there is potential for management override of internal controls) before approving the financials and the bonus payouts. Apparently, the audit committee placed too much trust in management. The board of directors as a whole failed to: •

Foster an adequate control environment;

•

Assess financial reporting risk appropriately;

•

Ensure that adequate people and systems supported the control structure; and,

•

Exercise adequate monitoring of management estimates.

When businesses are restructuring, management is generally concerned with earnings targets and often cut expenses dedicated to internal controls. There is little attention paid to “back office” functions including accounting, internal audit and human resources. As a result, increased control risk result in a higher chance that management’s manipulation of earnings may occur without detection. 8. What questions should the Audit Committee of the board have asked? See discussion above. Also, they should have asked questions targeted to address achieving not only earnings targets but also key strategic milestones to rebuild shareholder value. Also, they should have asked what the role was of the reversals and how these reversals were determined. 9. What internal control flaws permitted the fraudulent manipulation to occur without detection?

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P a g e | 264 The following is a list of potential flaws. Some will not be clarified until expert witnesses testify. •

•

Control environment: o

Lack of thoroughness in audit committee oversight

Lack of accounting knowledge of audit committee members

Lack of auditor's due care in examining management's estimates

Unclear control structures, roles and responsibilities

Weak ethical culture and lack of a thorough ethical awareness program

Risk assessment: o

•

Control activities: o

Lack of personnel with strong accounting and reporting skills and expertise, and proven records of integrity and ethical behavior, particularly in key finance positions

Inadequate training in accounting issues

Information and communication: o

•

Ineffective risk assessment by the board of directors, failing to identify risk factors (business risk), dubious transactions (opportunity to commit fraud), and inadequate compensation programs (motive for fraud)

Inadequate ongoing communication between audit committee, internal and external auditors, and management

Monitoring: o

Lack of effective whistleblower programs

Lack of effective internal and external audits

10. Would the new SOX requirements have prevented the manipulation per se –why or why not? The Sarbanes Oxley Act of 2002 includes helpful broad provisions such as establishing a Public Company Accounting Oversight Board (PCAOB), maintaining auditor independence, improving corporate responsibility and enhancing financial disclosure. In addition, it spawned several more specific requirements that might have prevented this manipulation. For example, SOX requires a complete evaluation, CEO and CFO certification, and audit of the company’s internal controls and financial reporting system (Section 404) , creation of entity level controls such as whistleblower programs, and accountability of senior manager and directors for financial information (Section 302 certification), while emphasizing directors’ and auditors’ independence. On the other hand, they might not have prevented this manipulation because of the risk of management override in a weak control environment, and the fact that internal controls cannot prevent all frauds – they can only minimize the possibility of fraud occurring. 11. How have the expectations of the Audit Committee changed since SOX with regard to corporate culture? How can the audit committee ensure that these are met?

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P a g e | 265 Prior to the enactment of SOX, there was a general sense that the CEO was really in charge of the company and its affairs. SOX reaffirmed the primacy of the board of directors, clarified roles and set expectation for performance. In the new framework, the audit committee is the overall guardian of financial integrity for shareholders. Audit committee members must be critically aware of their oversight responsibilities and must completely understand them. How their responsibilities are carried out may vary, but a failure to address them may have consequences for the audit committee, the board and, most of all, the shareholders. Every audit committee must assume three fundamental responsibilities: •

Overseeing the process related to the company’s financial risks and internal control;

•

Overseeing financial reporting and related systems; and

•

Overseeing internal and external audit processes.

There is a new understanding of the importance of corporate culture as part of the internal control system that is essential to the preparation of reliable accurate financial reports. Consequently, the audit committee would have to report and remedy any cultural inadequacies as part of their duty to review internal controls. The audit committee is now seen to be in charge of the internal and external auditors – serving as the functional head of the internal audit department and also assuming the dominant role in appointing and reviewing the work of external auditors – and actively questioning management in financial reporting integrity issues. External auditors must now report to the audit committee discussions with management, opinions expressed and where those opinions were not followed. 12. Should the Audit Committee or the whole board be held legally liable for the weaknesses noted in the review? Why and why not? Management is responsible for designing and implementing an effective system of internal control. The audit committee must determine that management has implemented policies that ensure the company’s risks around financial reporting are identified and that controls are adequate, in place, and functioning properly. As part of its assessment of the processes relating to a company’s risks and control environment, the audit committee should request from management an overview of the risks, policies, procedures, and controls surrounding the integrity of financial reporting. The audit committee should supplement those representations with information from the internal and external auditors. The audit committee makes inquiries of the internal and external auditors regarding internal controls as part of its responsibilities for overseeing the controls over financial reporting. The audit committee and other members of the board are liable if they are negligent in performing their oversight duties. While the board delegates its authority for close scrutiny of financial matters to the audit committee, they cannot escape liability for negligence unless they can demonstrate that they checked that the work of the audit committee was been done properly. However, the members of the audit committee are the front line of defense and usually possess higher levels of financial expertise than the rest of the directors, so their responsibility and liability would be greater. Case law will determine the relative levels of liability during the next 5-10 years. richard@qwconsultancy.com

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P a g e | 266 13. In February 2005, Nortel hired a new Chief Ethics and Compliance Officer using an incentive compensation scheme based upon profits. Is this a sound arrangement? Given the recent fraud motivated by Nortel’s bonus scheme, this is not the best way to maintain or appear to this officer's independence and objectivity. Sensitive posts such as this should be structured to maintain independence not only in substance but also in appearance. Furthermore, it is a basic assumption of any compensation scheme that employees should be rewarded only for achieving milestones on variables directly controllable by them. It is unlikely that the ethics officer will have any direct impact on the company's profits in the short run, so if a bonus plan must be employed, it would be better to use stock options that would not be able to be sold until a year or so after the departure of the executive. 14. Nortel has issued a new code of conduct with striking similarity to their previous version. Why might this new code be more effective than the last? A code of conduct has to be part of a thorough and comprehensive ethics program to be successful. An ethics program cannot succeed unless all elements of the plan as discussed in the Text, are in place. Most importantly, the outspoken commitment (see Text discussion in Chapter 5, section, Ethical Leadership, page 297) of senior executives is essential to get employees to be concerned about ethical behavior and buy into the program. In the Nortel situation, with so recent a fraud in everyone’s mind, a new code, even if little changed, will resonate with all employees and leaders should have no problem exhorting adherence. 15. In retrospect, what were the major failings of the Nortel Audit Committee? Were they the same as those for the board as a whole? As noted in the answer to question 12, the board and the audit committee have overlapping responsibilities. The board of directors failed to oversee management in maintaining an adequate control environment and ensuring the integrity of financial reporting. The integrity and attitude of senior management and the board of directors, including its committees (referred to as the “tone at the top”) is the most important factor contributing to the integrity of internal controls, including those surrounding the financial reporting process. The “tone at the top” becomes the cultural core of the company and suggests a model of appropriate conduct for every level. The audit committee failed, at a more technical level, to oversee the compliance with GAAP and the integrity of the provision process. Moreover, besides their technical accounting role, the audit committee is expected to continuously evaluate specifically whether management is properly promoting an ethical culture (which is supportive of strong internal control systems). To facilitate the review, the committee should request updates and briefings from management and others (internal and external auditors, chief ethics officer, and so on) on how compliance with policies and other relevant company procedures is being achieved. Useful Articles, Links, and Videos

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P a g e | 267 “Canada’s technology star becomes financial black hole.” (September 16, 2009), CBC News, https://www.cbc.ca/news/business/canada-s-technology-star-becomes-financialblack-hole-1.782655 “RCMP lay fraud charges against former Nortel execs.” (June 19, 2008). CTV News, http://www.ctvnews.ca/rcmp-lay-fraud-charges-against-former-nortel-execs-1.303457 “CBC Archives: In Depth Nortel.” (February 27, 2008). CBC News, http://www.cbc.ca/news/background/nortel/newsarchive.html [Link no longer valid in 2017.]

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17. Adelphia – Really the Rigas Family Piggy Bank (Chapter 5, pages 348-351) What this case has to offer This case focuses on the fiduciary duty of managers, directors and auditors and allows examination of the potential implications of family control in publicly owned companies. It offers a lesson about the importance of an independent and objective board of directors that effectively challenges management, with the necessary technical skills and knowledge to understand the business and its financial reporting. Adelphia, controlled by the Rigas family, grew rapidly from a local cable company to an international telecommunications provider. However, unrestricted (unchallenged, really) access to company resources, allowed executives to use company funds for personal gain. To cover extensive self-dealing and overall poor financial performance, the company understated its debt by $16 billion, overstated revenue, and misrepresented its customer numbers in press releases. As often happens, a person or family that begins a business, or takes it to considerable success, forgets that using money from the public requires accountability to the public and their regulators – they can’t just continue to use company resources as if they were the sole owners with accountability only to themselves. Teaching suggestions I suggest starting by asking students what is the major problem presented by the case and managing the discussion until it produces the paragraph immediately above. This will facilitate a discussion of: •

differences between family-owned and publicly owned businesses,

•

what the responsibilities are of a public company to its investors,

•

what these responsibilities imply for the fiduciary duty of managers and directors

•

what allowed the Rigas family to set these duties aside, and

•

what barriers should be in place to stop management’s opportunistic behavior.

Finally, a discussion is in order of the auditors’ responsibility in case of fraud, and the need for a sound evaluation of potential risks linked to appropriate audit procedures. Discussion of ethical issues 1. What breaches of fiduciary duty does the Adelphia case raise? Fiduciary duty involves the responsibility of a second party to act in the best interest of a first party in a relationship of trust. This duty is especially important when the first party is vulnerable to the actions of the second party. There are four elements to consider in determining breach of fiduciary duty: the duty itself, breach of duty, direct causation and damages. Breach of duty becomes likely when the second party does not behave in a way that a reasonable person acting in the first party’s best interest would have behaved richard@qwconsultancy.com

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P a g e | 269 under similar circumstances. Note that professionals are held to a higher standard of care than an ordinary reasonable person would be. They should put the interests of their clients before their own, hold themselves free of conflicts of interest, and be reasonably knowledgeable of their profession abiding a professional code of conduct. Managers and directors are considered trustees of the shareholders’ property. In Adelphia’s case there is a clear breach of fiduciary duty of the Rigas family as managers and of all members of the Board, who were supposed to act in the public shareholders’ best interest, but acted against the public shareholders (and other stakeholders) and for themselves, disregarding evident conflicts of interest. As for the auditors’ responsibility to Adelphia’s shareholders, other factors should be taken into account including vulnerability, trust, reliance, discretion and the professional's code of conduct. However, the Auditors would not breach that duty if they performed their audit according to the professional standards of care. 2. Why do you think the Rigas family though they could get away with using Adelphia as their own piggy bank? A potential rationalization argument is possible if the Rigas family, former sole proprietors of the business, mistakenly think that other minority shareholders “owe” them for creating and expanding the company in their behalf. 3. What allowed the Rigas family to get away with their fraudulent behaviour for so long? The Rigas family got away with their fraudulent behavior for so long due to several weaknesses in the control environment: Rigas family members occupied key management posts; management’s lack of integrity, poor ethical values, competence, and an understanding of legitimate expectations of ethical behavior; management's aggressive growth philosophy and operating style; family preferences assigning authority and responsibility; and, weak oversight from a non-independent board of directors with a majority of family members. The external auditor’s oversight was limited by management’s misrepresentation. An auditor’s responsibility involves the detection of material misstatements caused by fraud, but normal audit procedures are not directed to specifically uncover fraudulent activity. However, audit risk assessment should include an evaluation for potential fraud, and significant risks should be investigated. 4. What concerns should have been raised in the following areas of risk assessment in Adelphia’s control environment: integrity and ethics, commitment, Audit Committee participation, management philosophy, structure, and authority? A company’s control environment, or internal control environment, refers to the framework of attitudes, awareness, and actions of directors and management that are needed to support adherence to the company’s policies, its actions in support of its objectives, and the accuracy of its financial reports. A wholesome control environment incorporates appropriate philosophy and values into the corporate policies and its culture, organizational structure and processes, operations, and human resource practices. In the Adelphia case, while stated policy was satisfactory, questions should have identified the weaknesses that allowed the Rigas family to misdirect company richard@qwconsultancy.com

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P a g e | 270 resources, falsify documents, and manipulate company disclosures to cover their massive misuse of company resources as if the company was their private piggy bank. Concerns should have been raised about: •

The competence, independence, professionalism, ethical awareness and ethicality of senior accounting, financial, and legal management who should have recognized and reported family misdeeds.

•

How committed where these senior people, as well as middle management, to an ethical culture that placed duty to all shareholders above their duty to the Rigas family?

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Did company policy and procedures clearly reflect the need for adherence to values and procedures that reflected this duty to all shareholders?

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The independence, competence, ethical awareness and ethicality of board members (particularly since the majority were family insiders), and particularly of those on the Audit Committee who should have understood that they needed to protect the interest of all public shareholders, not just the Rigas family.

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The existence and efficacy of a whistleblowing program, and the encouragement of its use by employees. Did the person in charge of the program understand their duties and report directly to the Audit Committee?

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Since the company had been created and run by the founder and his family, did management realize that once non-family shareholders were involved, they should be wary of doing anything they were asked to do by the family? Was there a mechanism in place for concerns on the part of employees who questioned their instructions to seek advice and/or report the actions in question?

5. What concerns should have been raised in the following areas of risk assessment in Adelphia’s strategy: changes in operating environment, new people and systems, growth, technology, new business, restructurings, and foreign operations? In Adelphia, the need for meeting targets and for keeping the company’s debt levels within market averages provided strong motivation to commit fraud. Opportunity for fraud was present due to lack of independent directors, quick changes in operating environment, and risk of collusion due to family relationships in key management positions. 6. What is your opinion on the importance of independence in corporate governance? What are the most recent rules on corporate governance for public firms? Independence is a basic element to ensure objective judgment. Directors and auditors are key control elements that can assess and stop management’s opportunistic behavior in a timely manner. Recent SOX and market regulations, such as the NYSE Corporate Governance Rules (NYSE 2017), require a majority of independent directors in public companies. Under these rules, no director qualifies as independent unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Companies must identify which directors are independent and disclose the basis for that determination. richard@qwconsultancy.com

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P a g e | 271 The relationship includes ties such as previous employment with the company in the last three years, and relationships of immediate family members. As for external auditors, the Sarbanes-Oxley Act and accounting Codes of Professional Conduct require independence from the client in fact and appearance, precluding the auditor from personal relationships with the auditee as partner, shareholder or officer in the year of the audit and a period before and after the engagement. In addition, the audit firm must not provide significant consulting services that may impair professional judgment in auditing the client’s financial statements. Consult the Text for SOX/SEC recommendations/regulations. 7. Discuss which changes could be done to the Adelphia’s control system and corporate governance structure to mitigate the risk of accounting fraud in future years. The investing public and lending institutions must ensure that there is sufficient independence of mind and expertise on the board to create and monitor an effective governance system. At the outset, a thorough review of Adelphia’s existing governance system and key people is called for by an independent firm, and key employees (CFO, CIO, Chief General Counsel, Chief Ethics Officer, and Chief Internal Audit Officer) should be replaced. The internal audit group should be charged with ongoing review of the policies and compliance and should report to the reformed Audit Committee. A protected whistleblowing mechanism should be instituted that also reports on financial and non-financial matters to the Audit Committee and the Governance Committee. SOX/SEC regulations are to be followed, and ethics training is to be undertaken. Above all, executives are to be hired who have demonstrated the proper ethical “tone at the top” and are proactive and outspoken in regard to the need for high ethical standards. 8. What is the auditor’s responsibility in case of fraud? Although fraud risk factors (motive, opportunity, lack of ethics or rationalization) do not necessarily indicate that fraud exists, they often do warn accurately. When obtaining information about the entity and its environment, the auditor should consider whether the information indicates that one or more fraud risk factors are present. Auditors should identify risk factors in planning the audit, in their consideration of internal control and inherent risk, and from past knowledge of the client and the industry. Moreover, they should be aware of the risk factors throughout an audit, not just at the planning stage. 9. What is the proper audit procedure to ensure: a. completeness of liabilities in the financial statements? b. that all related parties have been included or disclosed in the consolidated financial statements? Completeness is the most difficult assertion to prove in auditing financial statements. Looking for missing liabilities or operations with related parties might be very challenging. The first procedure to ensure completeness of such items is to interview management and take their signed statements of representations wherein they declare that the accounts are correct and/or disclose problems such as related party transactions, related companies, and company commitments, whether recorded richard@qwconsultancy.com

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P a g e | 272 or not. Additional procedures are necessary, such as review of the minutes of the Board meetings, review of subsequent events, and the performance of analytical procedures. Discussions may reveal other related interests and/or activities that are worthy of additional scrutiny. Audit professionals who are knowledgeable about the industry and client affairs should apply their knowledge to identify potential risks. Law firms used by the company and the Rigas family should be asked to disclose potential problems that could affect Adelphia or its assets where loans or advances have been made to Rigas family members. 10. Do you think analytical procedures would aid the detection of fraud? What is the responsibility of the auditor applying analytical procedures? Applicable analytical procedures include comparisons to industry ratios and reasonability tests. Auditors have to be aware of business trends and relevant statistics. This is the reason why audit partners and audit teams specialize by industry. In this case, for example, the number of subscribers is a key statistic for the analysts following the cable industry. An unreasonable increase of the number of subscribers should be a red flag for the auditor. 11. What should the 450 lending institutions have done to protect themselves from subsequent lawsuit? Lending institutions would be well-advised to create a due-diligence protocol/process for new and existing clients wishing financing that covers the full ethical culture and governance system of the enterprise and the ethics of the transaction proposed.

Useful Articles, Links, and Videos “Rigas Family: Times Topics.” (December 7, 2010). New York Times, http://topics.nytimes.com/topics/reference/timestopics/people/r/rigas_family/index.ht ml. News about Rigas family, including commentary and archival articles. C-Span and U.S. Department of Justice (Jul. 24, 2002). “Adelphia Executives Arrests [video]” http://www.c-spanvideo.org/program/171459-1 Discusses the arrest of several members of Rigas family who were accused of stealing hundreds of millions and causing investor losses of $60 billion while in control of Adelphia Communications. NYSE (2017). Listed Company Manual, Section 303A.00 Corporate Governance Standards. http://nysemanual.nyse.com/LCMTools/PlatformViewer.asp?selectednode=ch p%5F1%5F4%5F3%5F6&manual=%2Flcm%2Fsections%2Flcm%2Dsection s%2F [The website’s search feature can be used if the link is not direct. The rules from the year of the case are no longer available.] U.S. Securities & Exchange Commission (July 24, 2002). “SEC Charges Adelphia and Rigas Family with Massive Financial Fraud [Press Release]”, http://www.sec.gov/news/press/2002-110.htm richard@qwconsultancy.com

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18.Tyco – Looting Executive Style (Chapter 5, pages 352-355) What this case has to offer Tyco International is one of the most widely known cases of pervasive fraud perpetrated by top executives. Millions in company funds were misallocated, unreported and/or misrepresented by former CEO L. Dennis Kozlowski, CFO Mark Swartz, and General Counsel Mark Belnick. Their personal misuse of funds, lavish expenses, appetite for excesses, and flagrant denial of any wrongdoing are examples of the worst consequences of leaving management without adequate monitoring and restraint. Essentially, Kozlowski, Swartz and Belnick treated Tyco as their private bank, taking out hundreds of millions of dollars of loans and compensation, but not telling the directors. This case is interesting because it points out that extreme weaknesses in governance processes in an environment of deceit, too much trust by directors, and/or low ethical awareness, might open the door for unscrupulous executives to commit and conceal fraud. As such, the case provides a means for exploring governance structure and process, and the roles of the players involved. These players include directors, executives, external and internal auditors, whistleblowers, as well as others. Teaching suggestions In order to lay the groundwork on governance and the issues involved in the case and the questions listed at the end, I ask the following questions, in order: 1. How closely should the actions of executives be monitored by the board of directors – very closely, or with a great deal of trust? [Discussion of the role of the Board] 2. How and through what mechanisms and/or individuals should directors get the monitoring information they desire? [Discussion of governance mechanisms and players] 3. How can directors assure that they are getting all the information they need and are not being misled? [Discussion of internal controls, checks, whistleblower schemes…] 4. Could any of the reported self-interested actions of Kozlowski, Swartz, and Belnick be considered reasonable given their position and the size of the company? [Discussion of reasonability of remuneration, perquisites] Discussion of important issues/questions 1. The pattern of illegal and improper conduct described above took place for at least 5 years prior to June 3, 2002. What red flags or governance mechanisms should have alerted the following people to this pattern: a. Tyco management accountants? b. Tyco internal auditors? c. Tyco external auditors? d. Tyco board of directors?

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P a g e | 275 In public companies, there is separation of ownership from management. This creates need for a third party to monitor management on behalf of shareholders (i.e., the principal- agent problem) and society. The core mandate of the board of directors is to be this third party to oversee management, and to engage other mechanisms and people to facilitate this function. The board of directors, as part of their stewardship role, should demand from management a complete picture of the company's performance, including financial results, and of the actions of its executives and employees. In order to ensure that such information fairly presents the company's financial situation and actions, the board of directors receives reports from the company's internal auditors on its policies and adherence to them, and hires external auditors to review the company's financial statements and specific other activities. The corporate governance mechanism relies upon policies to guide expectations for behavior, and if these expectations are not met, the independence, objectivity, vigilance, skepticism, and ethical behavior of accountants, auditors and directors should lead to finding and correcting the problem. Therefore: a. Management accountants should have raised their concerns about waste of resources (no value for the company's money) in lavish parties, unreasonable loans to executives and excessive compensation. However, Tyco's accountants might not raise any issues because of fear to their bosses or because some of them were also involved at more senior levels. b. Internal auditors should have detected unusual expenses in the same way as accountants when reviewing the company's operations, executive offices expenditures and management compensation programs, as well as compensation committee minutes and authorities. c. External auditors should have detected very high (i.e., over material) executive expenditures or uncollected loans through their audit procedures, including a review of authorization of material expenses and loans by the company's board of directors. The partner in charge of the engagement may not have exercised proper due care or might have decided not to disturb a good relationship with the client. d. Directors should have monitored more closely managements' compensation, opening independent communication channels with internal and external auditors. They should have avoided potential conflicts of interest by prohibiting management from receiving loans from the company over a certain threshold and requiring them to ask for pre-authorization of certain expenses and postexpenditure reporting.

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P a g e | 276 2. Identify and discuss the most important weaknesses in Tyco's internal controls and governance systems. Internal controls should provide reasonable assurance that fraud will be prevented or detected. A strong control environment constitutes the most pervasive element to deter fraud. Control environment includes integrity, ethical values and competence, management's philosophy and operating style, and the attention and direction provided by the board of directors. In Tyco's control environment, integrity, independence and separation of duties were seriously compromised.

Tyco’s policy and/or compliance reinforcement were insufficient to encourage employees who must have witnessed excessive transactions to blow the whistle. Either they didn’t know what was right, or didn’t know what to do about it, or didn’t have the courage to come forward. High-level executive collusion went on unreported. The legal department, or office of the general counsel, typically plays a key role in reviewing disclosure documents for compliance with applicable laws and regulations. The legal department also assists management in establishing and maintaining internal controls to prevent and detect noncompliance with other laws and regulations. The General Counsel was also involved in Tyco's fraud with the CEO and CFO. The internal audit function should examine, analyze, and make recommendations on matters affecting the company's policies and internal controls. Internal auditors did not raise any issue regarding anti fraud controls or management illegal actions. The board of directors has a responsibility to the company's shareholders to oversee management's performance and relate it to compensation and benefit plans – but they did not do so. At least one of Tyco's directors was receiving additional pay as consultant. 3. Would a post-Sarbanes-Oxley Act whistleblowing program to the Audit Committee of the board have eliminated the improper and illegal actions? Why or why not? Whistleblowing is one of the most common ways by which fraud is uncovered. Effective whistleblowing programs should be: •

Independent,

•

Strictly confidential,

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Direct-line reporting to the board of directors' audit committee,

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Timely in responding to issues raised,

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Available and known to all employees, and

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Supported by a companywide ethics awareness program.

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P a g e | 277 However, these programs themselves are no guarantee that all improper and illegal actions will be stopped. There is no substitute control for a solid ethical culture within an organization. 4. If you had been a professional accountant employed by Tyco during this time, and you wanted to blow the whistle, who would you have gone to with your story? The first step is to discuss the accuracy of facts with your supervisor and try to escalate the issue using the regular chain of command. If this does not work, you should consider talking to the ethics officer, ombudsman or company's general counsel. However, if this is not possible or not effective, you should then use the company's whistleblower program. If the company does not have an internal whistleblower program, you may use external whistleblower programs including regulators' hotlines or the ethics office of your professional accounting body. The important step is to make sure that the company’s audit committee finds out what is going wrong. Finally, if there is no useful reaction, as a last resort you could talk with your lawyer and consider going public. 5. Why were so many Tyco employees willing to go along quietly with the looting by senior executives? There was a combination of factors: lack of clear communication that unethical behavior will not be tolerated (ethical awareness), bad example set by senior management (tone at the top), lack of effective whistleblower programs, and fear of retaliation from their bosses. 6. How many years in jail do you think Kozlowski should have received for his white-collar crimes? Discussions on this topic are extensive and often involve contradictory ethical and legal arguments. For Tyco's former bosses, their frauds were clear and huge. A significant penalty was important to show that such management misconduct will not be tolerated in public companies, and thus deter fraudsters in similar cases, and to restore investors' confidence that is at its lowest level in years after several fraud scandals involving executives’ opportunistic behavior. Additional Events April 17, 2006. Drawbaugh, Kevin (April 18, 2006). “Tyco to pay $50 million to settle SEC fraud charges.” Toronto Star, page C6. Tyco to pay $50 million to settle SEC fraud charges related to the looting of the company. May 13, 2006. Bloomberg News (May 13, 2006). “Tyco’s Kozlowski to pay millions to resolve tax case.” Globe and Mail Report on Business, page B7. This included $3.2 million in back sales tax, interest and penalties, plus $18 million in back income taxes. The original investigation into Kozlowski’s cheating on the 8.25% sales tax on $14 million in paintings triggered further SEC investigations that led to his ultimate downfall.

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P a g e | 279 Useful Articles, Links, and Videos “The Rise and Fall of Dennis Kozlowski [cover story].” (December 23, 2002). Bloomberg Businessweek, https://www.bloomberg.com/news/articles/2002-12-22/the-rise-andfall-of-dennis-kozlowski Tyco Fraud InfoCenter [website]. (May 9, 2006). http://www.tycofraudinfocenter.com/ Scannell, Kara (April 18, 2006) “Tyco to Pay $50 Million to Settle SEC Accounting Fraud Charges.”. Wall Street Journal, https://www.wsj.com/articles/SB114528622632927596 “Timeline of the Tyco International scandal.” (June 17, 2005). USA Today, http://www.usatoday.com/money/industries/manufacturing/2005-06-17-tycotimeline_x.htm

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19. HealthSouth – Can Five CFOs Be Wrong? (Chapter 5, pages 356-361) What this case has to offer The HealthSouth case points out how key weaknesses in the corporate governance structure may allow accounting fraud pass without detection, highlighting how difficult is to make CEOs and Directors accountable for such fraud and for the ultimate loss of shareholder value. In spite of the apparently overwhelming evidence of his involvement in the fraud, Richard Scrushy was acquitted, while the former CFOs were subject to penalties between 15 and 30 years in jail and fines totalling $11.2 million. This is a good case to discuss the effectiveness of the penalties involved in the enforcement of the Sarbanes-Oxley Act of 2002. In 2002, looking forward to lower Wall Street expectations, the company’s revenue decreased, blaming a one-time item; however, earnings kept going down progressively thereafter. A year later, the SEC's investigation uncovered serious accounting irregularities. The company overstated revenues for the years 1996-2002 by $2.74 million. Former CEO Richard Scrushy, together with 5 former CFO's and other accounting employees, was charged with accounting fraud under Sarbanes-Oxley Act provisions. Crucial accounting lessons from this case include the significant potential role of accruals and adjusting entries in accounting fraud, and the risk of management’s override of internal controls. The accounting manipulation happened right after preliminary end-of-period results were reviewed in management meetings during the “off books” adjusting period. Also, the case provides elements to discuss on what the involvement of CEOs and directors should be in preparing financial statements, as well as what their degree of financial expertise should be. Needless to say, the ethical awareness and sensitivity of participants was severely lacking, as was their ethical courage to say no when asked to undertake unethical and illegal acts. Teaching suggestions I start by asking the students, “What is the nature and purpose of corporate governance?”This is about who controls corporations and why. Then I ask, “What are the benefits of separation between management and ownership?”. Thirdly, I ask about management’s responsibility in making accounting decisions, i.e., who in the company is responsible for accounting choices, what should be the involvement of CEOs and directors in the process of preparing a company's financial statements, and what should be an appropriate degree of accounting expertise for CEOs and directors. The central issue for discussion, given the finding of the court, is how could accounting fraud have happened without the CEO knowing about it, since there is evidence that he told senior accounting officers to “fix” the problem when earnings did not match analysts’ expectations. I link this point with the moral character of the former CEO, since there is evidence that “Earlier frauds, bankruptcies, or questionable business dealings are part of the history of several companies owned at least in part by Scrushy and/or HealthSouth, and controlled by Scrushy with interlocking boards of directors to HealthSouth” (from the case, page 358). Also, it is important to bring out the difficult profit environment for the U.S. Healthcare industry in which HealthSouth stood out. Finally, I discuss the accounting entries used to perpetrate and conceal the fraud: reducing a contra revenue account, called “contractual adjustment,” and/or decreasing richard@qwconsultancy.com

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P a g e | 281 expenses (either of which increased earnings), and correspondingly increasing assets or decreasing liabilities. Discussion of important issues 1. What were the major flaws in HealthSouth’s corporate governance? •

Overall weak ethics environment/culture, and low ethical awareness and/or low moral courage to report problems

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Inadequate understanding of professional duty by professional accountants and lawyers

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Inadequate whistleblower process to uninvolved person reporting to the Board

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Insufficient oversight of related party transactions

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Lack of independence of the board of directors

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Inadequate understanding of accounting issues by members of the board of directors

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Failure of probing Board Audit Committee

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Deficient audit risk assessment and audit procedures

2 & 5. What should HealthSouth’s auditors, Ernst & Young, have done if they had perceived these flaws? What is the auditor’s responsibility in case of fraud? Auditors should use a systematic approach to identify events or conditions that could be root causes of a potential fraudulent action. Fraud is difficult to detect because it is generally concealed by the perpetrators by withholding evidence, misrepresenting information or inquiries, falsifying documentation and collusion. Even though it is not expected that normal audit procedures will detect these irregularities, auditors should assess if fraud risk is sufficiently controlled by a combination of prevention, deterrence and detection measures. The auditors’ assessment should include understanding and evaluating the risk factors that indicate incentives and pressures to perpetrate fraud, opportunities to carry it out, and attitudes or rationalizations to justify a fraudulent action. If the fraud risk is considered high, auditors should perform additional procedures to ensure appropriate revenue recognition, existence and ownership of assets, validity of sales, and completeness of expenses and liabilities. In this process, auditors should pay special attention to client’s accruals and audit’s materiality assessment. 3. How – in accounting terms – did the manipulation of HealthSouth’s financial statements take place? On a quarterly basis, the company’s senior officers presented Scrushy with an analysis of HealthSouth’s actual earnings compared with the analysts’ expected earnings. At these meetings, referred as “family meetings”, senior accounting personnel discussed what false accounting entries could be made to meet the expected earnings. The entries primarily consisted of reducing a contra revenue account, called contractual adjustment or decreasing expenses, and correspondingly increasing assets or decreasing liabilities. The contractual adjustment account was a revenue allowance account that estimated the difference between the gross amount billed to the patient and the amount that various richard@qwconsultancy.com

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P a g e | 282 healthcare insurers would pay for specific treatments. A $800 million overstatement, equal to 10 percent of the total company’s assets, was book in a fictitious asset line called AP Summary, under Property, Plan and Equipment. HealthSouth accounting personnel designed the false journal entries to avoid detection by the external auditors. For example, instead of increasing revenues directly, the entries decreased the contractual adjustment account; this account had a limited paper trail based on estimates. HealthSouth also knew that the auditors only questioned additions of fixed assets at any particular facility if the additions exceeded a particular threshold. By increasing the AP Summary account, the entries never exceeded that threshold. False documents and altered invoices supported additions of fictitious assets. 4. Why did all the people who knew about the irregularities keep quiet? There was a combination of factors, including: lack of clear communication of wholesome company values and expectations respecting shareholders and other stakeholders and that unethical behavior will not be tolerated (ethical awareness); bad example set by senior management (tone at the top); lack of effective whistleblower programs; fear of retaliation from their bosses. There was an unethical culture cultivated by ‘group-think’ about deception. 5. (See #2, above) 6. What are the proper audit procedures to ensure existence of assets in the financial statements? What are the proper audit procedures to validate estimates? Physical inspection is the basic audit procedure to ensure existence of assets such as property, plant and equipment. This procedure may be used together with inspection of other corroborative evidence, such as invoices or cheques paid to vendors. Auditors must ensure, subject to a comprehensive materiality threshold, that all assets in the balance sheet exist and also belong to the client. Furthermore, through regular business activities, assets increase as a result of contracting liabilities or from the revenue generating process. Existence and ownership of asset tests also confirm the completeness of liabilities and validity of sales (i.e. pertain to the entity and have occurred in the accounting period). Making an accounting estimate often requires management to develop models and assumptions regarding possible outcomes, including timing, transactions or events that are uncertain at the time of the estimation. Guidance on audit procedures for validating accounting estimates, including materiality and restatements, remains somewhat unclear and dispersed throughout different sections of the Auditing Standards. However, auditors should ensure that the client is using an appropriate estimation model and is considering reasonably accurate assumptions. In some cases, auditors may opt for consulting with an actuarial expert when reviewing very material estimates. 7 & 8.What areas of risk can you identify in HealthSouth’s control environment before 2003? What areas of risk can you identify in HealthSouth’s strategy before 2002?

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Business risk: An increased business risk gives rise to a higher probability that management will overstate revenue or conceal losses by using incorrect or inappropriate accounting practices. HealthSouth – while trying to meet analysts’ targets – reported profitability and growth that were far better than the industry average, while operating in a very competitive industry on a path towards consolidation. Under pressure to maintain good financial performance, others in the industry were involved in fraud at different levels, providing inadequate services, billing in excess and cutting costs beyond reasonable standards.

•

Control risk: an increased control risk results in a higher chance that management’s manipulation of earnings may occur without detection. The company recruited enthusiastic impressionable young and relatively inexperienced staff from the local community in Birmingham, Alabama. They were malleable and apparently easily induced into unethical and fraudulent corporate practices. The CEO’s authority was thus unchallenged.

The company lacked effective whistleblower and ethics’ awareness programs. Some participants in the fraud admitted to the U.S. Attorney that they feared physical or psychological retribution if they came forward with details of the fraudulent accounting practices. Over the years, some shareholders complained that HealthSouth was run like a personal company of Mr. Scrushy, with many investments in ventures that stood to be profitable for Scrushy and other executives and directors. Few directors appeared to question Mr. Scrushy or any of his decisions. 9. What changes could be made in HeathSouth’s control system and corporate governance structure to mitigate the risk of accounting fraud in future years? In 2005, the company released restated results for the period from 2000 to 2003. HealthSouth President and CEO, Jay Grinney, estimated that the restatement of the company’s financial statements required more than 1,000,000 of outside consultant hours incurring costs over $250 million. With 3.8 m shares, Richard Scrushy was still member of the company’s board of directors. The following measures may help to improve the company’s governance structure: •

Board of directors with more members

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A majority of independent directors

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More audit committee meetings

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Financial experts on the audit committee

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Separate CEO and Chairman of the Board roles

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Auditor’s and executives’ appointment by recommendation of the Audit Committee

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Internal audit function reporting to the board’s Audit Committee

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Company-wide ethics awareness programs

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Confidential whistleblower programs for accounting and ethics concerns

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see other Sarbanes-Oxley reforms

10. Was Scrushy’s defense ethical? Scrushy alleged he lacked accounting knowledge to understand the fraud and the implication of the proposed journal entries. His defence used several potentially unethical tactics to convince a local court that Scrushy, previously an investment banker, was unaware of the accounting manipulations. These included his religious inclinations and folksy character, his support to local causes, and the apparently “dubious moral character” of the CFOs testifying against him. The trial took place in Alabama, and the defendant’s lawyers successfully manoeuvred to have seven blacks on the jury and five whites, all from workingclass backgrounds. The jurors apparently believed that a CEO could be unaware of manipulations arranged by his company’s accountants, at his direction. On the other hand, a person is entitled to a trial by his peers and their emotions may be appealed to. The court process provides that the opponent’s interests are to be protected, in part by his/her lawyer, as well as by the rules of the court. Consequently, it can be argued that unethical tactics, if any, should have been exposed (i.e., rendered impotent) by the opposing lawyer. Sometimes, however, this is not possible, and in this case there may have been other attempts to influence the jurors inside and outside of the courtroom; for example, by threats or intimidation implied by the set of black Bible class members who sat behind Mr. Scrushy throughout the trial. Useful Articles, Links, and Videos Weidlich, Thom (April 23, 2010). “UBS to Pay $217 Million to Settle HealthSouth Case.” Bloomberg, https://www.bloomberg.com/news/articles/2010-04-23/ubs-agrees-to-pay217-million-to-healthsouth-investors-to-settle-lawsuits U.S. Securities and Exchange Commission (March 20, 2003). “SEC Charges HealthSouth Corp., CEO Richard Scrushy with $1.4 Billion Accounting Fraud [Litigation Release].” http://www.sec.gov/litigation/litreleases/lr18044.htm “HealthSouth Whistleblower Lectures UAB Students on Company Fraud” [2010]. uabnews [University of Alabama News], http://vimeo.com/7710751

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P a g e | 285 “Special Report: Richard Scrushy Trial” Birmingham News http://www.al.com/specialreport/birminghamnews/healthsouth/ This site provided the Scrushy indictment, trial details, press releases and SEC filings. [Link no longer valid in 2017.] “Timeline of Accounting Scandal at HealthSouth.” (Sept. 30, 2004). Washington Post, http://www.washingtonpost.com/wp-dyn/articles/A24671-2003Oct14.html “Topics: HealthSouth Corporation.” (2017). New York Times, http://topics.nytimes.com/topics/news/business/companies/healthsouthcorporation/index.html This website provides many news articles about HealthSouth Corporation, including commentary and archival articles published in The New York Times. Articles range from 1996 to 2011.

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20.Royal Ahold—A Dutch Company with U.S.-Style Incentives (Chapter 5, pages 361-364) What this case has to offer This case is interesting because it ties stock option compensation and accounting irregularities in a European-based multinational company. Nevertheless, granting management stock options is a common practice in North American companies and some research suggests it is a good mechanism to align managers' and shareholders' interests. The case points out the risks derived from aggressive expansions--and joining companies with different control cultures--under pressure to meet analyst expectations. It presents interesting accounting issues, including revenue recognition for vendors' rebates and full control versus joint venture control in consolidation of subsidiaries. Teaching suggestions I start the class with a brief discussion about performance-based management compensation, and the advantages and disadvantages of granting management stock as a way to improve a company's financial results. •

•

Key advantages of stock option compensation: o

Motivates managers to improve financial performance, aligned with the personal gain derived from exercising stock options over the company's shares;

Reduces the company's cash needs, given that the options granted are not paid in cash, thus making cash available for pursuing growth opportunities; and

Links rewards with performance in a way easy to understand and control, potentially reducing or eliminating the cost of tracking metrics for performance measurement

Key disadvantages of stock option compensation: o

Motivates managers to produce short-term gains, disregarding long-term results;

Causes a dilution effect, reducing shareholders' participation in the company; and

Poses a threat for the shareholders, as it might be tempting for managers to manipulate public financial results in the absence of effective internal control mechanisms

I then introduce the case, explain the background of the company, and ask the class to identify the risk elements present before the fraud was uncovered. I also ask about the two accounting issues, and depending upon the accounting foundations of the students, tease out the proper accounting treatment for revenue recognition for vendors' rebates (no recording of unearned rebates (see below), verification of sales beyond representation letters, and comparison to past results), and consolidation of subsidiaries with full control versus joint venture participation (100% profit pick-up versus percentage pick-up). Next, I ask students about their opinion of the auditor's role in the case. Some interesting points are: the auditor's responsibility in case of fraud, the auditor's actions after some irregularities were uncovered--including the decision of not making them public--and the

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P a g e | 287 appropriateness of relevant audit procedures (i.e., preliminary risk assessment and confirmation of receivables). Finally, I wrap up by discussing the appropriateness of the changes made by Royal Ahold in its corporate governance structure in preventing future manipulation of financial results. Discussion of important issues/questions 1. A vendor may offer a customer a rebate of a specified amount of cash or other consideration that is payable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified period of time. When should the rebate be recognized as revenue? At what value should the rebate be recorded as revenue? Cash consideration received from a vendor is presumed to be a reduction in the prices of the vendor's products or services and should be accounted for as a reduction in cost of sales and related inventory, when recognized in the customer's income statement and balance sheet. Amendment to EIC-144 issued in January 2005 requires disclosure of the amount of any vendor allowances that have been recognized in income but for which the full requirements for entitlement have not yet been met. 2. The SEC investigation found the individuals involved in the fraud “aided and abetted the fraud by signing and sending to the company’s independent auditors confirmation letters that they knew materially overstated the amounts of promotional allowance income paid or owed to U.S. Foodservice.” Is the confirmation procedure enough to validate the vendor’s allowance amount in the financial statements? No. The confirmation process, if properly controlled by the auditor, can be a useful tool, but there should also be a verification check of some of the actual transactions in which amounts are significant in order to avoid the problem of falsified or misunderstood confirmations. 3. The SEC investigation also revealed “a significant portion of U.S. Food Service operating income was based on vendor payments known as promotional allowances.” How might irregularities have been discovered through specific external audit procedures? Interestingly, Ahold’s auditors, Deloitte & Touche insisted that they warned the firm about problems in its U.S. unit. The auditors also pointed out that Ahold did not supply them with full information. These problems were never disclosed to the public. Deloitte said during the inquiries that they identified the problems during the 2002 audit and gave the details to Ahold’s Board immediately before the audit was concluded in 2003. Royal Ahold revealed the accounting irregularities voluntarily. Ahold blamed a group of executives of fraud and the company did not face any penalties. See the answer to question 2. Irregularities may generally be discovered by detailed review of transactions, particularly when fraud is suspected, or the risk is considered high. There are three common elements present in cases of fraud: motivation, opportunity, and lack of ethics or rationalization of conduct. In this case, probable motives were a stock option compensation program and the continuance of a period of aggressive expansion. Opportunity was present because the company did not update its richard@qwconsultancy.com

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P a g e | 288 reporting lines and did not strengthen its internal controls following its high growth period. Also, the culture of the US subsidiary was probably not the same as the culture of the European parent. Finally, lack of a company-wide integrity and ethics program left awareness of ethical issues at the level of the individual. The presence of some of these elements should cause the auditors to set inherent and control risks as high, and therefore compensate with additional detailed testing. 4. Royal Ahold made several changes in its corporate governance structure. Discuss how those changes will mitigate the risk of accounting fraud in future years. Ahold undertook several corporate governance changes to prevent future accounting irregularities: •

Rotation of the members of the Board of Directors, paying special attention to succession issues, targeting improving their overall independence, objectivity and skills set required to oversee a complex organization;

•

Thirty-nine executives and managers were terminated, and an additional sixty employees faced disciplinary actions of different degrees, showing that unethical behavior would not be tolerated;

•

Developed a one-company system with central reporting lines, facilitating division of duties and authorization of non-routine transactions; and

•

Initiated a company-wide financial integrity program aimed at 15,000 managers, raising overall ethical awareness.

However, other measures might also be appropriate including an accounting concerns hotline and ongoing approval of performance-based compensation programs by the board of directors. Related Events May 22, 2006. Sterling, Toby (Associated Press) (May 23, 2006). “Ex-Ahold executives fined for fraud.” Toronto Star, page C4. In a very disappointing ruling, the CEO and the CFO were each fined 225,000 euros (approx. $300,000) and given nine-month suspended sentences for falsely asserting that companies in Brazil, Argentina, and Scandinavia should be consolidated because they were fully controlled, when only 50% of them were owned. According to the judge, neither of the men benefited personally as a result of the resulting overstatement of profits. The CEO is estimated to have been worth 43 million euros. Useful Articles, Links, and Videos Mui, Yian (November 7, 2006). “Royal Ahold to Sell US Foodservice Unit.” Washington Post, http://www.washingtonpost.com/wpdyn/content/article/2006/11/06/AR2006110600290.html Crouch, Gregory & Jennifer Bayot (February 26, 2003). “Market Place; Royal Ahold Accounting Scandal Leaves Dutch Employees with Heavy Debts.” New York Times, richard@qwconsultancy.com

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P a g e | 289 http://www.nytimes.com/2003/02/26/business/market-place-royal-ahold-accountingscandal-leaves-dutch-employees-withheavy.html?scp=11&sq=Royal%20Ahold&st=cse U.S. Securities and Exchange Commission (Oct. 13, 2004). “SEC Charges Royal Ahold and Three Former Top Executives with Fraud; Former Audit Committee Member Charged with Causing Violations of the Securities Law [Press Release].” http://www.sec.gov/news/press/2004-144.htm “Ahold Europe’s Enron.” (February 27, 2003). Economist, http://www.economist.com/node/1610552

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21.The Ethics of Bankruptcy: Jetsgo Corporation (Chapter 5, pages 364366) What this case has to offer This case presents a true story of firm that used deception and lies, called ‘white lies’ by the owner of the airline, to minimize the cost of bankruptcy. It allows students to discuss the concept of lying, understand its consequences, and determine if there are any situations in which lying is an acceptable business alternative. Teaching suggestions Before discussing the details of the case, there should be two general discussions: the first on the nature of bankruptcy and purpose of bankruptcy laws, and the second on the ethical aspects of lying. Darwinian economics argues that bankruptcy is a natural event. Firms that cannot effectively compete are forced out of the marketplace. In the struggle for survival, only efficient and effective firms survive. Because of the high cost of going bankrupt, firms will strive to ensure that they provide the goods and services that people need and want, in an effective and efficient manner, in order to generate sufficient positive cash inflows to remain economically viable. Bankruptcy protection laws are intended to allow a period of time for firms to reorganize. Firms are provided protection from creditor claims under laws such as Chapter 11 of the United States Bankruptcy Code or the Companies’ Creditors Arrangement Act in Canada. The purpose of these laws is not to help firms avoid their economic obligations. Instead, they remove some of the financial pressure, thereby allowing the firm to rearrange certain aspects of its operations and structures so that it can resume its place as an on-going business. Lying is a lapse from moral idealism. Bok (1978) argues that when wrongdoing, such as lying, is excused (for example, as in “Nobody is getting hurt and I can’t afford to do otherwise”), trivialized with a euphemism (such as, “Everybody does it. It’s just the way the business world works”) or denied (as in, “Nobody cares about this anyway”), then it may be an example of succumbing to pressure. The liar must identify the pressures that are causing the person to be hypocritical. Bok also notes that what the liar perceives to be harmless, a white lie, may not be so in the eyes of the one who is being deceived. Discussion of ethical issues 1. For many organizations, bankruptcy protection is just another operational and financial strategy. Discuss the ethical aspects of intentionally remaining silent, collecting money and then suddenly announcing that the company is bankrupt? Bankruptcy protection laws can be abused when solvent firms enter bankruptcy as a cost-effective strategy. The firm may use bankruptcy protection to: •

avoid making legitimate payments,

•

adjust pension plans without consolation or renegotiation with employees,

•

break union agreements, and /or

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P a g e | 291 •

circumvent terms of contracts.

Bankruptcy laws are not intended to help firms to entirely avoid their obligations. As such, a key ethical aspect is to investigate whether all stakeholders are being treated fairly. These aspects can be addressed by asking the following questions. •

Is the firm using the bankruptcy laws in ways in which they were not intended? Are solvent firms using them as a cost-effective means to avoid honoring their legitimate liabilities?

•

If bankruptcy is just another cost-effective financial stratagem, then does this encourage firms to take unnecessary risks? If the risky venture succeeds, then the firm benefits. But if the venture does not succeed, then the firms can easily move in and out of bankruptcy, with only the creditors suffering as their claims are not fully honored.

2. Do you accept that the little ‘white lie’ told to the pilots was justifiable? A white lie is often used to protect the feeling of another. Complimenting someone’s hat or attire is a social nicety. The problem with the white lie is that the recipient of the lie does not know that the comment is untrue. In the Jetsgo case, LeBlanc feared that the pilots would not fly the planes to Quebec City if they were told the truth. So, this is not a white lie in which the truth was altered as a polite social gesture. Instead, it is a deception intended to benefit only the liar. The central problem with deception is that it tends to erode trust, which is a key element in the economic system. 3. Was it operationally wise for Jetsgo to keep the online reservation system open until the company officially declared bankruptcy? Was it an ethically correct or incorrect decision? Keeping the on-line reservation system open all day on March 20, when Leblanc knew it would be permanently closed at midnight that evening was a deception and very unfair to many passengers. These people made their reservations in good faith were misled and deluded into thinking that their reservations would be honored and that their flights would occur as scheduled. Deception is considered to be unethical because the people who are lied to are not allowed to make an informed decision. They are being treated as means to achieve the liar’s objective. As result, when the subterfuge is discovered, they normally feel wronged and manipulated.

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P a g e | 292 4. Should Leblanc have waited until the busy spring-break holiday period was over to then close down operations? Nash (1990) notes that unethical behavior and actions often occur because managers ask the wrong questions. •

Instead of asking whether this will reduce costs, or achieve a personal objective, ask whether this is consistent with the values the firm. Will this decision result in value creation?

•

How will this decision affect the quality of the firm’s relationship with its customers?

If the manager cannot answer these questions positively, then the manager may be in the wrong line of business. Perhaps Jetsgo should not have been in the discount airline business. Perhaps the financial and ethical obstacles were too great. If a manager feels that deception, lying and subterfuge are the only means to staving off bankruptcy, then perhaps the manager should admit that operating the business successfully is beyond his or her capabilities. In such situations, the ethical alternative is to hire good talent to run the firm or rearrange the business model so that lying, deception and subterfuge are not part of the operating strategy of the firm. Useful Articles, Links, and Videos Bok, Sissela. 1978. Lying: Moral Choice in Public and Private Life (Random House) Nash, Laura. 1991. Good Intentions Aside: A Manager’s Guide to Resolving Ethical Problems (Harvard Business School Press). “Jetsgo lost $55 million in 8 months, court told.” (March 11, 2005). CBC News, https://www.cbc.ca/news/canada/jetsgo-lost-55-million-in-8-months-court-told1.556685 Alexander, Doug (March 11, 2005). “Canada’s Jetsgo Ceases Operations, Stranding 17,000.” Bloomberg, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLSjmZ0MF7lM&refer=c anada [Link no longer valid in 2020.] Austen, Ian (March 12, 2005). “The No. 3 Airline in Canada Suddenly Grounds All Flights.” New York Times, http://query.nytimes.com/gst/fullpage.html?res=9F0CE1DA143CF931A25750C0A9639 C8B63 “Jetsgo’s founder Leblanc says he is sorry [video].” (March 18, 2005). CTV News, http://www.ctv.ca/CTVNews/TopStories/20050318/Jetsgo_apology_050317/ [Link no longer valid in 2020.] “Discount airline Jetsgo declares bankruptcy [video].” (May 14, 2005). CTV News, http://www.ctv.ca/CTVNews/Canada/20050514/jetsgo_bankruptcy_20050513/ [Link no longer valid in 2020.]

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Stock Market Cases 22.Société Générale’s Rogue Trader (Chapter 5, pages 366-368) What this case has to offer Rogue traders, such as Jérôme Kerviel, can severely damage an organization, such as Société Générale (SocGen), or even bankrupt a firm, as did Nick Leeson’s rogue trades that brought down Barings Bank. It is important that students remember that •

no internal system can prevent all rogue trades from occurring,

•

there is a cost-benefit trade-off when installing internal controls, and

•

it is important to have a positive organizational culture that does not encourage rogue activities. Teaching suggestions

The class can begin with a discussion of the key elements of corporate governance and accountability. They can discuss •

how an organization could unintentionally install a negative organizational culture, and

•

how that negative organizational culture could be re-enforced. Then the students can discuss the opposite.

•

the elements that would go into developing a positive organizational culture, and

•

how the organization could reinforce that positive organizational culture. Afterwards, the questions at the end of the case could be taken up. Discussion of ethical issues

1. Did Jérôme Kerviel perpetrate a fraud? Why or why not? Fraud is a legal concept. Essentially it means that an individual or organization intentionally deceived another for personal gain. In this case, Kerviel did not personally gain from his unauthorized trades nor was he convicted in a court of law of having perpetrated a fraud on anyone. However, he was guilty of a breach of trust. His employer, SocGen, was relying on him to stay within his proscribed trading limits, which he failed to do. As such, he did violate the trust that SocGen had placed in him. 2. When such mammoth unauthorized trades occur, and the bank is bankrupted or severely damaged financially, should the board of directors, who have the ultimate responsibility for the bank’s activities, or its executives whose job it is to protect the bank, go to jail rather than the rogue trader? The board of directors has the responsibility of overseeing management, and management has the responsibility of ensuring that the organization operates in an efficient and effective manner within the law and in accordance with standards of richard@qwconsultancy.com

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P a g e | 294 normal ethical business behavior. If people fail to live up to their responsibilities, they should be held accountable for their shortfalls. This means that management should be held accountable for the activities of its employees if those employees are not properly trained and supervised. The report of the special committee of the board highlighted numerous failures of management to install effective internal controls. As such, management is partially responsible for the loss and therefore should be disciplined. The degree of the disciplinary actions would be a function of management’s degree of culpability in not installing adequate controls to supervise employees. Jail for directors or management would be unlikely unless it could be shown that the individuals involved recognized that a problem existed and purposely failed to take action to prevent it. Fines would be a more normal sanction to be applied. 3. Where the bank’s actions in liquidating Kerviel’s positions ethical? Unfairness in financial markets can occur when there is volatility, i.e., when there is a mismatch between buyers and sellers. Although the market will eventually correct for any mismatch, during the mismatch period, investors may be harmed by either paying to too much or selling too low. The size of SocGen’s liquidating trades was equal to eight percent of all trades that were conducted on the various exchanges in that three-day period. Eight percent of all trades may be enough to move the marketplace. The bank was concerned that if they revealed the magnitude of the anticipated trades that this information might adversely affect the price the bank would receive. This, in turn, might increase the size of the bank’s losses. On the other hand, by flooding the market over a three-day period, the bank may also have been creating an unfair marketplace in which prices did not reflect all available information. In other words, investors could have sold at prices that were too low, and investors purchased without knowing all of the market risks. 4. Did the French officials who authorized the liquidation behave ethically? In the U.S., the Securities Exchange Act of 1934 authorizes the SEC to intervene in the marketplace to correct any volatility or excess price swings thereby ensuring ‘fair and orderly’ markets. This suggests that the French officials who authorized the liquidation were acting in an ethical fashion, but that they should have intervened if they thought that the size of the Bank’s trades was unfairly moving the marketplace.

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P a g e | 295 5. There is considerable debate about whether better controls can ever stop a rogue trader. What is your opinion, and why? There is a trade-off to be considered for all internal prevention costs between their costs and their benefits. It would be cost-prohibitive to install a control system that completely prevented rogue trades from occurring. That is why it is important to develop a much more cost-effective, positive organizational culture that will discourage rogue activities. It is important that organizations carefully screen their employees to ensure that they do not put into a position of trust a person who lacks the moral fiber to not abuse that trust. It is also important that employees see that the organization is monitoring and supervising them. This shows employees that if they engage in rogue trades their activities were will be caught. A rogue trader would also be dissuaded by the prospect of heavy sanctions. 6. If enhanced controls really can’t stop all rogue traders, how are companies to be protected from them? Companies can protect themselves from rogue traders by installing the key elements of corporate governance and accountability that are outlined in Chapter 5, especially those elements that are summarized in Figure 5.9 (Organizational Culture, Individual/Team Outcomes, and Organizational Effectiveness) in the Text. 7. Was the court’s verdict justified? Could it have been improved? It seems like the court decided to impose a very harsh penalty on Mr. Kerviel, possibly to serve as an example and deter other people from doing something similar. Nevertheless, it seems like the economic sanction of 4.9 billion euros is excessive after three years in jail. There is almost no possibility that Mr. Kerviel could ever pay this amount. A possible improvement for this sentence would be a strong recommendation by the court for Société Générale to strengthen its internal controls. Arguably, the company is partially responsible for what happened. Useful Articles, Links, and Videos Nicholson, Chris (November 17, 2010) “Kerviel: Bosses Never Said a Thing.” New York Times, http://dealbook.nytimes.com/2010/11/17/kerviels-comeback-they-never-said-a-thing/ Clark, Nicola (October 5, 2010). “Rogue Trader at Societe Generale Gets 3 Years.” New York Times, http://www.nytimes.com/2010/10/06/business/global/06bank.html?_r=1&partner=rss& emc=rss “Societe Generale trader Kerviel says risks ‘encouraged.’” (June 8, 2010). BBC News, http://www.bbc.co.uk/news/10259720

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23. Galleon’s Insider Trading Network (Chapter 5, pages 368-370) What this case has to offer This case is the story of an apparently successful hedge fund manager who based his trading strategies on inside information from tipsters and not on sound market research. Billionaire Raj Rajaratnam used a vast network of contacts to profit from tips on nonpublic information from a number of companies such as IBM, Google, Hilton Hotels, and Intel. This is a very good case to discuss what constitutes inside information and insider trading. It represents the first time that wiretap information was allowed as evidence in insider trading cases, and therefore lifts the veil of secrecy that prevented earlier attempts at prosecution. Teaching suggestions I start the discussion asking students how a trader, or hedge fund manager, can gather information to develop a successful trading strategy. I then ask for an explanation of the concept of illegal insider trading and discuss the apparent fine line between gathering information and obtaining confidential information from insiders. After discussing some of the key case facts, I ask students whether or not Galleon’s trading was illegal and/or unethical. Finally, I highlight two takeaways from this case, first, that given that insider trading is illegal it should be prosecuted as any other form of fraud; and second, that the liability for insider trading violations cannot be avoided by passing on the information, as long as the person receiving the information knew or should have known that the information was confidential to the company (i.e., was its property) and its insiders. I also point to the potential change for prosecution that wiretap evidence will bring in the future. Discussion of ethical issues 1. Should inside traders, who are non-violent, white collar criminals, be subject to Mafia-style investigation tools? Insider trading is a crime equivalent to theft. The U.S. Supreme Court explicitly adopted the misappropriation theory of insider trading in the case United States v. O'Hagan (q.v.). The U.S. SEC guidance (U.S. Securities and Exchange Commission 2011) on insider trading cites the Supreme Court’s decision as a legal landmark in making insider trading a crime: “In the course of its opinion, the Court identified two discrete arguments for prohibiting insider trading. First, the Court (United States v. O'Hagan) stressed that prohibiting insider trading is: “…well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence…Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law. An investor's informational disadvantage vis-à-vis a misappropriator with material, non-public information

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P a g e | 297 stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill.” Second, the Court acknowledged the "information as property" rationale underlying insider trading prohibitions: “A company's confidential information…qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty…constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another.” [Emphasis added.] Given the criminal nature of insider trading, regulatory agencies can and should use any legal means to collect evidence to prosecute insider trading. The consequences of insider trading can be very severe for those who suffer loss. 2. How can a stock trader know when she or he is receiving inside information that would be illegal to act upon? It is not always easy to decide whether or not trading on certain information can be deemed insider trading. The SEC guidance on insider trading (U.S. Securities and Exchange Commission 2011) explains that; “Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” Furthermore, a fundamental component of illegal insider trading is being aware that certain information is nonpublic: “Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.” As a way to avoid illegal insider trading, Rule 10b5 establishes that: “A person other than a natural person also may demonstrate that a purchase or sale of securities is not "on the basis of" material nonpublic information if the person demonstrates that: The individual making the investment decision on behalf of the person to purchase or sell the securities was not aware of the information; and The person had implemented reasonable policies and procedures, taking into consideration the nature of the person's business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of material nonpublic information. These policies and procedures may include those that restrict any purchase, sale, and causing any purchase or sale of any security as to which the person has material richard@qwconsultancy.com

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P a g e | 298 nonpublic information, or those that prevent such individuals from becoming aware of such information.” [Emphasis added.} Based on the above guidance, if a trader receives or seeks to obtain direct information from an insider and that information is believed to be nonpublic, it is the trader’s personal responsibility as well as his firm’s responsibility to avoid trading on such information. In such cases, the trader or his firm could seek additional legal counsel if it is not a straightforward case to determine if the information received could be considered insider information. 3. How can a stock trader avoid using insider information? The answer to this question is related to the answer of the previous question. Using insider information is directly linked to the means by which a trader obtains information. If direct information is obtained from a person with a fiduciary duty and that information cannot be found or directly inferred from publicly available information, that information should not be used by a trader. Most cases of insider trading involve not only one instance but several instances where traders used nonpublic information. Furthermore, illegal insider trading cases may be detected through market surveillance systems. Regulators can use computer programs to find changes in volume and price that are outside normal patterns. Trading just before a major corporate event is a red flag for illegal insider trading. 4. Would a private investor be subject to the same rules against using insider information as a stock trader? The same rules apply for private investors as for stock traders. In fact, the SEC has enforced insider trading rules against: •

Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;

•

Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information;

•

Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;

•

Government employees who learned of such information because of their employment by the government; and,

•

Other persons who misappropriated, and took advantage of, confidential information from their employers.

5. Should a person giving a tip (the tipper) be subject to the same penalties as the user (the tippee)? The liability for insider trading violations cannot be avoided by passing on the information as long as the person receiving the information knew or should have known that the information was company property. Insider trading violations also include tipping information. A person giving a tip is an accomplice of the person using the richard@qwconsultancy.com

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P a g e | 299 information. All parties that may have been involved are at risk of being found guilty of insider trading. Useful Articles, Links, and Videos United States v. O'Hagan, 521 U.S. 642 (1997); 117 S.Ct. 2199, 138 L.Ed.2d 724 , 65 USLW 4650, available at https://www.law.cornell.edu/supct/html/96-842.ZO.html ... U.S. Securities and Exchange Commission. 2011. Insider Trading. http://www.sec.gov/answers/insider.htm U.S. Securities and Exchange Commission. (September 19, 1998). “Speech by SEC Staff: Insider Trading –A U.S. Perspective.” http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm [

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24.

Conflicts of Interest on Wall Street (Chapter 5, pages 371-373)

What this case has to offer This case illustrates some of the complex set of conflicts of interest that exist in the investment community and offers the opportunity to discuss some of the means available to manage them. It represents the first occasion where an enterprising district attorney (DA) took the lead on a securities case when the SEC and other agencies run by friends of Wall Street were slow to act. Eliot Spitzer, the DA involved, made things happen that should signal changes on the Street. Teaching suggestions I start off by asking why Eliot Spitzer acted when the Sec and other agencies did not. This sets the stage for a discussion of conflicts of interest, and those shown in the case (question 1). Then I turn to the penalties assessed, and their adequacy. question 2 about the adequacy of the rule changes comes next, followed by questions 3 and 4. Discussion of ethical issues 1. Identify and explain the conflicts of interest referred to in this case. The following conflicts are identified in the case: •

Self-interest of brokers vs. the interest of investors: o

•

Self-interest of analysts vs. investors: o

•

Brokers and brokerages have investments on which they speculate and do not disclose their own interests fully, but upon which they also advise investors who expect the brokers to act only in the investors’ interest,

Analysts tout investments that they believe are poor because: ▪

They are remunerated from profits for IPOs or trading in those investments

▪

They are influenced to do so to benefit others – children in a private school

▪

Their bosses tell them to

▪

They want to curry favor with repeat issuers of IPOs, or excellent prospect for future investment banking business

Self-interest of retail brokers getting early information on IPOs vs. the public who cannot and therefore invest in an unfair market.

2. What additional rules should the SEC make? The SEC should consider instituting additional rules such as: •

Investment firms should disclose their investment positions to their clients whenever they are buying or selling a stock, bond or commodity they have a

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P a g e | 301 position in for that client •

A code of behavior should be developed covering analysts, brokers and so on, and compliance programs should be developed and monitored, with appropriate sanctions

•

And so on.

3. What should be included in the investor education that the settlement funds are earmarked for? The objective here is to encourage discussion and thinking in the class about the knowledge required by investors, and the investment community. The investor education program should contain such programs as web-based, easy-to-access, selftraining for investment assessment in various levels from elementary to advanced, potential conflicts of interest to be aware of, risks to be aware of in investments, ongoing timely commentaries by leading knowledgeable analysts, and so on. It is too bad some money cannot be spent on ethics programs for investment analysts and brokers, and on compliance programs for them. 4. Was it appropriate for the New York Attorney General’s Office to have become involved in securities regulation, or should this have been left to securities regulators? Yes, Eliot Spitzer’s initiative was timely and had a beneficial impact. The problem arose in his geographic jurisdiction, and it was not so arcane that it was beyond the capacity of his office to correctly consider and arrive at a just result. The SEC does not have exclusive jurisdiction over malfeasance in the securities field. Useful Articles, Links, and Videos Berenson, Alex & Andrew Ross Sorkin (December 22, 2002). “How Wall Street Was Tamed.” New York Times, http://www.nytimes.com/2002/12/22/business/how-wall-street-wastamed.html Valdmanis, Thor (April 29, 2003). “Few believe $1.4B deal will change Wall St.” USA Today, http://www.usatoday.com/money/industries/brokerage/2003-04-29-settle-cover_x.htm “Eliot Spitzer Talks to Fareed Zakaria about Wall Street Bonuses [Video].” (January 17, 2010). Huffington Post, http://www.huffingtonpost.com/2010/01/17/eliot-spitzer-talks-tofa_n_426422.html Ignatius, Adi (December 30, 2002). “Eliot Spitzer: Wall Street’s Top Cop.” Time, http://content.time.com/time/magazine/article/0,9171,1003960,00.html Cullen, Ann (October 18, 2004). “The Bias of Wall Street Analysts.” Harvard Business School, http://hbswk.hbs.edu/item/4430.html

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25.Loyalty, But to Whom? (Chapter 5, pages 373-375) What this case has to offer Too often, employees are misguided by thinking too narrowly and/or too short-term about the benefits and costs of their actions. Many employees act to satisfy interests that conflict with the legitimate, ethical strategic objectives of their employer, or of their profession, or even of themselves in the longer term. This is a case that illustrates how a well-intentioned but short-sighted action caused a lot of trouble for the actors and the employer. This suboptimal decision making is one of the problems that trouble governance systems, and underscore the need for a strongly supported, well-developed ethical corporate culture to provide the necessary guidance for employees. Glen Grossmith told me that he was just trying to help a team-mate – a guy with whom they had worked for quite a while. At the time, he didn’t see significant harm in doing what he did. As noted at the conclusion of this note - this case illustrates that a consequentialist or utilitarian approach needs to be supplemented with both deontological and virtue expectations approaches to yield a sound, defensible, and ethical decision. Teaching suggestions This case identifies a common occurrence that students should be able to identify with. The reasoning behind “take one for the team” or “help the team” “group think” is what keeps police and unions from whistleblowing on each other, and for other employees to rationalize not behaving according to company goals. Referring to the police and the union mores will bring the problem into focus, but the instructor may not want to do this at the outset – preferring instead to introduce the extra examples when the class has defined the problems and issues inherent in the case. I would suggest asking for the class to define the problems and issues inherent in the case, introduce the extra examples, and then take up the questions posed at the end of the case, followed by a summary of the material in the ‘What this case has to offer’ section above. Discussion of ethical issues through the case questions

1. Loyalty is a highly desirable ethical value, and disloyalty is serious unethical and often illegal activity. Explain how and to whom Grossmith, Horcsok, and Webb (G, H, and W) were disloyal. G, H, and W were disloyal to UBS because they did not follow its ethical guidelines, which were intended to protect the integrity of clients and hence the market. They were disloyal to the U.S. client and perhaps to a professional body they might be members of that specified a code of conduct. Loyalty involves respecting the interests of others and not acting contrary to the best interests of clients, their employer, and the market regulators.

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2. Although Grossmith’s actions did not negatively affect the wealth of any client, why did UBS fire him? Glen was probably fired because he knowingly falsified documents, and in so doing broke company policy, and market regulations. He was a two-time offender. Also the company needed to show an example of their vigilance so that the rest of their employees would get the message as well as the regulators. In the end, if regulators had not been satisfied that UBS was enforcing the company code and ethical culture, the company, its executives and directors could have been vulnerable to charges of failure to maintain proper governance oversight and procedures. Finally, the company may have seen the firing as a chance to save the bonus money, but this is probable too cynical. 3. How should an employer like UBS encourage employee loyalty? An employer needs to mount a comprehensive ethics program that includes clear guidance to employees, with appropriate training, monitoring, rewards and sanctions. Above all, employees need to understand why loyalty is important to themselves, to their clients, the employer, and to the market. Most importantly, top management must ‘walk the talk’. Because they do not see any harm from unethical and sometimes illegal actions does not make them OK or permissible. A consequentialist argument (the end justifies the means) would lead the employee astray in these cases. This case illustrates that a consequentialist or utilitarian approach needs to be supplemented with both deontological and virtue expectations approaches to yield a sound, defensible and ethical decision. Useful Articles, Links, and Videos “Former UBS traders fined, suspended.” (July 18, 2005). CBC News, https://www.cbc.ca/news/business/former-ubs-traders-fined-suspended-1.533306 [Link no longer valid in 2020.] “Former Senior Traders of UBS fined by RS for Violating Trading Rules.” (July 18, 2005). Market Wire, http://www.marketwire.com/press-release/Former-Senior-Traders-of-UBS-Finedby-RS-for-Violating-Trading-Rules-548820.htm

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26.

Bankers Trust: Learning from Derivatives (Chapter 5, pages 376-

379) What this case has to offer Bankers Trust is the story of a company that emphasized maximizing profit at almost at any cost. Certainly, its employees placed earning commissions before the interests of their clients. Therefore the case illustrates the operating value differences between “buyer beware” and “seller beware”, and it shows that Bankers Trust (BT) did not have high interest in the fiduciary responsibilities that have motivated the brokerage community to institute “know your client rules” etc. Conflicts of interest abound, and unfair sales practices, non-compliance with company policies, taped conversations (privacy), and charges of using RICO as a blackmail tactic are issues well worth discussing with your class. Teaching suggestions/Discussion of ethical issues I would suggest beginning the case by having someone in the class give a recap of it. I would then ask what the class understood by the term derivatives, and how they think the derivatives that BT was selling worked, in general. In this case, although the details of the contracts are not known precisely, it would appear, since P & G would make money if interest rates went down and lose if rates went up, that the derivative contracts cost $195.5 million more than P & G expected due to interest rate increases. This loss is high, in part, because P & G leveraged their contracts, so a small investment could give rise to a big win or a big loss. The next matter to deal with is whether BT was acting as a principal or an agent when selling the derivative contracts to P & G. What did BT think, and what did P & G think? What does the class think? If BT was acting as an agent, then P & G has the right to expect BT to act in P & G’s best interests. If BT was acting as a principal, and P & G ought reasonably to have known this, then P & G would not expect BT to be acting in P & G’s best interests and presumably should/would have instituted defense mechanisms to guard against being taken advantage of. Modern stockbrokers are in much the same position in that they sell some securities (bonds) from their own inventory for profit and some they arrange for the client to purchase with a commission to the broker. Modern stockbrokers are expected to discharge their fiduciary responsibilities to their clients by assessing their knowledge level, risk preferences and ability to sustain losses etc., under “know your client guidelines.” If the stockbroker advises a client to invest in a security beyond a reasonable risk level for that client, the stockbroker is liable to receive a fine and is subject to lawsuit for failing to discharge their fiduciary duties. Also, if a modern stockbroker fails to notify his/her client that a sale is being made as a principal rather than as an agent, the sale can be overturned, and the broker fined. Modern laws have made it dangerous for a broker to ignore these conflicts of interest. For normal clients of stockbrokers, the operating policy of seller beware is now in force rather than that of buyer beware as it had been up until about 1990 or so. However, the question is: Was P & G a normal client? The answer is no because it was a big multinational and had a massive portfolio including derivatives that it had managed for years. I then ask: Did the BT salesman take unfair advantage of P & G even though P & G was an expert client, and does that make any difference? Unfortunately for BT, according to the tapes, richard@qwconsultancy.com

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P a g e | 305 the BT salesman knew that P & G did not understand the leverage aspect of the transaction he had sold them. Therefore, he knew he was taking advantage of P & G. Moreover, since the loss could be astronomical, it could be argued that he was taking unfair advantage of P & G. What does the class think? At this stage you have the answers to questions 2, 3, and 4, and I would recap them or ask the class their views, and I would then press on with question 1. The settlement has never been publicly released so we don’t know the specifics as yet. Question 5 is intended to bring together the other issues of the case, including: •

Unethical corporate culture of BT The buyer beware/profit at the expense of our clients’ attitude that was fostered at BT got BT into great difficulty and threatened its reputation worldwide. It was a policy that did not foster the continued support of its clients who are a most important stakeholder support group for any company. As such it was an unsustainable strategic building block.

•

Was P & G responsible? No. Its internal policies were not followed, and its personnel did not understand the risk involved in the contracts. They tried to get P & G to explain, but P & G refused to show its proprietary risk model and knew that the client had not grasped the explanation. P & G could have been more responsible and so should probably share some of the loss.

•

Privacy of taped conversations Usually this is unethical. However, conversations are usually taped in the brokerage industry in order to verify who said what at a later date. Moreover, the parties are told that the taping is occurring and tacitly agree to it.

•

RICO blackmail By adding RICO charges to the lawsuit, P & G was upping the risk of loss from the lawsuit substantially. Presumably, if the RICO charge was frivolous, the cost to get it dismissed would have involved legal and investigative time, but not a triple payout. Therefore, it would not have increased the settlement much unless the charge had some merit. The claim of “blackmail” was probably a counter-ploy to relieve the stress on BT’s reputation and put P & G somewhat on the defensive. The RICO issue probably hastened a settlement. You might ask the class: Does the end justify the means? Useful Articles, Links, and Videos

Holland, Kelley and Linda Himelstein. (October 16, 1995). “The Bankers Trust Tapes.” Business Week, http://www.businessweek.com/1995/42/b34461.htm [Link no longer valid in 2020. Reprint available from https://www.bloomberg.com/news/articles/1995-10-15/the-bankers-trust-tapes ] Andrews, Edmund (December 1, 1998). “BANK GIANT: THE OVERVIEW; Deutsche Gets Bankers Trust for $10 Billion.” New York Times,

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P a g e | 306 http://www.nytimes.com/1998/12/01/business/bank-giant-the-overview-deutschegets-bankers-trust-for-10-billion.html “Derivatives: Alive, but oh so Boring.” (January 30, 1995). Business Week, http://www.businessweek.com/archives/1995/b340981.arc.htm [Link no longer valid in 2020. Reprint available from https://www.bloomberg.com/news/articles/1995-01-29/derivatives-alive-but-oh-soboring ]

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27.

Barings Bank: Rogue Trader (Chapter 5, pages 379-381)

What this case has to offer Nick Leeson was definitely a rogue trader, but he didn’t get into trouble on his own – he had help. The story of how he did so involves conflicts of interest, a poor corporate ethical culture and compliance system, misguided motivational systems, poor control reports, and unwitting advice from senior management. Conflicts of Interest, Cultural Aspects, Relevance of Controls This case offers interesting insights into typical problems in the three areas noted. Students can readily see the common conflicts faced by employees, management and owners, and how these groups can be blinded by tradition, habit and the erroneous assumption that everyone is honest – or at least they won’t bite the hand that feeds them. The experience of forensic investigations experts given in the Text at page 277 (section, Forensic Experts & Evidence: the 20/60/20 Rule) provides an interesting insight on this as it suggests that as many as 60% of employees will commit a fraud if given the chance, and a further 20% will do so without any opportunity. Therefore only 20% of employees can be relied upon not to commit a fraud under any circumstances. The theory is based on expert observer experience and not on rigorous scientific testing, but it is probably not far off. Would you gamble on a 20% chance of winning? That’s what managements do that work on faith without adequate controls. Teaching suggestions I would begin by having a class member or two recap the salient points of the case. This should show that Nick was operating on his own. He had evidently decided to make unhedged investments on his own to increase his profits to recoup his losses that had been hidden in the Error Account No. 88888. He was in control of the investment operation and the record-keeping back office that should have provided information that would have brought questions on his increasing losses and need for cash. The Head Office of Barings had warnings in term of reports of potential lack of control and of the need of lots of cash, but did nothing because they thought Leeson was making a lot of money, and they were needy and greedy. I would also ask for a clarification of how Leeson was making his deals to see that the class understood derivative investments. I would then ask the questions posed at the end of the case. Discussion of ethical issues 1. How would you deal with a star trader who would be extremely sensitive to additional controls that implied he or she wasn’t trusted or would generate more time on paperwork and explanations? Unfortunately, exceptions to compliance or control systems usually end up badly. The star gets into trouble because s/he is unaware of problem areas or thinks that rules are not for her/him to observe. Therefore, the star must be convinced or cajoled into accepting the ethical culture and compliance system. Top management must set a strong, committed example, and be convinced what they are doing is important or else the star may not accept the overture. The star may well respond to a self-interest argument – that the system will protect the reputation and financial health richard@qwconsultancy.com

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P a g e | 308 of the organization, and thereby protect him from other employee actions. He or she, as a leader, should serve as a good example to others. After all, he or she wouldn’t want to see another case like Barings Bank, or… 2. What ethical and accounting controls would you advise ING to institute at Baring’s? I would recommend instituting the following in order to move the firm away from reliance on faith in the “old boy” or “old school tie” networks: •

a full ethical culture program, including: a code of conduct, training, initial and annual sign-off, reinforcement and encouragement mechanisms, whistleblower protection plan, generic reporting to a board committee, etc.

•

daily (on-line if possible) report of hedged and exposed securities positions sent to upper line management and top management,

•

daily, or online if possible, report of cash flows of over $50 million (10% of equity) to be sent to upper line management and top management.

•

separate supervision of trading (front) and record-keeping (back) offices,

•

have internal audit check that all company policies are followed, and report to an Audit Committee with non-employee Directors from the Board on it (who are supposed to be protecting the public interest) so that actions are not ignored without outside directors knowing about it.

3. Who was more at fault – top management or Nick Leeson? Management was more at fault than Nick Leeson. They had early warning of inadequate controls and did not do their job as stewards of the company assets to protect them. They could have moved much earlier and have prevented the bankruptcy and takeover. Leeson is not blameless, of course, but it is the old story of someone leaving something of value open to misuse (a pie on the windowsill) thus tempting someone else to steal or misuse it. Leeson went to jail for about two years and is now in poor health, and the Barings lost their Bank. Is this fair? Useful Articles, Links, and Videos Curtis, Adam (Producer) (1996). 25 Million Pounds [video], available at http://www.bing.com/videos/search?q=documentary+25+Million+Pounds+&view=detai l&mid=59894AAFFDAFFED6FB3E59894AAFFDAFFED6FB3E&FORM=VIRE Documentary video about Nick Leeson and The Barings Bank Collapse. Leeson, Nick (1996). Rogue Trader: How I Brought Down Barings Bank and Shook the Financial World. London: Little, Brown & Co. Autobiography of Nick Leeson written while in prison. Norris, Floyd (March 31, 1996). “Upper-Class Twists Made Me Do It.” New York Times, http://query.nytimes.com/gst/fullpage.html?res=9C03EFDF1239F932A05750C0A96095 8260 Dearden, James (Director) (1999) Rouge Trader [Film]. richard@qwconsultancy.com

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P a g e | 309 Movie about Nick Leeson.

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Cases on Product Safety 28.

Dow Corning Silicone Breast Implants (Chapter 5, pages 382-

383) What this case has to offer This case offers the chance to examine why an excellent code of conduct, and an excellent ethics audit or ethical assurance program may prove to be ineffective. Dow Corning Inc. had a celebrated ethics control system which did not surface the problem of health risk associated with their silicone breast implants, which were prone to rupture. The investigation of why involves looking at the following ethical issues: •

What are the critical success factors involved in making a code of conduct and an ethical assurance program effective?

•

How to instill the desire to comply with the company’s ethical guidelines.

•

How to apply ethical principles to crisis decisions and announcements.

•

The need to balance legal risk with ethical performance.

•

Should products used for purposes of vanity be subject to the same ethical/safety concerns as one which is used for purposes of utility or health improvement? Teaching suggestions

The case builds upon a Harvard Case which provides the details of the company’s code of conduct, the process of preparation of that code and of the audit process used to examine compliance with the code. This is a very useful discussion of background details, which can be very instructive for those facing the refinement of less developed systems. I have the students come to class having read the full case, and begin the discussion with a short statement covering the issues laid out above. Sometimes the class wants to discuss whether the company is at fault because the purpose of the product is viewed (usually by men) to be purchased to satisfy female vanity. I facilitate this because it serves to raise the awareness of the men in the audience about the problem from a women’s perspective and gets into the relationship of appearance to mental health. I then get the class to describe the code of conduct and the related compliance process in their own words. When we are all at the same level of understanding, I use the questions at the end of the case to shape the discussion, covering the issues described below. I use the Dow Corning Breast Implant Case, either to start off the discussion of codes of conduct, or to reinforce the discussion on codes. The case induces strong discussion and takes about 30-35 minutes.

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P a g e | 311 Discussion of ethical issues Vanity vs. utility: Although men usually see the breast implant as just a response to female vanity, the women in the class are quick to point out that many breast implants are installed as part of the after-treatment for breast cancer involving mastectomy. Consequently, these implants are not considered to result from frivolous whimsy. In addition, and more importantly, the women will make the connection between physical appearance and mental health. The men can then see that poor mental health can have an impact on health costs and job performance, so the breast implant issue suddenly becomes important to the men in the class for reasons other than avoiding legal risks. Often a woman or I, who am balding, playfully raise the issue of hair transplants for men, and this seems to settle the vanity issue. This discussion is useful in setting up the need to include both sexes in ethical audit/assurance programs in order to have the best chance to surface single-sex issues – those which have special significance for one sex but which may not appreciated by the other. 1. Why didn’t the Dow Corning ethics audit program reveal any concerns about the silicone-gel breast implant line? Usually the class suggests several reasons for the failure of the ethics audit program to surface the breast implant issue at an early stage so that it could be acted upon and resolved as early as possible, including the following: •

The audit team may not have been tuned in to women’s problems (a single sex issue);,

•

The audit team may have not have included a manager grounded in the science or health disciplines;

•

The audit focus may have been internal rather than external, so that the press reports on the problem were not surfaced;

•

The group input sessions with local personnel involved up to 35 people, so some attendees may have been too shy to speak, or may have considered whistle blowing in such a large group to be too risky;,

•

Whistleblowing without anonymity, when a lot of jobs are at stake was too much to expect;

•

Original memos had been written by a person who had “left” the company, and this may have dissuaded further discussion;

•

The issue of cause of leakage (installation, accident) and culpability was not sufficiently clear from the company’s or employee’s perspective; and

•

Some personnel apparently believed the problem to be already under review in a testing program and therefore not worth raising again.

These faults can be summarized under the following topics, some of which relate to the code and culture of the company: •

Audit team: expertise and sensitivity

•

Audit focus

•

Audit processes

•

Whistleblowing processes

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P a g e | 312 •

Trust

•

Understanding of the intent and scope of the process.

2. What are the critical factors necessary to make such an ethics audit program work effectively? This case offers an opportunity to reinforce the issues discussed in the Text on pages 282-288 (section, Developing, Implementing, & Managing an Ethical Corporate Culture). In particular, the following are germane to the case: •

Continued endorsement of the process by top executives;

•

Clear communication of performance guidelines, and identification of an ombudsman or other person for clarification of problems;

•

Continued training/sensitivity sessions to ensure that participants understand the need for, scope of, and relevant issues to the process;

•

Creation of a condition of trust or whistleblower protection, so people will come forward and report wrongdoing;

•

Comprehensive compliance processes, including scans of the internal and external environments;

•

Formal, periodic reports to compliance officers on problems discovered earlier and under investigation;

•

Knowledgeable, sensitive assessors of problems;

•

Performance measures, linked to reward and discipline systems;

•

Internal and external reports of performance; and

•

Governance of the process by a senior officer reporting, at least annually, to a committee of the Board.

3. Was the March 20th announcement well-advised and ethical? The short answer is no on both counts. The spokesman did not convey much empathy for the women who had suffered from the leakages. He would have been better advised to acknowledge the possibility of a problem and indicate that further investigations were under consideration or underway. Instead he came across as noncaring and legalistic, which is not appropriate for a company in the health-products field. The stance taken would weaken the image of the company with potential customers for all products of the company even though this particular product is relatively low in revenue contribution. In addition, the stance taken with regard to paying for some excisions, where health insurance is not available, is unethical. It is unfair for the other fee-paying members of the plan to have to pick up the cost of a problem caused by Dow Corning, and the company is trying to shift the cost of remediation from their shareholders to the richard@qwconsultancy.com

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P a g e | 313 fee-payers. Where a national or government health plan exists, such an action would shift the cost to the taxpayers. 4. Are there any other ethical dilemmas raised by the case? This case opens up the chance to discuss the need to keep ethics in mind when handling a crisis. Crisis management, which is discussed in the Text in Chapters 5 and 7, offers approaches minimize the harm from crises, including the early recognition and acceptance of the reality of a crisis, and the recognition that ethical reactions can provide the best long-run solutions. For further discussion, see the Text, Chapters 5 and 7. One of the interesting aspects in this case is that Dow Corning Inc. was a joint venture of Dow Chemical Co. and Corning, Inc. and they had to seek protection from the courts to prevent the liability arising from breast implants to impact on the parent company resources other than their investment in the joint venture. This they were able to do, based on the argument that they had no knowledge of the concern, and were not the controlling mind involved in dealing with the problem. Subsequent Events For a chronology of events see Frontline (1995-2014). “Breast Implants on Trial: Chronology of Silicone Breast Implants.” PBS, http://www.pbs.org/wgbh/pages/frontline/implants/cron.html. For details of the payment as of June 1, 2004 pursuant to a second settlement (the first, which was negotiated in May 1995, collapsed) see Claimants’ Advisory Committee (2016). “Final Plan Documents.” http://www.tortcomm.org/plandocs.shtml Useful Articles, Links, and Videos Kolata, Gina (June 21, 1999). “Panel Confirms No Major Illness Tied to Implants.” New York Times, http://query.nytimes.com/gst/fullpage.html?sec=health&res=9B03E6D9103BF932A157 55C0A96F958260&n=Top%2fReference%2fTimes%20Topics%2fOrganizations%2fI%2fI nstitute%20of%20Medicine Feder, Barnaby (May 16, 1995). “Dow Corning In Bankruptcy Over Lawsuits.” New York Times, https://www.nytimes.com/1995/05/16/business/dow-corning-in-bankruptcy-overlawsuits.html Tabor, Mary (September 23, 1995). “Ex-Dow Corning Executive Faults Company’s Ethics on Implants.” New York Times, http://www.nytimes.com/1995/09/23/us/ex-dow-corningexecutive-faults-company-s-ethics-on-implants.html

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29.

Ford/Firestone Tire Recall (Chapter 5, pages 384-394)

What this case has to offer The Ford/Firestone Tire Recall is a classic in many ways. Here are two companies that have had a history of damaging recalls, but they did not learn or retain enough to avoid a repeat the errors of handling earlier damaging crises. The companies suffered because they had not developed an ethical corporate culture that provided formal and informal guidance when problem arose. The case illustrates many of the problems developed in the crisis management material in the Text, Chapters 5 and 7: denial rather than early action to control damage, belief that the world is too large for domestic consumer and capital market to take notice of foreign activities, no ongoing system of data collection and review, and so on. The case also illustrates that the biggest cost to the companies involved in a product liability case is not the fines – it is the cost of lost reputation and of lost trust by consumers that translates into future lost sales. Teaching suggestions This is a case that students find most interesting. After asking several students to recap the case, I deal with the questions at the end of the case. I frequently use this case as an assignment and have developed the materials that are presented below. In addition, I deal with the 3 questions located at the end of the material located below. Discussion of ethical issues Since I have used this case as an assignment, I have developed for feedback “Overview Comments” and a “Full Set of Comments” that contain the issues raised by my classes in regard to each of the seven questions at the end of the case. I have reproduced each below as a way of conveying what I think is relevant for the ethical issues involved. Overview Comments on Ford/Firestone Case I have returned a “Full Set of Comments” that were raised about the case, and another page that shows (by underlining) the comments raised by your group and my overall comments and mark. In general… My take on the Ford/Firestone Tire disaster is that they failed to recognize and develop an effective response because their corporate cultures had not embraced a risk assessment dimension focused on safety-related, consumer interests. Neither company was alert to or looking for safety-related problems, nor did they have systems in place to collect and analyze relevant data, and report against acceptable standards. Neither company could be considered a “learning company” due to these shortcomings. This failure, and the slow reporting to NHTSA, was due to many factors - short-term focus based on legal advice crafted in view of very low legal penalties, incorrect projection of consumer outrage, lost sales and new legal consequences, and so on, as noted in the “Full Set of Comments”. Clearly F & F did not foresee the largest cost – lost reputation/future revenue – involved.

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P a g e | 315 The ethical risks involved in this disaster are many. They would be discovered from an assessment of where the expectations of all stakeholders were not satisfied or likely to be satisfied. These ethical risks have a significant potential impact on reputational risk and the corporate value chain. This leads to the ethics risk management advice noted in the Executive MBA 20 …“Full Set of Comments”.

EMBA 20 Ford/Firestone Tire Grading Answer/Comments – Full Set of Comments ______________________________________________ Ethics Issues/Case Questions: 1.

Why no learning from earlier disasters: no culture/philosophy change, no training, short-term focus, concealment vs. disclosure, past evasion success – low cost & no personal cost, no legal imperative, poor risk management procedures, data analysis function lacking, no ethics officer/monitor, no personal memories, denial, Firestone’s problem not Ford’s, Ditlow’s statement useful

Why not earlier discovery: No safety related data bank, insufficient analysis and awareness of downside, lax employees, inspectors, labor unrest and poor risk management in Decatur, decision to not report Saudi problem to NHTSA, blamed someone else, no F & F cooperation, no organizational accountability established, no stakeholder dialog, NHTSA slow to investigate

Why no report earlier to NHTSA: Not technically/legally required if case by case treatment, could wait out 8 year limit, $1,000 per document withheld cap on fines if discovered – defense strategy dominates action, poor risk assessment of downside costs, short-term focus, lack of F & F collaboration

Largest cost: Lost reputation: revenue and costs estimates made – note that previous fine cost only 5 cents per car

CBA Corrections – most depend upon assumptions: Lost reputation estimate clarified/corrected – tire costs & numbers, present value, loss of share value to investors, higher costs of capital, intangible costs of dead, loss to each stakeholder, time and effort of F & F, productivity lost, insurance costs, difference in perspective/costs if nylon cap used, environmental impact, drop in market cap = lost reputation cost, job losses, ongoing litigation costs too low, possible criminal charges, U.S. market only so should expand to international

Ethical risks involved: Definition of ethical risk – see the Text, To each stakeholder group – safety, rate of return, employment, deceit – “customer notification enhancement action”, reputation risk and place in value chain viability/success/reputation/values/hypernorms - honesty, fairness,

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P a g e | 316 compassion, integrity, predictability, responsibility; global perspective, lack of trust, more regulation 7.

Ethics Risk Management Advice: Create or enhance Culture, Code, Cooperation with NHTSA, Stakeholder Analysis, Decision Analysis, Cost Benefit Analysis, Public Relations, more proactivity, strategic issue management team, factor in reputation losses, more early warning/detection and prevention effort, be accountable and transparent with problems, ensure that suppliers follow similar appropriate risk management practices, risk management strategy linking org. values, customer commitment and compliance, 6-step issues management, whistleblowers rewards & protection plan, complaint review, involvement and reporting to top management, domestic-international linkage, elimination of unreasonable risks, appropriate internal controls

Other Questions Raised: a) Was recall ethical? No, it was unfair (slow) to many warm weather customers b) Lessons for Crisis Management? See commentary above c) Whose was the responsibility for the warrantee issues? Both Ford and Firestone, as well as the NHTSA. GM does not leave this to their suppliers and have developed a group that tests and monitors tires. Also, how can a regulator do their job without any (independent) data source?

Other Factors Considered: •

Thoroughness/Depth of Analysis/Exhibits

•

Creativity Overall Grade Subsequent Events

From: Easton, Pam (March 16, 2004). “Judge approves $149 million Bridgestone-Firestone settlement.” Associated Press, https://www.mrt.com/news/article/Judge-approves-149million-Bridgestone-Firestone-7800665.php On March 15, 2004, a judge approved “..a $149 million settlement of 30 classaction lawsuits on behalf of [some owners of the 14.4 million potentially defective Bridgestone-Firestone tires that were recalled in 2000.” “At least 271 U.S. traffic deaths [and over 800 injuries] have been blamed on the tires, most of which were sold with the Ford Explorer… but the settlement [pertains only to those who had not] suffered any injury or property damage. “The settlement calls for Bridgestone … to pay an estimated $70 million to replace tires, $41 million to manufacture better tires, $15.5 million on a consumer education campaign, and $19 million for attorney’s fees. The company has also paid #3.5 million to notify owners of the settlement. richard@qwconsultancy.com

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P a g e | 317 “The settlement could affect up to 15 million people. The 45 named plaintiffs each could receive up to $2,500.” Others could have their tires replaced. A Firestone spokesman said the company was pleased with the settlement. One of the Plaintiffs attorneys, however, said that it was “really no settlement at all. Everything in the settlement was already being done by Firestone.” October 13, 2005 [Reuters and Bloomberg] (October 13, 2005). “Bridgestone and Ford settle tire recall feud”, Toronto Star, D16. Bridgestone agreed to pay $240 million to Ford covering about 11 percent of Ford’s cost of replacing up to an estimated 13 million tires in 2001. Useful Articles, Links, and Videos Greenwald, John (2001) “Inside the Ford/Firestone Fight” Time, May 29th http://content.time.com/time/business/article/0,8599,128198,00.html C-Span and Senate Commerce, Science and Transportation Committee (September 12, 2000). “Firestone Tire Recall: Senate Commerce Committee [video].” http://www.cspanvideo.org/program/159191-1 Witnesses testify about the recall of Firestone tires while Ford and Firestone officials insist on each other’s culpability. Shaffer, Marc and Goodman, Barak (February 21, 2002). “Rollover: The Hidden History of the SUV [Transcript ].” PBS Frontline, http://www.pbs.org/wgbh/pages/frontline/shows/rollover/etc/script.html

Business & Professional Ethics for Directors, Executives & Accountants, 9e Leonard J. Brooks and Paul Dunn

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Chapter 6—Professional Accounting in the Public Interest Chapter Questions and Case Solutions Chapter Questions.....................................................................2 Case Solutions.........................................................................15

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Chapter Questions 1. What is the difference between an honest financial statement and one with integrity? An honest financial statement is accurate but may not include or disclose critical negative information. A financial statement that has integrity will include or disclose all significant positive and negative information. 2. How can a professional accountant develop professional skepticism? By understanding and internalizing that the primary role of a PA is to serve/protect the public interest, that they cannot accept that all information given to them as trustworthy, and that they must continuously compare the information received to all other available information and to tests of reasonability. This approach, the awareness that drives it, and the competencies involved, can be stimulated, learned and reinforced by studying realistic cases, particularly such as Sino Forest, Enron, Bernie Madoff, Carillion, Toshiba, Danske Bank, HealthSouth, and Walt Pavlo. The following is a complete list: •

Chapter 2: Enron’s Questionable Transactions; Arthur Andersen’s Troubles; Bernie Madoff Scandal—The King of Ponzi Schemes

•

Chapter 4: Ford Pinto (a case where damage estimates are wrong or shortsighted).

•

Chapter 5: Manipulation of MCI’s Allowance for Doubtful Accounts; Satyam Computer Services—The Enron of India; Nortel Networks’ Audit Committee Was in the Dark; HealthSouth—Can Five CFOs Be Wrong?; Royal Ahold—A Dutch Company with U.S.-Style Incentives

•

Chapter 6: Carillion Bankruptcy: A Nightmare that Challenged the Foundations of the U.K. Accounting Profession; NOCLAR Solutions to Toshiba’s Accounting Scandals & Confrontations with Auditors; Sino Forest Fraud? Audit Challenges in China

•

Chapter 7: Danske Bank’s Money-Laundering Scandal; Walt Pavlo’s MCI Scams/Frauds; Digoxin Overdose—The Need for Skepticism, Courage, and Persistence

Further, the PA must understand that professional skepticism requires (Text, Chapter 6, pages 426-427): •

Independent judgment (Standards of independence are embedded in professional codes of ethics, and ethics codes for virtually all professional accountants are being harmonized to the IFAC Code.)

•

Objectivity

•

Approach of “trust, but verify” (Do not accept as accurate or true everything that is said; verify the information. Compare information received to what could be

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P a g e | 320 considered reasonable. If disparities exist between information received and other information available, investigate and satisfactorily explain the disparities.) •

Sight of what is best for protecting the public interest

•

Awareness of self-interest (e.g., pride, compromising to prevent loss of the client, and personal gain) that may prevent pointing out errors

•

Awareness of, and avoidance of, conflicts of interest (e.g., advocacy on behalf of a client or furthering the interests of current shareholders or management over the public interest)

•

“…[C]ontinuous questioning of whether the fact, decision, or action being considered is in the best interest of the client and is ethical, particularly with regard to the public interest” (Text, page 427.)

3. How can a professional accountant develop moral courage? To develop moral courage, a PA must understand and internalize that the primary role of a PA is to serve/protect the public interest. A case that highlights the problems and consequences resulting from a lack of moral courage is “Livent—When Maria, When?” (Chapter 6). A case that illustrates the benefits of exercising moral courage is “Moral Courage: Toronto-Dominion Bank CEO Refuses to Invest in High-Risk AssetBacked Commercial Paper” (Chapter 8). In addition, by maintaining professional competence and professional skepticism (see above), the professional accountant can gain the courage to (Text, Chapter 6, section Moral Courage Is Vital to Professional Accounting…, page 464): •

Say no to a client or third party and to explain why;

•

Resist self-interest and pressure from clients, friends, and others to hide the truth;

•

Act in the public’s best interest;

•

Report a problem or potential problem to employers, clients, or their audit committees;

•

Report to professional accounting bodies and/or regulators, if necessary, if the problem cannot be solved internally; and

•

Whistleblow or resign from an audit or other assignment, if necessary.

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P a g e | 321 4. Answer the seven questions in the opening section of this chapter. (See Text, Chapter 6, page 405.) •

Who really is my client—the company, the management, current shareholders, future shareholders, the public? SOX and IFAC have now spoken on this issue. See discussions in the chapter under Priority of Duty, Loyalty, & Trust in a Fiduciary (Text, page 409ff) and related to Text, Figure 6.1 (IFAC-IESBA 2018 International Code of Ethics Conceptual Framework Approach). The public interest ranks first, followed by the profession, current and future shareholders or the employer. Management ranks last.

•

In the event I have to make a decision with ethical ramifications, do I owe primary loyalty to my employer, my client, my boss, my profession, the public, or myself? It depends on the significance of the decision, on who is acting ethically and who is not, but consideration should be given to the stakeholders in the reverse order to that listed in the question except that duty to yourself as a professional should usually rank last.

•

Am I, as a professional accountant, bound by professional standards even when acting as an employee? An employed professional accountant must follow the profession's standards or be sanctioned. Most codes now confirm this. Some professionals would argue that the rules ought to be tighter for those in the audit function, but I do not agree. The mess created by an unethical accountant in management can affect as many, if not more, stakeholders if the company is wound up.

•

Is professional accounting a profession or a business? Can it be both? Yes, but the problem comes when the drive for profit overtakes the need for the exercise of proper ethical values and professional practices based on those. Shaving hours/costs on a job results in poor quality and raises the risk of audit failure, misrepresentation and poor judgments.

•

When should I not offer a service? When the client is unethical, or the risk to reputation is too high, or there is a conflict of interest involved, or the service involves breaking the law. Guidelines are now offered by the SEC per SOX, and these are discussed in the Text. As well, an extensive discussion is offered in this chapter about when services should be offered.

•

Can I serve two clients with competing interests at the same time? Rarely can this be done effectively because an optimal decision for one client is rarely the optimal decision for the other. It is very difficult to maintain the appearance and discharge the responsibilities of a fiduciary to two or more clients when their interests are different or may diverge in the future - see the

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P a g e | 322 Locker Room Talk case (Text, page 496). Such double service should not be undertaken without informing the two parties and advising them to obtain outside counsel to verify the service offered. Safeguards are needed, as is scrupulous attention to fairness to all. There are, however, times when the interests of the clients are not highly conflicting (such as when an accountant audits a supplier and the buyer of that firm’s product, or a bank and a customer of that bank) and where the accountant is bound to follow GAAP and GAAS. These are designed to be neutral between clients in order to serve the public interest by ensuring objectivity. The auditor, however, must be independent of all clients, and be seen to be independent. •

Is there any occasion when breaking the profession’s guideline against revealing confidences is warranted? Yes. The profession's confidentiality guideline was not intended to protect those guilty of unethical acts, particularly if the harm caused by ignoring an unethical act would cause great difficulty.

5. What is meant by the term "fiduciary relationship"? A relationship where the professional is dealing with a matter of vital significance to a another party, where there is such a difference in knowledge and expertise between the two that one must place trust in the competency of the professional and that s/he will act in the other's best interests. 6. Why are most of the ethical decisions accountants face complex rather than straightforward? More than one stakeholder’s interests are involved and trade-offs between the interests of these stakeholders are tough to assess (management vs. shareholders vs. lenders etc.), particularly where fairness of disclosure is concerned. Outcomes of such decisions are difficult to predict, so consequences have to be weighed carefully (going concern problems can arise, etc.). Also, usually the output of accountant’s decisions is subject to far more intense scrutiny than for other professionals such as doctors or lawyers. 7. When should an accountant place his or her duty to the public ahead of his or her duty to a client or employer? Because the public (in the form of future shareholders, lenders, customers etc.) is the ultimate user of some services such as the attest function and external corporate reports, and if internal reports or systems are faulty the decisions made will ultimately affect such external stakeholders as well. Focusing just on existing internal stakeholders tends to obscure this. Also when the public hears of a bad decision/action of an accountant, whether it is internal or external doesn't matter; it darkens the reputation of the entire profession as happened in the Arthur Andersen case. 8. Which would you chose as the key idea for ethical behavior in the accounting profession: “Protect the public interest” or “Protect the credibility of the profession”? Why?

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P a g e | 323 Protecting the public interest will, in the long run, protect the credibility of the profession. Unfortunately, when professionals focused of protecting the credibility of the profession, they try to sweep problems “under the rug.” Almost always, these secrets emerge and embarrass the profession, which then has to act in the public interest to salvage the profession’s credibility. 9. Why is maintaining the confidentiality of client or employer matters essential to the effectiveness of the audit or accountant relationship? If it were known that an auditor or accountant were likely to disclose secrets related to competitive advantage, or discussions of potential liability or concern, it is extremely unlikely that accounting personnel would ever be consulted or made aware of them. This would severely limit the audit role and the participation and effectiveness of accountants, who bring ethics and expertise to the discussions. 10. How do the NOCLAR Standards change the traditional practice of maintaining confidentiality of audit or client information? Why? NOCLAR provides a sanctioned, mandated response protocol when PAs discover or suspect that their client or employer is not complying on significant matters falling under laws or regulations. Previously, common practice was to ignore such matters unless they affected financial disclosures significantly. Often this practice of overlooking was bolstered by PAs, because one of their inviolate norms was to maintain confidentiality on client and employer matters. This was an erroneous practice, however, because confidentiality was never intended to protect criminal behavior, or behavior not in the public interest. However, the new NOCLAR standards will now clarify this error and focus PA responsibility on protecting the public interest. Helpful quotes from the Text include: •

NOCLAR rules will require “…professional accountants to report when they discover or suspect that their clients or employers have not or will not comply with laws and regulations.” Reporting might first be internal, but if the professional accountant does not see satisfactory rectification of the problem, reporting can be external. (Text, page 401.)

•

These NOCLAR rules, designed to further the primary purpose of professional accountants to protect the public interest, will require professional accountants to set aside traditional interpretations of confidentiality. Why? “These NOCLAR rules [are] designed to further the primary purpose of professional accountants to protect the public interest, [and] will require professional accountants to set aside traditional interpretations of confidentiality.” (Text, page 401.)

•

Before the NOCLAR rules, “[to] prevent the release of client/employer confidences, most codes of conduct [required that] confidences not … be divulged except in a court of law or when required by the discipline process of the profession.” (Text, page 411.)

•

“…[A] professional accountant facing a difficult choice should make that choice so as to preserve the trust inherent in the fiduciary relationships, first with the

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P a g e | 324 public, then with the profession, then with the client/employer, and finally with the individual professional. Placing the client/employer’s interests first is valid only if those interests will be overridden by the interests of the public and the profession in circumstances where a proposed treatment would not be in the public interest or profession’s interest, either legally or ethically.” (Text, page 411.) •

The NOCLAR standard sets aside the duty of confidentiality and provides a framework for professional accountants to act in the public interest.

11. What is the difference between exercising “due care” and “exercising professional skepticism”? “Due care” refers to a standard of thoroughness, comprehensiveness, and the exercise of judgment in a manner similar to other properly qualified professionals in the circumstances. This is often verified in court by the testimony of expert witnesses from the accounting profession indicating what they would have done. “Exercising professional skepticism,” on the other hand, refers to the constantly searching, challenging, comparing and verifying mindset a professional accountant is expected to apply so that incongruent facts and/or questionable actions are identified and explored. It is possible that expert witnesses could be called to testify on whether the professional skepticism exercised by another professional exhibited “due care.” 12. Why did the SEC ban certain nonaudit services from being offered to SEC-registrant audit clients even though it has been possible to effectively manage such conflict of interest situations? Faced with the inability of one of the largest and most respected firms (Arthur Andersen) to resist the lure of profit and protect the public interest—and the fact that such conflicts were common practice–SOX required the SEC to eliminate the most problematic conflicting services. The investing public and government observers would not have been satisfied with less. 13. Where on the Kohlberg framework would you place your own usual motivation for making decisions? You may want to suggest a trial decision for the class to use to operationalize this question, such as: whether or not to engage in a barter or cash transaction to avoid paying income tax, or whether to report that the government overpaid you on your tax refund.

14. Why do more professional accountants not report ethical wrongdoing? Consider their awareness and understanding of ethical issues as well as their motivation and courage for doing so. Frankly, although they are able to detect ethical wrongdoing, they may have misplaced loyalty to their boss, or company/employer instead of to the public interest. richard@qwconsultancy.com

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P a g e | 325 They may also lack the courage necessary to oppose their boss or blow the whistle, partly because they fear loss of their job or public denigration. 15. Independence, as defined on p. 432, seems very straightforward. Why did the IFAC-IESBA 2018 International Code of Conduct for Professional Accountants allocate roughly 50% of its space to cover the International Independence Standards that make up Parts 4A and 4B of the code? Frankly, independence is the key to making objective decisions and disclosures and, in turn, to serving the public interest. Therefore, the new International Independence Standards, which provide extensive coverage of conflicts of interest and other behavioral problems, are at the core of the new IFAC-IESBA Code’s purpose of focusing PAs on serving the public interest. Extensive coverage is therefore well warranted. The Textbook emphasizes the importance of independence. For example (Text, Chapter 1, section Reinforced Fiduciary Role for Professional Accountants, page 14): •

“The public’s expectations for trustworthy reports on corporate financial performance cannot be met unless the professional accountants who prepare or audit those reports focus their primary loyalty on the public interest and adopt principles such as independence of judgment, objectivity, and integrity that protect the public interest.”

•

In addition, “…the primary fiduciary responsibility of professional accountants should be to the public or to the public interest. Otherwise, the expectations of stakeholders in society will not be met, and the credibility of corporations will erode, as will the credibility and reputation of the accounting profession.”

•

The emphasis on international independence standards is necessary because:

•

“Loyalty by auditors to management and/or directors can be misguided because management and directors have frequently proven to be so self-interested that they cannot be trusted to protect other stakeholder’s interest.”

Professional accountants have, in cases such as Enron, Arthur Andersen, WorldCom, and Carillion, lost track of to whom they should ultimately be responsible.

“The impetus for recent reform, while begun with SOX, the U.S. Securities and Exchange Commission (SEC), and the Public Company Accounting Oversight Board in the United States, has shifted to harmonization with the global standards worked out under the auspices of IFAC and its boards, including the IAASB and the IESBA.”

Further, independence can be threatened in many different ways, through bias, threats, association with those who could be benefited or harmed by the professional auditor’s/accountant’s report; the appearance of bias or conflicts of interest. “Charges of bias are very hard to refute, so professionals are often

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P a g e | 326 admonished to avoid any situation or relationship that might lead to the perception of bias.” (Text, page 426.) 16. Which type of conflict of interest should be of greater concern to a professional accountant: actual or apparent? Per the discussion related to Figure 5.7 (Types of Conflict of Interest and Actions Required), they should both be of great concern given their potential impact on the professional’s reputation, but actual conflicts are more important given the harm that could be caused to the interests of the client involved. 17. An auditor naturally wishes his or her activity to be as profitable as possible, but when, if ever, should the drive for profit be tempered?

When it interferes with the auditor’s duty to the public interest, profession, or client (shareholders). 18. If the provision of management advisory services can create conflicts of interest, why are audit firms still offering them?

Because they are lucrative services that can benefit their clients without compromising the auditor’s objectivity. 19. If you were an auditor, would you buy a new car at a dealership you audited for 17% off list price?

No, this appears to be a more than nominal discount, not available to all, and which could be seen to sway the auditor’s judgment toward management and contrary to the interests of stakeholders and the public. 20. If you were a management accountant, would you buy a product from a supplier for personal use at 25% off list?

No, unless it could be shown that this did not adversely affect your judgment, and you received permission from your boss and the designated (ethics) officer of your company. 21. If you were a professional accountant, and you discovered your superior was inflating his or her expense reports, what would you do?

Report the matter to the ethics officer or an independent official. Confronting your boss is not likely to generate a positive result. 22. Can a professional accountant serve two clients whose interest’s conflict? Explain. See the answer to the second-last bullet in question 4 above. 23. If an auditor’s fee is paid from the client company, isn’t there a conflict of interests that may lead to a lack of objectivity? Why doesn’t it?

Yes, this is a normal practice that could give management an opportunity to influence richard@qwconsultancy.com

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the judgment of the auditor. However, corporate boards (via their audit committee) should negotiate and approve the audit fee, thus lessening the chance for undue influence to occur. This has now been mandated by SOX/SEC. 24. Why does the IFAC Code consider the appearance of a conflict of interests to be as important as a real but non-apparent influence that might sway the independence of mind of a professional accountant?

Because of the potential impact on reputation of the professional and the profession. See the answer to question 16. 25. What is the most important contribution of a professional code of conduct or corporate code of conduct? Codes provide guidance on the conduct expected of members of the profession or corporation in order that the services of the profession or corporation will be of acceptable quality so that the reputation either of the profession or corporation will not be tarnished and so that the public trust is not lost. (See Chapter 6, page 424.) 26. Are one or more of the fundamental principles found in codes of conduct more important than the rest? Why?

I would argue that the first one listed - To, at all times maintain the good reputation of the profession - is the governing principle because it focuses attention on the goal of maintenance of the trust of the public, not on self-interest, or on the interests of the short run. For example, it could be argued that technical competence was the paramount principle, but technical competence without integrity or objectivity can lead to trouble. Also, the reputation principle covers more than accounting matters, and it reminds accountants that criminal behavior or unethical business and personal practices can also affect the reputation of themselves and the profession. 27. Was the "expectations gap" that triggered the Treadway and Macdonald commissions, the fault of the users of financial statements, the management who prepared them, the auditors, or the standard setters who decided what the disclosure standards should be?

All of these to some degree. But the accounting profession and its members are involved in most of these roles and have the knowledge and expertise to close the gap. Usually, the stakeholder with the highest level of knowledge and expertise is seen to be responsible for remediation. Also, in this case, the profession is self-regulating and if it is seen not to be able to handle its responsibilities, then government will do so. There is, it seems, no point to passing the buck. 28. Why should codes focus on principles rather than specific detailed rules?

Because professionals need principles and can be interpreted when specific rules don’t cover a situation. Also, principles are far easier to understand and remember than rules.

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P a g e | 328 29. Is having an ethical culture important to having an effective system of internal control? Why or why not?

Yes, because an effective system of internal control depends upon the integrity and ethical actions of the participants. Without integrity and ethical action, top management, directors and auditors can be lied to—at least in the short run. This was the case in many of the financial scandals. 30. What should an auditor do if he or she believes that the ethical culture of a client is unsatisfactory? The auditor should immediately bring the matter to the attention of the person in charge of the audit, so that the increase in audit risk may be assessed and extra audit tests or a qualification or resignation can be considered. Also, the problem should be brought to the attention of the client's the top management—particularly to the CEO and CFO, and to the Audit Committee of the Board, and the internal auditors so that remedial action can be undertaken and increased costs and/or tests by the internal auditors can be arranged. If the matter is not corrected the auditor should consider qualifying their audit report and/or resigning the audit. They should also consider making the reason for their resignation clear to the public 31. Are the governing partners of accounting firms subject to a “due diligence” requirement similar to that for corporation executives in building an ethical culture? Can a firm and/or its governors be sanctioned for the misdeeds of its members?

Yes. In some jurisdictions the firm can be disciplined and fined. Also, any lawsuit will require the resources of the firm to defend or settle and will increase liability insurance costs. Possibly, some of the partners invested capital may be paid out in a settlement, even in a limited partnership. Personal capital may be required where the firm is a traditional partnership, or where they are personally negligent. 32. An engineer employed by a large multidisciplinary accounting firm has spotted a condition in a client’s plant that is seriously jeopardizing the safety of the client’s workers. The engineer believes that the professional engineering code requires that this condition be reported to the authorities, but professional accounting codes do not. How should the head of the firm resolve this issue? After checking that the safety problem is serious and the engineer is correct in his or her interpretation of his or her code, the senior partner should make sure that the client has been advised of the problem and has been given a chance to respond with a satisfactory explanation, and/or has agreed to rectify the problem. The client should understand that the problem will have to be reported unless rectified. The remedial action must be verified. A professional engineer can be reasoned with, but not ordered not to report such a violation. A multidisciplinary firm should have a code and culture that supports professional codes in a responsible manner. See also the discussion of the case, Multidisciplinary Practices—Ethical Challenges (Case #31) in this chapter. 33. Transfer pricing can be used to shift profits to jurisdictions with low or no tax to reduce the taxes payable for multinational companies. If such profit shifting is legal, is it ethical? Was richard@qwconsultancy.com

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P a g e | 329 Apple well-advised to shift $30 billion in profits to its Irish subsidiary, where it paid no corporate income taxes on those profits? Why or why not? No, it is not ethical because profits are being made in a jurisdiction, but a fair allocation of tax is not being paid there. Artificially low tax rates also create tempting opportunities to transfer profits to low or zero tax rate jurisdictions through the use of artificial or unreasonable costs or revenue recognition, which are often illegal. Frequently, the existence of such tempting opportunities causes executives or owners to put unreasonable pressure on accountants to create and/or use questionable or illegal practices to reduce the company’s overall tax burden. It will be interesting to see if Apple and other companies that took advantage of tax havens to reduce their taxes payable can ultimately transfer funds home to the U.S. without triggering some or all of the tax that was avoided earlier. 34. Many professional accountants know of questionable transactions but fail to speak out against them. Can this lack of moral courage be corrected? How? Moral courage can be encouraged by: •

ethical corporate culture led by supportive senior management

•

strong and effective whistleblower reporting and protection programs

•

repeated messaging from senior executives

•

ongoing scrutiny/monitoring of whistleblower reports and follow-up by the Board and its committees

•

tangible significant rewards and/or favorable publicity for whistleblowers

•

dismissal or significant penalties for persons who knew of a problem, but did not report it

•

dismissal or significant penalties for wrongdoers See also the answer to question 3, above.

35. Why do codes of conduct or existing jurisprudence not provide sufficient guidance for accountants in ethical matters? New variations of problems are arising every day, and existing codes/jurisprudence cannot anticipate these. Codes of conduct are rarely written as exhaustive documents (people won't read them and can't remember all the rules anyway) but rather stress principles which need to be interpreted for each specific application. On complex or difficult ethical problems, such interpretation usually requires judgment that is shaped by experience, so consultation with colleagues and other experts (lawyers) is desirable.

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Case Solutions Famous Cases 1. Carillion Bankruptcy: A Nightmare That Challenged the Foundations of

the U.K. Accounting Profession (Chapter 6, pages 473-478) What this case has to offer Carillion was a massive, well-regarded company, whose unexpected bankruptcy exposed accounting practices that produced revenue and valuations that were far too optimistic rather than conservative, and that hid the true status of the company’s profitability, pension liabilities, and liquidity. Several professional accounting firms were involved, but due to their lack of competence, their lack of understanding of their duty to the public, or their inability to rise above the inherent conflicts of interest between fees and reporting bad news, none raised any alarm with management or the board of directors. The audit firm, KPMG, was particularly at fault for not advising the Board of several practices that imperiled the company, and/or were vital to the protection of the public interest. The resulting outcry produced serious fines, and studies and cries for breaking up the CA profession and big firms in the United Kingdom. As a result, this case offers the opportunity to study improper accounting practices, performance-masking techniques, conflicts of interest, a lack of protection of the public interest, a lack of moral courage, and the future of professional accounting. Teaching suggestions I start the discussion by asking what the case is about, which informs the students about the scenario laid out above and prepares them for learning about the various pieces of the puzzle. I then call for discussion of the following in order to ensure that the students understand the issues presented in the case: •

Professional accountant’s responsibilities (i.e. to protect the public interest). o

What is in the public’s interest? This is a critical issue because most students and many professional accountants think that they need to serve management or the current shareholders’ interests. In fact, they should be concerned with all stakeholders’ interests, but financial reporting per GAAP is expected to protect (a), (b), and (c) (below), which often conflict. The implications for professional accountants are that (a), (b), and (c) need to be balanced, because serving just the interests of (a) may disadvantage the interest of (b) and/or (c). I precipitate a discussion of these matters by asking which of the interests listed below should be protected by professional accountants when making decisions about disclosure:

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P a g e | 331 (a) Just the interests of current shareholders who want to sell out in the short term. (b) Just the interests of long-term holders of shares. (c) Just the interests of future shareholders who will be buying shares based on the audited financial statements. (d) The interests of all non-shareholder stakeholders. (e) All of the above. I then ask what are the implications for professional accountants? o

What are the responsibilities of auditors to management, to the Board, to the public up to the following dates? (a) Up until the end of the fiscal year of the audit? Answer: for knowledge of all issues. (b) From the year-end date of the audit to the date of signing off the audit report? Answer: for knowledge of all significant issues affecting the audited financial statements up to the date the audit report is signed. This includes all issues that would impact on going concern considerations, or on asset valuations, and liabilities. (c) After the audit report is signed but before the audit report is made public? Answer: for the assumptions and facts underlying the financial reports and audit. If they were recognized to be so suspect that the audit report needed to be withdrawn to protect the public, then the auditor must report to the client, relevant securities regulator, any issuer in the case of a public stock offering, and any other person/company (i.e. lender) that might have received an advance copy of the flawed financial statements and audit report before it was made public.

What are the responsibilities of professional accountants as consultants on accounting or operational issues? Answer: To raise concerns with management, the Board, or in public.

To whom should the professional accountants in the employ of Carillion have been responsible? Answer: To the Board, to the public.

Were the new NOCLAR standards followed?

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P a g e | 332 Answer: No, but they had just been approved, and not yet formally adopted in the United Kingdom. However, the U.K. practice mirrored the NOCLAR rules before their adoption in the United Kingdom, so all the professional accountants involved were negligent regarding their duties. •

•

Improper accounting practices o

Recording revenue before customers signed off accepting the charges

Recording unrealizable profit by ignoring foreseeable losses when calculating profit earned under the percentage of completion method of revenue recognition.

Poor accounting judgement and/or practices o

Failure to assess the eroding value of goodwill properly and advise/recommend to the Board that management’s assessment was potentially, if not actually, flawed.

Failure to identify the significant contract dispute with Msheirab Properties in Qatar.

Failure to correctly consider going concern threats (unsustainable debt levels, liquidity generated by holding up payments to suppliers, profitability, ignoring status of pension liabilities)

Failure to comprehend the significance of the fact that Carillion was the most shorted stock on the London Stock Exchange, which indicated that knowledgeable investors thought that the company’s shares were significantly overvalued (i.e. a high risk of devaluation existed that was not being signaled by the company’s financial statements. Any competent auditor should have considered/investigated why before signing off.).

These and other audit shortfalls sprung from a lack of professional skepticism and/or competence.

Masking practices o

Reverse factoring arrangements leading to bank indebtedness that was recorded as other payables rather than bank indebtedness thus overstating the working capital ratio.

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P a g e | 333 •

Conflicts of interest o

•

Continuity of audit fee revenue versus advising/confronting management and the Board about the questionable practices noted above.

Lack of moral courage o

It takes a lot of courage to bring unpleasant news forward within a company, or to the Board given that many of the executives and Board members are looking forward to bonuses or capital gains from good financial results because your job or the audit may be in jeopardy. If the professional firm representatives were not as incompetent as they seem to be, then there is a definite possibility that they were competent enough to discover the problems noted, but lacked the moral courage to raise the unpleasant truth and insist on correction of the financial statement and processes.

This discussion leads to and incorporates the questions noted below. Discussion of ethical issues 1. To which date are auditors responsible for attesting to financial statements: the year end, the date of the auditor’s report, or the date of release of the financial statement and auditors’ report to the public? Why? •

See the discussion under Professional accountants’ responsibilities, above. Responsibilities are related to the expectation that a professional accountant, as an auditor, consultant or employee is supposed to protect the public interest.

2. To whom is the auditor responsible to when attesting to a company’s financial statements? •

See the discussion under the first bullet, above.

3. What is an accounting firm responsible for if its audit opinion fails to raise any concerns and the client goes bankrupt? Consider losses to creditors, lenders, employees, construction clients, and suppliers, as well as infrastructure disruption. •

An auditor is generally legally responsible for reasonably foreseeable damages suffered by investors and/or lenders and creditors who relied upon the financial statements on which s/he opined. In addition, an auditor whose work is proven to be negligent can be fined by securities regulators, and by their professional governing body. Stakeholders who suffered indirectly, such as employees, suppliers, and others who suffered from the disruption of infrastructure projects are not generally able to sue for damages. However, the negligent auditor would suffer damage to his or her reputation for damages caused directly and indirectly.

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P a g e | 334 4. Should an auditor be responsible for finding fraud? Was there a fraud at Carillion? •

Fraud is an act of deception undertaken for financial or personal gain. There were such acts at Carillion by accounting personnel. If these were done at the request of executives or members of the Board, then those executives or Board members would also be implicated as fraudsters. It is, however, often very difficult to assess and prove the intent of such actions.

5. Based on what happened at Carillion, do you think that the Big Four accounting firms should be broken up to provide more competition for the audits of major corporations? •

There are arguments for and against such restructuring related to the limited availability of knowledgeable audit personnel, the efficiency of a one-firm audit, the obvious difficulties in servicing large clients that have only four major firms to choose from, and so on. But there is little doubt that greater competition would afford a greater choice of auditors and would prevent some conflicts of interest. However, how to effect such a break-up is very difficult to foresee, because the Big Four firms are collections of country-wide, sub-firms, and they would be unlikely to voluntarily agree to give up their competitive advantage in every country if the United Kingdom or a small number of countries mandated it in each of their jurisdictions.

Useful Articles, Links, and Videos See the Text.

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2. Parmalat—Europe’s Enron (Chapter 6, pages 478-484) What this case has to offer Starting as an Italian milk producer in the Parma region, Parmalat grew to become a multinational company, widely regarded as one of Europe’s most successful food businesses. However, Parmalat will be remembered as one the biggest European corporate frauds, ever. The company's bankruptcy caused vast losses affecting multinational banks, investors in US and European markets, and tens of thousands of employees and farmers. This case presents an interesting combination of conditions that created motives and fostered opportunities to commit fraud. The fraud involved the former CEO Calisto Tanzi and members of his family, running the company as a "family business." Rapid expansion, unprofitable acquisitions and poor management led the company to bankruptcy. Nevertheless, Tanzi and other executives manipulated the company's financial statements to mask the problem, while continued raising capital through marketable securities. Parmalat's true financial condition was uncovered when the company failed to do a scheduled bond repayment in December 2003. Further investigation revealed a vast network of fraudulent activity that involved creative tax planning, complicated off-balance sheet transactions, related-party transactions, illegal diversion of funds, and falsification of documents. This case can be also used for discussion of a wide range of governance and audit issues, including: inadequacies of governance, adequacy of auditor’s risk assessment, completeness of liabilities, confirmation of receivables, transactions with related parties, and responsibility when relying on other auditor’s work. Teaching suggestions and discussion I start the case describing Parmalat’s business of the manufacture and distribution of foods and drinks worldwide—many are brands that the students have heard of or consume. Then I ask the students how it is that a food company, which operates in a stable, cashgenerative sector, can develop a shortage of cash. They respond by suggesting fraud as well as financing a series of acquisitions in Asia, southern Africa and Australia, as well as adding to its North and South American holdings and moving into Eastern Europe. Many of these additions offer potential synergy gains from merging business, but some are in seemingly unrelated markets. I point this out and ask what the chances are that a firm like Parmalat will be successful at entering unrelated business such as owning a soccer team, starting a chain of travel agencies and hotels, or sponsoring a Formula 1 racing teams. I also ask whether the use of derivatives to raise funds is advisable for Parmalat. At this point, students should start thinking that something is not quite well with this business: a dairy and drinks manufacturer growing at a fast pace, entering unrelated markets and business, and involved in unclear financing operations. Following this analysis of the business’ inherent risk, we explore how the Tanzi family kept 51% of Parmalat’s voting shares after going public in the 1990’s, and how Calisto Tanzi (CEO & Chairman) had control of the firm and undertook activities beyond the oversight of its Board of

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P a g e | 336 Directors. We review the activities undertaken to see how they were used to fraudulently bolster the company’s finances. I close the case by leading the discussion to the auditor’s responsibility in cases of fraud and what went wrong with their audit procedures in this case. I stress the need for independent, objective, truly challenging auditors, which are prepared to act in the best interest of the public. Discussion of ethical issues 1. What conditions appear to have allowed the Parmalat situation to get out of control? The shortcomings of the system of internal controls included: lack of supervision and control; violation of statutory provisions and provisions of the bylaws by directors and executives; a board that was inadequate (in size, independence, and expertise) for such a large and complex group of companies; alterations of the accounting records; publication of falsified financial statements; inadequate documentation of material transactions; inadequate supervision and approval of various corporate processes; and lack of standardized administrative procedures and processes. This situation permitted unlawful behavior to continue for several years. 2. What specific audit procedures could have uncovered the fraud earlier? The most important audit procedure in detecting fraud is adequately assessing significant risk factors. The auditor needs to exercise professional judgment when considering risk factors individually or in combination and whether there are specific controls that mitigate the risk. The size, complexity, ownership and control environment of a company have significant influence on the identification of relevant risk factors. Analytical procedures are useful tools in assessing risk, examples of these procedures are modeling changes in financial statements, reasonability analysis, comparison to industry practices, etc. If the probability of fraud is considered high, and the effectiveness of controls low, the audit firm should apply additional procedures to ensure that common fraud types will be detected. The most common frauds are improper revenue recognition, overstatement of inventories, capitalization of expenses, creation of discretionary cookie jar reserves, understatement of liabilities, and misappropriation of company funds by controlling executives. In this case, an audit confirmation was definitively not enough audit evidence to ensure the existence and ownership of the overly material 3.95 billion Euros ($5 billion) bank account in Cayman Islands, nor was it appropriate to send confirmations through the client’s internal mail system. 3. What audit steps should Deloitte have taken with regard to the seventeen off-shore subsidiaries that continued to be audited by Grant Thornton? Relying on a second (agent) auditor’s work is valid up to a certain extent when business reasons make a local firm more efficient than the principal auditor. It is also acceptable when the auditee is not able to provide the group auditor with sufficient access to subsidiary companies due to valid reasons (previous contracts and agreements, joint venture control, etc.). richard@qwconsultancy.com

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P a g e | 337 International Accounting Standards allow shared audit opinion, and the IASB had recently issued guidance in this matter. However, even though auditors can split responsibility in some cases, the principal auditor is publicly seen as ultimately responsible for all audit work and opinion. This responsibility should have caused Deloitte & Touche (Parmalat’s principal auditor) to closely monitor audits performed by Grant Thornton, thus reviewing their risk assessment, audit plans, work papers, and conclusions. Probably Deloitte should have directly performed the audits deemed as high risk through the firm’s partner offices in each subsidiary’s’ country. 4. What impact will the Parmalat fraud have on Grant Thornton and on Deloitte & Touche? In 1999, Deloitte & Touche replaced Grant Thornton as auditors of Parmalat, but Grant Thornton maintained the audit of 17 Parmalat’s Subsidiaries, including Bonlat. Under the Italian law, in case of accounting fraud, the auditors are able to deny any charges where the company’s executives misled them in the course of their audits. After the company’s bankruptcy, Deloitte & Touche denied wrongdoing and Grant Thornton severed its links with its Italian arm. Eleven members of Grant Thornton were charged of fraud. However, unfortunately, it is likely that the accused auditors will be discharged or subject of short sentences, as were the Parmalat’s convicted executives. Major international auditing firms are usually organized as an international organization of national firms. This means that if the Italian firm runs into lawsuits that go against the firm, the assets of the international firm in other countries are not directly affected, nor are the assets of partners in other countries directly at risk. However, the reputation of the international firm will suffer if one of its member firms is alleged to have committed wrong-doing and convicted, and that will probably trigger a loss of clients and/or future revenue in member firms other than Italy. Therefore, there will be an indirect loss to out-of-country firms and partners. In addition, if the SEC or other regulators suspect that the international firm has a weak governance and control structure, they may suspend the firm’s ability to audit new SEC-registered clients or apply some other sanctions which will have an impact on revenues and/or reputation. The executives convicted included former CEO Calisto Tanzi, chief financial officers Fausto Tonna and Alberto Ferraris, internal auditors, and Tanzi’s own brother and son. As Italian law waives jail terms for first-time offenders sentenced to no more than 2 years, eight of the 11 convicted were granted suspended sentences and will not be required to serve time in prison. Tonna was sentenced to 2 1/2 years, spent several months in detention in 2004 and was expected to work with social services instead of returning to jail. Lawyer Gian Paolo Zini, sentenced to 2 years, and former CFO Luciano Del Soldato, sentenced to a year and 10 months, were also expected to work with social services in a bid to reduce any jail sentences other criminal trials were awaiting to be resolved. 5. How did the areas of risk in Parmalat’s control environment contribute to the fraud: integrity and ethics, commitment, audit committee participation, management philosophy, structure, and authority?

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P a g e | 338 •

The company’s management lacked integrity, objectivity and ethics, using company’s funds to finance personal endeavors of the CEO and his family members, such as being soccer team owners and participate in Formula 1 races.

•

The board of directors was not independent and its members, including the audit committee, lacked sufficient financial expertise to understand off balance sheet derivatives and appropriately assess the impact of related party transactions.

•

The company’s structure grew too fast without consolidating authority and controls. A company with several products in multiple countries, with access to global capital markets cannot be run as a family business.

6. How did the Inherent risk factors in Parmalat’s strategy contribute to the fraud: changes in operating environment, new people and systems, growth, technology, new business, restructurings, and foreign operations?? When businesses are growing at fast pace, management is generally concerned with constantly finding new acquisition targets and with restructuring and merging operations. However, there is little attention paid to “back office” functions including accounting, internal audit and human resources. In addition, merging information systems after an acquisition is a tremendous task that takes considerable time. Finally, the culture shock derived from change in reporting channels and authority may seriously weaken the control structure of a company right after material acquisitions. A lack of control is even more pervasive when several acquisitions are in different countries were other barriers such as language, local laws and cultural differences make the integration more difficult. All these factors contributed to increase the inherent risk of control breakdowns in Parmalat, where many changes in the operating environment were occurring without adequate planning.

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P a g e | 339 7. Should the banks and other creditors be legally responsible for so-called irresponsible lending that contributes to higher than necessary losses? If so, how can they protect themselves when dealing with clients whose viability is in doubt? Banks can provide funds to a client by direct lending or by issuing market securities in their behalf acting as investment bankers. In both processes, and depending on the size of the loan, lenders have to go through a credit analysis process that involves not only looking at the company’s financial statements but also to other indicators such as managements’ competency, industry sector, market potential, cash flows, credit ratings and probability of default. It is very likely that Parmalat’s bankers were aware of problems with the company’s operating cash flows, given its difficulty to keep growing or even consolidate its acquisitions without additional cash, and its unusual appetite for derivative products. Moreover, the company’s bankers were instrumental in setting up offshore accounts and issuing Parmalat’s debt securities at the same time. In Italy, financial institutions lending money to a client prior to insolvency have to pay back interest and other fees if there is suspicion that the institutions knew the client was in financial trouble. This case points out again the importance of independence and objectivity, but now from the bankers’ perspective while lending or issuing securities. Banks can protect themselves in doubtful cases by several ways including performing appraisals and due diligence assessments of the client, demanding collateral, sharing exposure thorough syndicated loans, using external agencies’ credit ratings, or ultimately denying granting credit to certain clients. 8. Do you think that applying bankruptcy projection models should be a regular tool used by auditors, creditors, and regulators to assess the reasonability of a company’s financial statements? Bankruptcy models are analytical models, often based on financial ratios, and used in assessing the likelihood of a company’s bankruptcy. For obvious reasons, creditors regularly use these models when analyzing credit applications, however auditors and regulators might benefit in applying these models, because they constitute a systematic, efficient and effective method of review and have been tested by researchers. Bankruptcy model results may provide the auditor with additional insights about the client company's financial condition that a more traditional analysis of financial statement’s ratios data might not reveal. For example, showing if the overall probability of bankruptcy diminishes over the years would assist the auditor in assessing at what point substantial doubt exists about the client's ability to fulfill its financial commitments, thus increasing the risk of accounting fraud targeted to disguise the client’s true condition.

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P a g e | 340 9. Is independence important in corporate governance? What are the most recent rules on corporate governance for public firms? As evidenced in this case, independence and objectivity are fundamental in maintaining corporate governance. Corporate governance requirements for public firms at the time (2004) and now at the NYSE, NASDAQ, and through the Sarbanes-Oxley Act, require independent auditors and directors to oversee management. 10. Discuss which changes could be made to the Parmalat’s control system and corporate governance structure to mitigate the risk of accounting and business fraud in future years. •

board of directors with more members

•

majority of independent directors

•

audit committee made up of financially expert, independent directors elected by the board

•

frequent audit committee meetings

•

separation of the roles of CEO and chairman of the board

•

auditor and senior executive appointments by the board of directors

•

internal audit functional reporting to the board’s audit committee

•

Company-wide ethics awareness programs

•

Confidential whistleblower programs for accounting and ethics concerns

Other Events: April 18, 2006 Van Voris, Bob [Bloomberg News] (April 19, 2006). “Deloitte Italy seeks to sue Parmalat, alleging fraud.” National Post, FP11. Deloitte (Italy) asked for permission to sue Parmalat in a federal court in New York. Useful Articles, Links, and Videos Gumbel, Peter (November 21, 2004) “How it All Went So Sour.” Time, http://content.time.com/time/magazine/article/0,9171,880285,00.html “Parmalat in bankruptcy protection.” (December 24, 2003). BBC News, http://news.bbc.co.uk/2/hi/business/3345735.stm “Parmalat on road to recovery [video].” (September 2008). BBC News, http://news.bbc.co.uk/player/nol/newsid_6650000/newsid_6654700/6654789.stm?bw= nb&mp=wm “Italy puts 56 on trial in milk scam [video].” (March 14, 2008). Reuters, http://www.reuters.com/news/video?videoId=78138

Professional & Fiduciary Duty Cases

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3. NOCLAR Solutions to Toshiba’s Accounting Scandals & Confrontations

with Auditors (Chapter 6, pages 485-486) What this case has to offer This case offers the opportunity for accounting professionals and students to consider the audit and governance challenges of identifying and preventing questionable, earningmanipulative transactions in a corporate culture of secrecy and obedience to leaders. It also exposes the real problems of too few auditors to choose from in the Big Four, and the difficulties of taking over a problematic audit. Explored are the new NOCLAR standards and whether they might have been helpful in preventing the long secrecy of the accounting manipulations. Teaching suggestions I begin the discussion by asking students for a brief overview of the case. After making sure that the manipulative techniques are understood, I discuss how, in some cultures, respect for elders and/or authority figures, or the primacy of loyalty to leaders, confuses employees and accounting professionals about whom they really need to serve. This provides the opportunity to review the priority of duty of professional accountants, which is ultimately to serve the public interest. I then ask and discuss the questions below. Discussion of ethical issues 1. The Toshiba accounting frauds were enabled by the culture of obedience to authority that permeates Japanese and other Asian cultures. How should a company avoid the risk of fraud or malfeasance being perpetrated by authority figures in such cultures? •

The company should ensure that the prime values and norms in its corporate culture are loyalty to the company’s values (i.e., not to protect leaders at the expense of the company), and that those values are supportable by and not harmful to internal or external stakeholders. This value set will best keep the company on an ethical track and will allow professional accountants to comply with their professional codes of ethics, including the NOCLAR standards when/if those are adopted. As noted in the Text, the development and maintenance of an ethical corporate culture will require continuous training, exhorting, reporting, monitoring, rewarding and punishing when appropriate. A trusted whistleblower protection program is essential, and the need for it must be understood and supported with the understanding that it enables the Board to ensure that problems are discovered before they become dangerous.

2. Given Toshiba’s practice of dismissing or wishing to replace auditors who did not agree with Toshiba’s accounting methods, are there any circumstances in which another audit firm should be prepared to take over the audit? •

Yes. It is possible that a company that dismisses auditors on questionable grounds, or where audit risks are recognized as unreasonably high, may not be able to secure

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P a g e | 342 a replacement auditor. If so, an auditor considering taking on Toshiba’s audit is in a strong position to demand conditions before taking on the engagement, such as: o

Suspected problems must be investigated thoroughly, and at-fault people must be dismissed from the company or have their power suspended if they are dominant shareholders.

Executives and the Board must state, in writing, that no further manipulations are known and that an effective whistleblower program, overseen by the Audit Committee of the Board, will be installed, promoted, and supported.

Other similar controls.

3. Given that Japan has partially adopted the NOCLAR standards, will those standards be successful in preventing accounting frauds similar to those perpetrated at Toshiba? Why or why not? •

Since Japan has only adopted the NOCLAR standards requirement for internal company reporting, it is not certain that the earnings manipulation and cover-up would have been remedied given the senior authorities who were involved. The probability of arresting and remediating the wrongdoing would have been substantially greater if Japan had also adopted the external reporting requirement, because those authorities would, arguably, have been beyond the influence of the senior Toshiba personnel involved. In fact, if Japan had adopted the external reporting aspects of NOCLAR, then Japanese professional accountants would have more clearly understood their duty to protect the public regarding such matters.

Useful Articles, Links, and Videos See the Text.

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4. KPMG’s Ethical Red Flags—Advance PCAOB Information and Cheating

on Ethics Exams (Chapter 6, pages 487-488) What this case has to offer This case shows that organizations—and even the accounting profession–can develop a culture that accepts and encourages unethical behavior. Although many people know specific acts are unethical and/or illegal, no one is encouraged or willing to report such activity even though the consequences for the organization could be catastrophic in terms of lost reputation, lost customers, and penalties. This case offers the opportunity to illuminate and discuss the important elements of an ethical corporate culture, the foundational aspect of ethics in a profession, the importance of ethical leadership from the top, the hazards of ethical lapses, the need for an effective whistleblower program, and the need for vigilant follow-up. Teaching suggestions I begin by asking the students which stakeholders lose if advance information on PCAOB audits is obtained, or by cheating on the firm’s internal ethics exams. This leads to a discussion of the benefits of both quality control measures (PCAOB audits and ethics exams). I next ask the students to characterize the thinking of those who would do each of these unethical acts (accepting advance PCAOB audit information or cheating on ethics exams). This leads to a discussion of “mindset problems” discussed in Chapter 7, and to consideration of how these can be identified, rectified or eliminated when recruiting, hiring or monitoring employees. I then ask the students who are employed with accounting firms whether they have taken internal ethics-type quizzes and exams. Most say yes. Then I ask whether they thought they were useful. Many will say that they considered them a joke because there was no accountability. The questions were overly simplistic, and even if they scored poorly, there were no repercussions. I then ask what message this sends out about the importance of ethics. Discussion of ethical issues 1. Identify what you think contributed to KPMG developing a culture that accepted utilizing insider information and cheating on ethics exams as legitimate business practices. Among the factors that contributed to these ethical failures were: •

A fear of being reprimanded by the PCAOB that KPMG’s audit standards were below an acceptable level.

•

Lack of a robust firm quality control function that points out audit deficiencies, and/or a lack of appropriate training or firm protocols that guide audit practice.

•

Lack of understanding about the fundamental ethical values that a proper professional should know and adhere to in order to serve the public interest and protect the reputation of the profession and the firm.

•

Internal norms that indicated that:

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P a g e | 344 o

cheating was OK on ethical matters

cheating was acceptable rather than learning about ethics.

2. Assess Thomas Fox’s comments about KPMG’s ethical failures. Some students may argue that one or two bad apples do not spoil the entire basket. The firm admitted that ethical lapses had occurred and fired the partners involved. Therefore, KPMG acted appropriately. Other students will follow the argument of Trevino and Brown (2004), who contend that bad behavior is not necessarily the result of unethical employees (bad apples) but, rather, is the result of a system or culture that encourages or supports unethical behavior. Flawed behavior in more than one area at KPMG represents a perverse, unethical organizational culture. KPMG disregarded ethics by engaging in lying, cheating, and subterfuge. These students will argue that an unethical culture will also affect other aspects of an organization’s activities. Consequently, there is no reason to suppose that it does not spill over to having a negative effect on the attitude of the professional staff towards audits and taxation. 3. Is there anything the accounting profession could have done to prevent these two ethical failures? The accounting profession should make clear to aspiring students and professionals that this kind of unethical behavior is not acceptable, and why. This means that university courses and professional development courses should include cases such as this, and penalties for such actions should be made public. The accounting profession did nothing, even though almost half the KPMG audit files inspected by the PCAOB had audit deficiencies. If the profession wants to maintain the highest ethical standards, then unethical behavior and ethical lapses must be dealt with quickly and effectively. Otherwise, ethics becomes something in name only, not something tangible and worrisome. The accounting profession should have sanctioned KMPG. Useful Articles, Links, and Videos See the Text. Trevino, Linda K., and Michael E. Brown, “Managing to be Ethical: Debunking Five Business Ethics Myths.” Academy of Management Executive 18, no. 2 (2004): 69-81.

5. KPMG Partner Shares Confidential Information with a Friend (Chapter

6, pages 488-489) What this case has to offer This case describes why a senior professional, thinking he was helping a friend in a small way, ruined his own career, damaged his firm’s reputation, and caused his firm to resign from two major audits. It offers the opportunity to explore/understand the following topics: 1. Insider information and tipping and why they are unethical and illegal. richard@qwconsultancy.com

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P a g e | 345 2. Why seemingly small bits of information can result in very damaging consequences. 3. Why a leader, a senior professional accountant, can/would make such an error in judgment. 4. Why a firm would have to resign an audit if its integrity/credibility was in doubt (i.e. What is the role of the profession/firm?) 5. Why the insider argument that trading on insider information benefits other market participants is flawed, and why insider trading is not a victimless crime. 6. How firms can guard against the sharing of confidential information and how professional codes can help. Teaching suggestions To motivate a class discussion about the points above, one of four alternatives can be chosen: A. Start a discussion about point #1 above, and then expand to discuss the other points. B. Start with a debate with one half of the class arguing that insider trading is good, and the other half arguing it is bad, and then deal with the points, above. C. Ask the class their opinions on point #3, and then expand to pick up the other points. Or D. Ask the class the first question below, and then work through the other points, above. Discussion of ethical issues The Text covers information on inside information, tipping, insider trading, errors in judgment, role of the professional and professional accountant, and professional codes. Comments for the questions posed at the end of the case are as follows. 1. Should an accounting firm have to resign as the auditor of a company when the partner in charge of the audit is convicted of releasing confidential information about that audit client? Since the auditor’s role is to provide an objective assessment of corporate reporting in order to make it credible to investors and other stakeholders, the apparent lack of integrity by the audit leader undermines the desired impact of the firm’s audit as well as other audits done by the firm. In order to restore the audit firm’s reputation for integrity, the firm must not only punish the offending audit partner but must show that it is taking the matter very seriously as a firm. Resignation from major audits is one way to show this. It should be noted that KPMG may have been asked to resign from Herbalife and Skechers, if they had not done so voluntarily, because the partner had been in charge of them as well. 2. How can accounting firms ensure that their partners and staff do not release confidential information? Training should be provided on the ethical codes and practices of the firm and the profession, not only at the beginning of their careers, but also periodically and richard@qwconsultancy.com

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P a g e | 346 consistently throughout their careers. The firm should canvas all its personnel to ensure they have not violated important rules, and it should require sign-offs annually. Firm leaders should stress what is right, and what penalties will befall transgressors. Useful Articles, Links, and Videos GrumpyOldAccountants [Anthony Catanach] (April 26, 2013). “KPMG’s Insider Trading Scandal: A Watershed for the Auditing Profession? [video]” http://www.youtube.com/watch?v=4qUo4nexfQM In this video, Dr. Anthony Catanach (Cary M. McGuire Fellow at the Center for Ethics in Financial Services, American College), author of the GrumpyOldAccountants blog (formerly www.grumpyoldaccountants.com ), uses this video to emphasize the gravity of this offence, despite its relatively low monetary consequences, because of the seniority of the partner and his supervisory authority over—and ability to influence--so many other auditors (50) and over staff (500). Pettersson, Edvard (April 24, 2014). “Ex-KPMG Auditor London Gets 14 Months for Insider Trading.” Bloomberg News, accessed at http://www.bloomberg.com/news/2014-0424/ex-kpmg-auditor-london-gets-14-months-for-insider-trading.html on September 23, 2014. This article describes the sentence handed down to Scott London, a former senior audit partner at KPMG, for leaking confidential information to Bryan Shaw who, with it, made more than million dollars. Snyder, Riley (June 2, 2014). “Bryan Shaw sentenced to prison in KPMG insider trading case.” Los Angeles Times: Business, accessed at http://www.latimes.com/business/la-fi-insidersentencing-20140603-story.html on September 23, 2014. This article describes the sentence handed down to Bryan Shaw who profited from insider trading by KPMG partner Scott London.

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6. Livent—When Maria, When (Chapter 6, pages 489-490) What this case has to offer This case illustrates the Professional Accountant’s responsibility to not be associated with misleading or false information. Maria Messina, CA and Livent’s chief financial officer delayed making public the irregularities in the company’s accounting policies. This case shows the personal and professional trade-offs that professional accountants may face between publicly disclosing accounting irregularities and pleasing upper management to keep their employment or fearing other negative repercussions. The most important aspect of this case is to determine when Maria should have spoken out inside Livent, or with the auditors, and in public once she was aware of the accounting manipulations. The case provides an opportunity for students to consider what steps a professional accountant could and should take to reveal misleading or false information. Teaching suggestions It would be useful to ask the class what responsibilities of a professional accountant are involved in the case. This should lead to a discussion of: •

service in the public interest

•

applicability of professional accounting codes whether in public practice or when employed

•

no association with a misrepresentation

•

integrity

From this point, except for one issue, the questions at the end of the case present a reasonable approach for discussing the case. That issue is how Maria should have reacted when Garth Drabinski became abusive, and I would ask that at the end of the case. Discussion of important issues 1. Did Maria blow the whistle at the right time? Why or why not? The case facts seem to point out that it was too late when she blew the whistle, which caused significant harm to many stakeholders including shareholders, auditors, herself and others. It is reasonable to expect that an accountant in her situation would try to reason with her boss before going public; however, she waited too long to gather the courage to confront her boss and Drabinski. She should have tried to talk to her boss and should have also sought legal counsel immediately after she became aware of the fraud in July 1997. She should have acted as soon as there was any evidence that the manipulations were not being corrected. Maria’s personal circumstances—that led her to delay making an issue of the deception–while personally trying, must be set aside by professional accountants behaving professionally. 2. Was her planned response appropriate? Why or why not? No, it was not. In a situation like this, waiting is likely to make things worse for both the company and the professional accountant acting as CFO. The fraud was clear richard@qwconsultancy.com

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P a g e | 348 and once she became aware of it, she became an accomplice by not doing something right away. 3. How would you suggest she should have dealt with the problem? First, she should have tried to deal with the issue internally by talking to her boss immediately, or by reporting the issue to the chief internal auditor or compliance offices. As soon as there was evidence that her chat with Eckstein got nowhere, she should have gone to Drabinski and then on to the Audit Committee. Second, if the internal mechanisms did not work, she should have sought legal advice and could have tried to disclose the fraud to the company’s auditors –her former colleagues—or to the appropriate regulatory agencies such as the stock exchange. Confidentiality rules were not intended to hold back employees so that frauds could succeed or go undiscovered. She could also have discussed the matter with the Ethics Officer of her professional accounting body for advice. As an ultimate response, she could have resigned, thereby disassociating herself from any misleading information. She should have considered blowing the whistle publicly. 4. Should whistle-blowing be encouraged? Why or why not? Whistleblowing should definitely be encouraged. Appropriate whistleblower programs should be in place to protect employees who fear negative repercussions from their superiors. In several instances, accounting fraud has been discovered after an employee became a whistleblower. Most publicly listed companies, as part of their entity-level financial reporting controls, have a whistleblower program. The existence of such programs encourages employees to come forward, since they convey the expectation that whistleblowing is appropriate and useful to the board of directors. Additional Question 5. How should Maria have reacted to Drabinski’s abuse? There should be a company policy covering verbal or physical abuse that states clearly that it is not appropriate and will result in appropriate discipline. In some jurisdictions such behavior can result in human rights charges against the employer for failing to properly manage their work force and to provide a harassment-free workplace. Where the CEO or some other top official is the problem, the employee has to choose whether to go along or to make the abuse known to the Chief Ethics Officer and to the Governance Committee of the Board. This takes guts because the working relationship with the CEO could get worse. On the other hand, it may get better if the CEO thinks that someone will stand up to him. Many people leave the company when confronted with such choices, leaving the CEO free to do it again with someone else.

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P a g e | 349 Useful Articles, Links, and Videos “Livent co-founders found guilty of fraud, forgery [article and video].” (March 5, 2009). CTV News, http://toronto.ctv.ca/servlet/an/local/CTVNews/20090325/Livent_trial_090325/2009032 5?hub=Toronto Acharya, Madhavi & Tom Yew (March 26, 2009). “Livent looks like our WorldCom.” The Star, http://www.thestar.com/News/GTA/article/608510 Gray, John (April 27, 2009). “Livent: I told you so.” Canadian Business Magazine, https://www.canadianbusiness.com/business-strategy/livent-i-told-you-so/

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7. The Lang Michener Affair (Chapter 6, pages 490-494) What this case has to offer The Lang Michener Affair provides a surprisingly rich view of a self-regulating profession—the legal profession—on topics which are almost all transferable to the accounting profession. The case deals with a lawyer at the partner level who is breaking the law, and the efforts of a whistleblower, junior lawyers, senior lawyers, the law firm and the legal profession to assess, come to grips with, sanction, and be fair to potentially harmed clients of the individual. Along the way, the following specific issues are raised: A. The role of a professional with regard to: •

Fiduciary responsibility,

•

Responsibility to self the profession clients,

•

Loyalty to the firm,

•

The self-regulatory process,

•

Whistle blowing, and

•

Conflicts of interest.

B. Do junior professionals have the same ethical responsibilities as their seniors, or can they be excused if seniors are involved? C. Problems in ethical decision making, including: •

Is there a victimless crime (i.e., a no-impact action)?

•

The process of rationalization employed to downgrade the seriousness of an action.

D. Should the purpose of a self-regulating mechanism for a profession to be to “add luster to the profession?” Teaching suggestions I use the Lang Michener Affair to lead off the segment on the role of a professional. It provides the student with an opportunity to think through many of the basic issues confronting professionals in a non-threatening (non-accounting) framework. After the case discussion I go on to discuss the rest of the issues in the chapter on “Roles”. I set the case up with a statement covering why we are looking at a sister profession and why it is important to view accounting as a profession rather than as a mechanical exercise. This leads into the questions at the end of the case which are intended to move in focus from professions in general, to the specifics of accounting. The discussion takes up to 45 minutes and is frequently punctuated by bouts of incredulity on the part of the students. This is a real-life case, however, and the students need to be reassured that the scenario is not far-fetched from an accounting perspective. Having lived through a few of these, I know! richard@qwconsultancy.com

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P a g e | 351 Discussion of ethical issues Questions from the case are numbered 1 to 5; answers for questions introduced under What this case has to offer (above) are labelled A to D. 1. Are professionals bound to meet a higher standard of ethical behavior than nonprofessionals? If so, why? A. The role of the professional with regard to fiduciary duty/responsibility: The primary reason for professionals to behave more ethically than nonprofessionals is that their duties involve services to the public on matters of great import (health, wealth, etc.) where there is also an expectation of trust by the public that the public’s interests will be served properly. This is the essence of fiduciary duty or responsibility (see Text, Chapter 1, section, Reinforced Fiduciary Role for Professional Accountants, page 14; end-of-Chapter 1 question 14, “Is a professional accountant a businessperson pursuing profit or a fiduciary that is to act in the public interest?” See also Chapter 5, Table 5.2 (Directors’ Behavioral Expectations) and section, Misunderstanding Objectives & Fiduciary Duty, page 269). If the trust inherent in the fiduciary relationship is not maintained, the profession will lose credibility and its rights (like self-governance or a practice monopoly) will be curtailed and its ability to command premium fees will diminish. It is interesting to ask the class which professions they rank most highly and why? The features I describe usually become evident in the process. 2. In what respects were the actions of the lawyers involved in the Lang Michener affair not up to the ethical standard you would expect? Consider: a. Pilzmaker’s conduct; b. the conduct of members of the executive committee at Lang Michener—in particular, Burke Doran; and c. the investigation and proceedings by the Law Society. What obligations did each owe to clients, the legal profession, the Law Society, and the public? A. Priority of duty to self, profession, client, etc.: All of the following represent some form of conflict of interest between selfinterest and the interests of clients, public, profession and firm. As a result, the legal profession suffered some tarnish in the view of the public. a. Pilzmaker put himself before: i.

the clients’ lawful interests by providing false residency and exposing the clients to the risk of not getting citizenship,

ii. the public, by smuggling, iii. his junior colleagues by involving them in the above, iv. his partners, firm and profession by exposing them to sanction and public ridicule. b. i. Burke Doran put his own and the firm’s interests before those of the profession and the public when he gave questionable advice as a partner while he was the head of discipline for the profession.

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P a g e | 352 ii. The junior colleagues failed to come forward and report Pilzmaker’s wrongdoings to the firm or to the profession. iii. The executive committee of the firm delayed action on and reporting of the wrongdoing, sidestepped, rationalized, and may have kept silent when files were given back to Pilzmaker. iv. Douglas could have reported to the profession or the public earlier, but chose to handle the matter internally. Was this misplaced loyalty? v. The discipline process involved only the executive committee members at a particular point in time, and then the sanction was behind closed doors and apparently quite light. Was this an attempt to keep the profession’s dirty linen out of the public’s view? c. The investigating, retired judge seemed to launder or whitewash the situation. 3. Do the same considerations apply to other professionals as to lawyers? B. Are junior members of a firm excused from reporting an ethical wrongdoing? If a person is a full-fledged professional (has passed all the examinations), then they ought to abide by the ethical code of the profession. A student professional also ought to refer problems to more senior, fully qualified colleagues, keep notes, and consider contacting the professional body if certain that wrongdoing is occurring. Otherwise the interests of the clients, public, profession etc. will not be served and there is a possibility that the student will be barred from becoming a professional due to ethical improprieties. This must be handled delicately, after consultation within the firm, and with a lawyer hired by the student, or with an ethics consultant provided by the profession. If a full-fledged, but junior professional, passes information on ethical malfeasance to a more senior professional in their firm, they must follow-up to ensure that the proper action has been taken to protect clients, the public and the profession. They cannot simply wash their hands of the affair. The case does not offer strong evidence on this, because of fault (f.) above, but subsequent discussions with leading lawyers has confirmed this interpretation. 4. Is the self-regulation of a profession on ethical matters effective from the perspective of: a. the members of the profession? b. the public? c. clients? It is unlikely, in retrospect, that the legal profession, the public, or the clients involved would consider the self-regulatory process to be effective in this case. All have lost something due to its poor function. However, in the long run—if repetitions of this fiasco are not forthcoming—a case can be made for retaining the autonomous, selfregulatory framework. That argument would be based on the efficiency of having knowledgeable professionals involved in reviewing complex cases, at no cost to the public purse. At the same time, the profession would have its affairs handled expertly, discretely and with as little red tape and cost, as possible. The public and clients, however, would see no benefit to this efficiency if the process continually failed to protect their interests—that is to be effective in policing the fiduciary relationship, from their perspective. D. Is the purpose of self-regulation to add luster to the profession? richard@qwconsultancy.com

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P a g e | 353 Yes and no. Adding luster is appropriate if that luster is of the long-term variety. If it consists of hiding the profession’s dirty laundry in the short term, with the result that repetitions are possible, or a bigger disillusionment is forthcoming when the truth come out, then luster is most inappropriate. C. Is there a victimless crime? No. Somewhere a stakeholder’s interest has been worsened. In the case, the residence-passport fraud resulted in the immigration of persons who may not have otherwise been able. Presumably the residency law had utility, so a test was shortcircuited, and the public received an immigrant who might not have been accepted if closer observation over a defined period had been endorsed. The public—you and I— lost. The use of the concept that “No white man had been harmed” to describe this situation is particularly offensive. Rationalization of questionable acts: Professionals owe all their stakeholders to investigate sufficiently to ascertain the facts about a wrongdoing. To do less offends the principles of objectivity and independence that are necessary to the maintenance of the fiduciary relationship. The delay which results when decision makers avoid the truth is usually very costly to all stakeholders involved. 5. Would you agree with the argument, which was used to exonerate members of the management team, that “when a professional makes a serious mistake, the error is of no consequence, if it is honestly made”? (Jorgensen, Bud. (February 5, 1990). Globe and Mail, B9).

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8. Wanda Liczyk’s Conflicts of Interest (Chapter 6, pages 494-496) What this case has to offer Wanda Liczyk, Toronto’s Chief Financial Officer and Treasurer at the time of this case, was involved in a scandal questioning her independence and due care at awarding and overseeing supplier contracts for the city of Toronto. This case is an example of questionable conduct in assigning government contracts and raises the issue of whether the accounting profession should be disciplining its own members. This is a good case to discuss the implication of professional codes of conduct and the process in place to discipline professionals that breach the professional code of conduct. Teaching suggestions I start this case explaining to students the system of professional self-regulation as well as the potential penalties that a professional faces for breaching a professional code of conduct, for example: •

formal reprimand, orally or in writing

•

fine

•

supervised practice for a specified period, with or without conditions

•

re-investigation by the professional conduct committee by a specified date

•

practice inspection, with or without conditions

•

counseling or treatment

•

restriction of or conditions on practice or employment for a specified period

•

establishment and implementation of quality control procedures or professional

•

training programs, as specified

•

suspension of professional license or authorization to practice, for a specified period, with or without conditions and,

•

other possible sanctions.

Afterwards, I discuss the facts of this case and ask students to take a vote on whether or not Wanda Liczyk appears to be guilty of breaching the Institute of Chartered Accountants of Ontario (ICAO)—now the Chartered Professional Accountants of Ontario (CPAO)--professional code of conduct, and what are their recommended sanctions.

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Note: The ICAO became the Chartered Professional Accountants of Ontario (CPAO) in 2015. The code referred to in the case and its questions is now the “Chartered Professional Accountants of Ontario CPA Code of Professional Conduct” and its rules can be found at http://www.cpaontario.ca/Resources/Membershandbook/1011page20931.pdf (See CPAO 2016a in Useful Articles, Links, and Videos, below.) The disciplinary rules referred to in the case and its questions are referred to now as regulations, and can be found in “CPA Ontario Member's Handbook (Revised to November 29, 2016),” available in pdf form at http://www.cpaontario.ca/Resources/Membershandbook/1011page5011.aspx (See CPAO 2016b in Useful Articles, Links, and Videos, below.) The case solution provides the revised (2016) versions of the sections of the code and regulations and refers to the replaced sections named in the case. Discussion of ethical issues 1. If Wanda Liczyk did not benefit financially, did she really have a conflict of interest? Should she have been disciplined by the ICAO [now CPAO]? Why or why not? Students should come to realize that a conflict of interests can arise without a person having to benefit financially. There are many other ways in which a person’s judgment can be influenced (or threatened), and professional standards do not require financial benefit. The following excerpts are useful in showing this. The objectivity standard, Section 202.2 (CPAO 2016a), which replaces ICAO Section 200, says: “A member or firm shall not allow his or her professional or business judgment to be compromised by bias, conflict of interest or the undue influence of others.” The Guidance for this section, The public interest [Clause 6] says, “Clients, employers and the public generally expect that a member or firm bring the qualities of objectivity, integrity and due care to all professional services. It therefore becomes that members or firms will not compromise their professional judgment to the will of others.” The preamble to the Code (page 3) discusses Objectivity with respect to fundamental principles governing conduct of members and firms. That section concludes with the following: “…With respect to both independence and conflicts of interest, the profession employs the criterion of whether a reasonable observer would conclude that a specified situation or circumstance posed an unacceptable threat to a member’s or firm’s objectivity and professional judgment. Only then can public confidence in the objectivity and integrity of the member or firm be sustained, and it is upon this public confidence that the reputation and usefulness of the profession richard@qwconsultancy.com

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P a g e | 356 rest. The reasonable observer should be regarded as a hypothetical individual who has knowledge of the facts, which the member or firm knew or ought to have known, and applies judgment objectively with integrity and due care.” In this case, Wanda Liczyk had a conflict of interest and could be subject to sanctions for her actions. Arguably, “a reasonable observer would conclude that [the case’s] specified situation or circumstance posed an unacceptable threat to a member’s [Wanda’s] objectivity and professional judgment.” [Emphasis and casespecific elements added.] The objectivity standard does not explicitly address whether or not a member needs to benefit financially when there is a conflict of interests. Nevertheless, Regulation 7-3 (formerly Rule 7-3) on Discipline and Appeal, under Sanctions (CPAO 2016b, page 2), establishes that: “In determining appropriate sanctions, the tribunal shall consider any aggravating and mitigating factors.” Students should be asked if they can identify any mitigating factors. 2. Should the accounting profession be allowed to police itself, or should an independent third-party, such as the government, enforce professional codes of conduct? Professional self‐regulation is the regulation of a profession by its members. A central purpose of professional self-regulation is the protection of the public from harm. Professional self‐regulation should encourage professional conduct and competence, fairness, transparency, accountability, and public participation. Individual members are personally accountable for their practice through adherence to professional codes of conduct and standards. A fundamental problem with self-regulation is maintaining independence from the interest of individuals or firms influencing the decisions of professional standard setters and enforcers. The self-regulation of the accounting profession is moving to a self-regulation combined with oversight from government bodies through the appointment of “public” observers who report to government bodies. The self-regulation of the accounting profession, and particularly in regard to audit standards, was put to test after the scandals that led to the passage of the Sarbanes Oxley Act of 2002. In essence, the US government decided that self-regulation was not enough to protect the public interest and created the Public Company Accounting Oversight Board (PCAOB), this organization is: “…a non-profit corporation established by Congress to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports. The PCAOB also oversees the audits of broker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.” (See PCAOB, 2003-2017)

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P a g e | 357 The Canadian Public Accountability Board (CPAB) has a similar role for audits of Canadian public companies. CPAO Regulation 7-1 Complaints (CPAO 2016b, Clause 41, page 8), formerly ICAO Rule 7-1, mentions that: “The Professional Conduct Committee shall ensure that, in every matter where the Canadian Public Accountability Board (“CPAB”) is a complainant, CPAB is given timely notice of every significant stage of the investigation and, if the matter is not referred to the Discipline Committee, prompt notification and a written explanation of that determination.” 3. Do you agree with Doug Elliott’s complaint that closed-door trials of accountants by the accounting profession is not in the public interest? Not necessarily. The objective of a CPAO (formerly ICAO) investigation, trials and disciplinary actions is to maintain the reputation of the profession and enforce breaches of the CPAO’s Code of Conduct. Not all complaints investigated will result in a disciplinary action, and it may be unfair to publicly disclose every time a firm has been investigated. However, all convictions and sanctions should be documented and disclosed to the public. As explained by the CPAO Regulation 7-3 on Discipline and Appeal (formerly ICAO Rule 7-3), clause 9, page 3): “In determining appropriate sanctions, the tribunal may consider the relevant principles, which may, but need not, include: • • • • •

protection of the public interest general deterrence of the membership specific deterrence of the Member rehabilitation of the Member; and denunciation.”

On the other side, the CPAO [formerly ICAO] investigation process should be reasonably transparent and satisfy the inquiry placed by the party who filed the complaint. Moreover, CPAO Regulation 7-1 Complaints (CPAO 2016b, Clause 12, page 4), formerly ICAO Rule 7-1, mentions that: “If the Professional Conduct Committee determines, pursuant to section 10, to take no further action or to provide guidance or to admonish, it shall also advise the complainant in writing of the right of review by the Reviewer of Complaints, as provided in Regulation 7-2.”

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P a g e | 358 4. By not prosecuting Liczyk after the Bellamy Report was published, did the ICAO [now CPAO] give the appearance that it was protecting its own, and not wanting to publicly acknowledge that some chartered accountants actually violate the rules of professional conduct? The CPAO/ICAO Disciplinary Proceedings file (CPAO 2017) has hundreds of cases in which the Discipline Committee enforced the Code of Conduct. Specifically, in early 2016, since 1987, over 50 of these proceedings found the professional accountant in a breach of Rule 202 Integrity and due care and Objectivity that includes Rules 201.1 Integrity and due care and 202.2 Objectivity standards, and over 200 of not maintaining the good reputation of the profession (Rule 201 and 201.1). Each of these proceedings contains a detailed explanation of the case and the reasons behind the decision. Therefore, the CPAO [formerly ICAO] does not seem to be consistently protecting its own members. On the other hand, arguably the ICAO could have done a better job at investigating this case and could have substantiated its decision. This would have indicated that it conducted a fair assessment of Wanda’s behavior. 5. Should Liczyk, as the chief financial officer of the city, have been prosecuted by the ICAO [now CPAO] on the more serious charge of failing to provide the required financial oversight, competence and necessary due care associated with monitoring the MFP lease? Why or why not? Wanda might have been prosecuted for not exercising due care for the following reasons: •

She did not control the costs associated with the MFP leasing contract;

•

She did not report the overspending to city council on a timely basis; and,

•

She failed to maintain a strong internal control system over the city’s procurement activities.

On the other hand, Wanda may not have been prosecuted for not exercising due care for the following reasons: •

She may not have had the sole responsibility for the swelling costs in this contract;

•

She may not have been solely responsible for the design of the original contract. The contract was improperly designed in first place, allowing the vendor to increase the total leasing costs, without a project charter to set out the scope of the project, the associated risks, the resources needed, the competencies required, and the tasks to be completed within due dates;

•

The police investigation may not have found enough evidence to press charges against Wanda.

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P a g e | 359 Useful Articles, Links, and Videos Chartered Professional Accountants of Ontario (CPAO) (2016a). CPA Code of Professional Conduct [in CPA Ontario Member's Handbook (Revised to November 29, 2016)], available at http://www.cpaontario.ca/Resources/Membershandbook/1011page20931.pdf . [Link not valid in 2020.] An updated version of the code of conduct referred to in the case is available at https://media.cpaontario.ca/stewardship-of-the-profession/pdfs/CPA-Ontario-Codeof-professional-conduct.pdf. Chartered Professional Accountants of Ontario (CPAO) (2016b). CPA Ontario Member's Handbook (Revised to November 29, 2016), available in pdf form at http://www.cpaontario.ca/Resources/Membershandbook/1011page5011.aspx . [Link not valid in 2020.] The regulations referred to in the case solution can be found in an updated version of the Member’s Handbook at https://media.cpaontario.ca/stewardship-of-theprofession/pdfs/CPA-Ontario-Members-Handbook.pdf. Chartered Professional Accountants of Ontario (CPAO) (2017). “Decisions, Orders and Reasons in Cases involving Disciplinary Proceedings: Index of Disciplinary Proceedings By Rule of Professional Conduct.” https://ebusiness.cpaontario.ca/discipline/RulesIndex.cfm Decisions, orders, and reasons can be examined alphabetically or by rule from https://ebusiness.cpaontario.ca/discipline/ . “Every case since June 1987 in which a finding of guilty of professional misconduct was made is included in this site, as well as settlement agreements approved by the Discipline Committee.” Public Company Accounting Oversight Board (PCAOB) (2003-2017). “About the PCAOB,” at https://pcaobus.org/About/Pages/default.aspx

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9. Strategic Roles (Chapter 6, page 496) What this case has to offer The public expects responsible behavior from their professionals, and professional accountants are no exception. Consequently, the old interpretation that professional accountants should concern themselves only with financial matters is considered very risky for the reputation of the professional and the profession. The mandate of some professional accounting associations is being broadened to include more areas of competence, and codes of conduct are being modified and applied more broadly than to just financial matters. There has usually been a requirement of professional accounting codes that warns not to engage in activities that will damage the reputation of the profession, and indications are that professional bodies are taking it more seriously. They are concerned not only with accounting-related matters, but also statutes/acts that relate to non-accounting matters. More importantly, nonaction when a professional accountant knows of something that is unethical or illegal is likely to attract negative sanctions in the near future. This leaves the Professional Accountant (PA) the problem of knowing what to do when such a problem arises. Doing nothing carries an increasing risk. Teaching suggestions Two alternatives are worth considering, with the selection depending upon the length of time available for the discussion. Either a preliminary discussion centered on the commentary above could be first, and then followed by taking up the case questions; or, if a longer time is available for discussion, the questions could be taken up first, followed by a summary of the commentary. Discussion of ethical issues 1. What is your responsibility in each of these situations? Misrepresentation of products that come from environmentally irresponsible sources as environmentally friendly. While this is unlikely to generate sanctions for the PA individually, it will erode the company’s reputation and will result in loss of consumer and other stakeholder support. In the modern world, it is unlikely to go un-noticed, so it may also generate fines and perhaps some lawsuits. The risks and consequences will likely be strategic, legal and financial. Consequently, the PA should raise these issues with the CEO and General Counsel, and with the Audit Committee of the Board if the response is not appropriate. Bribery of foreign officials Bribery is not only unethical, it is illegal in most countries, and carries significant fines under laws like the U.S. Foreign Corrupt Practices Act that now exist in over 30 countries. U.S. subsidiaries are covered under that act. Consequently, a PA should convey this understanding to the CEO and others as noted above. Use of faulty or unethical analyses and/or decision techniques

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P a g e | 361 If the PA has or is expected to have competence in an area, then it is the PA’s responsibility to bring such faults to the attention of company authorities to prevent bad decision making and harmful actions. Depending on the nature of the problems, the reporting chain noted above should be pursued. Encouragement of an unethical corporate culture PAs should understand the consequences of an unethical culture—poor internal controls raise risks of inaccurate financials, lower reputation, and drive away concerned employees. A PA should enlist the support of the CFO, caution the CEO against such encouragement, and report the matter to the Chief Ethics Officer and the Chief Risk Officer. If the response is not appropriate, the PA should identify the problem and risks to the Audit Committee. If the encouragement continues, and the problems are serious, it may be wise for the PA to consider resignation and/or whistleblowing. Misleading of the Audit Committee This would be a serious professional and perhaps legal offence to ignore or be involved with. According to most PA codes, PAs are not to be involved with misrepresentations. Don’t do it. Argue against it, indicate that you will have to report it if it happens, and report it immediately as noted above if it does happen. Ignoring of important internal controls This would expose the company to significant risks that could compromise the accuracy of financial reports, and permit/lead to unethical and illegal acts. It would be a breach of fiduciary duty punishable by professional, and likely legal, sanction. For the CEO and CFO who have to certify under SOX-spawned rules that an effective system of internal controls is in place and observed, the action contemplated could lead to jail and/or fines, and the ruin of the PAs reputation. Don’t do it or condone it. Argue against it. Report it using the chain noted above if you find that it has happened.

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10. Locker Room Talk (Chapter 6, pages 496-497) What this case has to offer The Locker Room Talk Case is taken from the excellent set of loose-leaf cases put together by the American Accounting Association. It presents a short, but realistic, problem of an auditor who learns something while on an audit which he is wondering how or whether to apply to another assignment he has. The problem involves multiple conflicts of interest and conflicts with usual provisions in the accounting profession’s code of conduct. The case provides a forum for discussing the following issues: 1. Conflicts of interest, in general, and for auditors, specifically. 2. Maintenance of confidentiality and its relation to the proper function of an auditor. 3. The role of an auditor/accountant/consultant with respect to the maintenance of a fiduciary relationship. 4. Involvement of an accountant in misrepresentation. 5. The role of audit evidence. 6. How to resolve conflicts between the accountant’s code of conduct and the requirements of a fiduciary relationship. 7. Which client’s interests should be given priority? 8. The importance and nature of independence. Teaching suggestions This is a terrific, short case which presents much more difficult issues than first thought. I use the questions at the foot of the case to guide the discussion. It is always interesting to me to see the split in the class along gender lines. The women tend to side with the wife, and the men side with the husband, even though he is probably going to leave his wife penniless in divorce proceedings. The debate between these two sides illustrates the conflict between the need to look out for the needs of a client (the wife) in a proper fiduciary relationship and the need not to break the confidence obtained by an auditor even though a client (the husband) may benefit when he shouldn’t. In the end, the class can see what they would like to do (help the wife), but not how to do it. By examining the fundamental basis of and need for evidence, a creative solution may be found. In the end, the desirability of maintaining independence is seen as attractive. The instructor’s opening statement on the case should provide the usual position on the maintenance of confidentiality found in accountants professional codes of conduct, as follows: “Information about client matters cannot be divulged except in a court of law or subject to a disciplinary hearing.” Later on, the instructor should be prepared to interject the other wisdom usually found in codes, that: “Accountants should not be party to misrepresentation.” richard@qwconsultancy.com

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P a g e | 363 These two statements will frame the issues and inform the discussion. Otherwise, it will wander unduly. What you want is for the class to explore and identify the audit evidence as confidential, and to realize that they can’t issue a financial plan for the man and wife if they know it will be based on misrepresentations of assets, etc., and therefore itself be a misrepresentation. What is the solution? I usually ask the class to vote on the alternatives they suggest. Then I ask if there is any other creative solution they might like to try. Several come forward, some of which are quite humorous. In the end, I suggest they ask for a meeting with both the husband and wife and ask for permission to confirm the details of the assets and liabilities, if any, with the bank prior to the issuance of the planning report. If the husband refuses, the ensuing discussion will inform the wife. If the husband will not allow the confirmation procedure, then the accountant must resign, and decide what to tell the wife. Telling her anything will break the strict confidentiality guideline, but, depending on her naiveté, telling her could be ethically justified. Consultation should be sought from the professional accounting society involved, or from a legal expert. Discussion of ethical issues Much of the flavor of the classroom discussion is captured in the preceding section, but specific background references are included below. Conflicts of interest; fiduciary relationship; and confidentiality: These topics are dealt with extensively in the Text in Chapters 5, 6, and 7. 1. What are the ethical issues? Confidentiality and the role of an auditor In order to perform the audit and assess audit risks, an auditor must be party to information and discussions about issues, such as are subject to settlement in a court, where the outcome is in doubt and where disclosure would harm the interest of the client. If auditors were not subject to stringent rules of confidentiality, clients would not discuss sensitive issues with them, and the audit function would be compromised. In addition, the disclosure of information in a non-audit forum to the detriment of a client could result in a lawsuit by the injured client, as well as the loss of the client. Some students think that they should avoid being placed in this situation by avoiding the scrutiny of the files of other clients when they perform an audit. This, of course, is nonsense because it would then be possible for a devious client to manipulate the accounts of other known clients of his or her auditor. Some students will argue about whether information overheard in a lock room is restricted by rules intended to restrict evidence gained on an audit. In this case, however, the locker room talk appears to be confirmed by an audit review of financial details, so the genesis of the concern is overtaken, and audit rules are properly in question. Which client’s interest should be given priority? Concern over the direct interests of the public are not a significant issue in this case, so the students should be redirected to a consideration of the interests of the profession to which the auditor belongs and those of the husband and wife, the bank richard@qwconsultancy.com

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P a g e | 364 loan officer, and the auditor. Following the discussion in the Text, the interests of the profession involved should take precedence. However, this does not mean that the confidentiality guideline should be followed slavishly if it is not in the interests of the profession, as appears to be the case here. Because of the probable naiveté of the wife, the public may perceive that her need for protection in the fiduciary relationship expected of an auditor should take precedence over that of the husband, bank loan officer or even the auditor himself. This follows from an analysis of the interests of the stakeholders and a ranking of those interests based upon the stakeholder’s ability to withstand the probable impact of alternative actions. Therefore, if a stratagem like that suggested in this case (confirmation) cannot be found, the auditor might have to find a way to inform the wife directly. 2. What should Albert Gable do? Resignation may not be appropriate The foregoing analysis suggests that just resigning from the financial planning engagement, as would be called for to avoid a report which misrepresents the financial position of the couple, will not sufficiently protect the wife and will therefore be unethical. Resignation with an accompanying statement of concern would not be justified until after asking for the right to confirm the financial details, as referred to above, and having been refused. Avoiding conflict of interest situations Any resignation should be accompanied by a referral of the couple to independent advisors, that is, one for each of them. In fact, taking assignments where there is a potential for conflicts to develop is not advisable, but if the clients insist, then they should be urged to submit the finished product to review by independent experts. In this case, if it were known that a divorce was thinkable when the assignment was undertaken, then taking it reflects very poor judgment—akin to playing with a time bomb. Serving two masters well is almost impossible in the best of times. Act for one and avoid the heartaches.

richard@qwconsultancy.com

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P a g e | 365 The value of independence This case illustrates the desirability of auditors not being dominated by a single large client, or by the size of a specific fee. If the auditor is not financially dominated, it is far easier for the decision to be made to forego the fee or ongoing relationship involved. Independence provides the cornerstone of the fiduciary relationship expected of accountants.

richard@qwconsultancy.com

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P a g e | 366

11. Advice for Sam and Ruby (Chapter 6, pages 497-498) What this case has to offer This is a real case in which I have changed the names and situation somewhat to protect the innocent/guilty. It depicts a type of involvement that most professional accountants face many times during their careers, whether they are in public practice or not. In fact, in real life, Sam was involved in negotiating the original agreement that included the “off-book revenue” clause. Sam believed that he was using his MBA skills in doing so, not his accounting skills, and so (erroneously) did not see his negotiating involvement as jeopardizing his professional standing. In spite of his good intentions, Sam became involved in a scheme to evade income tax, as well as sales tax and other revenue-derived costs such as workmen’s (compensation) insurance and rent (possibly). The scheme is almost certainly illegal, and/or involves misrepresentation, and is therefore specifically banned in most professional accounting (PA) codes of conduct whether or not the PA is in public practice. This case offers an opportunity to discuss how PAs should be alert for such situations, how they should be identified, and what should be done to avoid involvement and yet assist Ruby and his relative, if possible. Teaching suggestions I would recommend calling for a student to summarize the case and identify the potential problems. Then I would call for a student to argue that Sam’s actions were reasonable and ethical. After this, I would ask a student to argue that Sam’s actions were not ethical, and to indicate why. Then the class should weigh in on both sides of the argument about Sam’s position. When this discussion is concluded, I would ask the class what, if anything can be done by Sam for Ruby. Discussion of ethical issues I have reproduced below for guidance, the comments (adjusted somewhat) from a prominent senior PA with experience with an international firm, underlined and embedded in the case write-up. Dear John: I really appreciate your willingness to give me your opinion as a fellow professional accountant on what I should do, and what I should advise the minority owner to do, given that I have found myself in the following situation. Please note that: 1. I am not (and have not) been retained, nor am I being compensated, in any manner related to the situation. I became involved through extended family contacts. Involvement should be considered as the basis for professional conduct whether or not one is formally retained or compensated. 2. I have not been providing accounting services in any shape or form related to the situation. Yes, Sam has been providing accounting services if only by advising Ruby to get outside accounting advice and

richard@qwconsultancy.com

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P a g e | 367 advising Ruby and this accountant that ‘these amounts must be tracked’ in point 6. 3. I have ensured that Ruby, the party I was advising, did seek out accounting advice from another party throughout the course of events outlined below. By ensuring Ruby did seek out accounting advice from another party, Sam presumably became aware of what this advice was—not knowing what this advice was, it is difficult to make any further comment. 4. Approximately three years ago, Jimmy, an owner of a small auto body shop, approached Ruby to give her a 10% equity stake in the shop, and to provide day-to-day management functions for the entity. 5. Jimmy wanted Ruby to allow certain cash receipts to bypass the books of the shop, and in return Ruby would directly receive a commission on these transactions. Cash receipts would likely indicate also underreporting of sales tax and if the Workman’s (compensation) insurance reporting was thus distorted, it could also affect insurance coverage so there are more issues than just the reporting of the taxable income for income tax purposes. Similarly, banks and other creditors may have be able to argue misrepresentation if the business perishes. We do not know if these amounts were claimed as taxable income by Jimmy, but there is always the possibility of this. This requirement was incorporated into the shareholders’ agreement, signed by both parties, and witnessed. 6. I informed Ruby and her accountant, that these amounts must be tracked, and reported on her tax returns as taxable income without deduction. See note re other tax and reporting requirements 7. Ruby was lax, and followed Jimmy’s advice in completing certain paperwork, such that the incorporation documents and subsequent filings still reflect her as the sole director of the company, even though she merely set up the new company formed at the time of the initial transaction. Ruby as a director and involved party has full personal responsibility for the un-remitted amounts and reported withholdings. 8. Now Jimmy has approached her to buy her out. 9. During the course of the negotiations, which I attended, Jimmy’s accountant disclosed he was aware: o

That the 'off book' revenue was occurring, but still I am unaware as to how it was treated for tax purposes by Jimmy. There is a high likelihood, especially when coupled with the other disclosures listed below, of premeditated tax evasion on Jimmy’s part.

Jimmy has had, and continues to have, various taxation "issues".

Among the previous taxation issues experienced by the majority shareholder was one for approximately $80,000 that had caused the initial transaction to occur, as Jimmy was then attempting to hide assets from the tax authorities, and used the then unaware Ruby to effectively be a shield for him.

Jimmy’s accountant indicated that he is a professional accountant. And therefore has also incriminated himself in the activity and probably put Sam in the position that he is required to report this accountant to the professional body involved.

richard@qwconsultancy.com

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P a g e | 368 o

The negotiations of the transaction for the sale of the minority shares have now been transferred to Ruby’s lawyer, and I am still providing some help through her lawyer.

Many thanks for your advice. Sam

Discussion of ethical issues 1. Keeping in mind that no compensation, nor accounting services, were ever received or provided, has Sam stepped “out of bounds”? Yes, as the notes from a prominent PA above indicate, the absence of compensation does not matter, and he has provided accounting services, and has become involved in an illegal matter which is contrary to professional codes. 2. What is your advice for Sam? •

Consider his professional reporting obligations regarding the professional accountant and the income tax evasion. (i.e., reporting to the PA’s accounting body).

•

Consult with a lawyer and/or ethics advisor with his professional accounting association regarding his personal professional position.

•

Decline to provide further advice to Ruby as such advice is involved with a criminal activity.

3. What is your advice for Ruby? •

Retain a lawyer.

•

Then consider resigning immediately as a director.

•

If possible, escrow sufficient company funds to pay the back taxes.

•

Have the lawyer approach tax authorities on a “no names” basis to discuss the matter and propose actions to make restitution and payment.

•

Forget any proceeds that may be coming from her minority shares—this thing will be worthless. Further:

Essentially, a PA should be continually alert for red flags that reveal an illegal scheme, and/or one that involves misrepresentation. If an illegal scheme is identified, then care must be taken by the PA to immediately distance himself or herself from it, by recommending legal advice be sought. In the case of a scheme involving misrepresentation, a PA should advise against the misrepresentation and then resign from any involvement if the misrepresentation is not clarified. Notes should be kept by the PA of all issues and actions, and a practice advisor should be consulted. Ruby, and all involved with the off-book arrangement, were naïve and exposed themselves to legal and professional sanctions. The remedy for Ruby is to make a clean

richard@qwconsultancy.com

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P a g e | 369 breast of it to the tax authorities through a lawyer, as soon as possible, hope the authorities accept her story of naiveté, and are in a good mood. 4. Given the alleged disclosures by Jimmy’s accountant, has he crossed any boundaries? If so, does Sam have to take any actions, and what would these actions be? •

Yes, as the notes above show, he has become involved in an illegal matter, and likely is party to a tax evasion scheme.

•

Sam should report the other PA to his professional accounting body, and advise Ruby and her lawyer as to his concerns.

richard@qwconsultancy.com

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12. Biker Nightmare (Chapter 6, page 498) What this case has to offer Most Professional Accountants (PAs) have found themselves in the position of discovering an illegal act and have wondered what to do about it. In this case, the company president has asked for you to summarize a number of illegal transactions, and to sign the summary. If discovered or reported to the authorities, it is likely that the $200,000 will have to be paid, as well as some additional fines. The duties and fines may be considered to be contingent liabilities and will have to be disclosed. If the president does not correct this situation after being informed, then the issue should be reported to the auditor and Audit Committee of the board after informing the president. The request to sign the summary is interesting, in that it will indicate when the PA came to know about the problem—a fact that will be important to assess how quickly and, therefore, responsibly the PA has acted. If a PA doesn’t act, the president could demand future favors such as improper accounting adjustments in return for not informing the Professional Accounting body. A PA would need to be aware of this risk. Whether or not you have signed the summary does not change your professional duty. Teaching suggestions The most expedient way to approach the case is to ask the class to recap the ethical issues presented in the case. That will lead to a discussion of the items above, and then to the end-of-case questions as noted below. Discussion of ethical issues 1. What does our professional code say about this? Most codes contain general, if not specific, provisions against acting in or covering up an illegal transaction. Such actions would contravene expected standards of integrity, behavior in the public interest, protection of the good reputation of the profession, and fiduciary duty to the company’s board. Also, there is a specific provision in most codes that a PA should not be involved in a misrepresentation, which would be the case if the practice continues. See Text, Table 6.7 (Fundamental Principles in Codes of Conduct for Professional Accountants). 2. If this issue is uncovered by the government regulatory authorities, will I be implicated? Potentially yes, depending on the statute or regulation, and the rigor of the professional accounting body involved. 3. Should I quit my job and then go and report this situation to the regulatory authorities? Not unless the president refuses to change the practice after you advise him or her of the problems associated with it. Even then, you should advise the Audit Committee of the board so that the practice cannot continue without their knowledge and consent. They are relying on you for that advice. Ultimately, the PA has to decide whether to stay or resign and when, but even if the PA leaves, the PA should advise the president and the Audit Committee of the problem. richard@qwconsultancy.com

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P a g e | 371

richard@qwconsultancy.com

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13. Budget Conflict (Chapter 6, page 498) What this case has to offer As CFO of an organization, particularly one where financial acumen may be weak, it is expected that a Professional Accountant (PA) will try to clarify any perceived misunderstanding on financial matters. Consequently, if the Board of Directors approves a “stretch budget” that assumes unreasonable revenues and/or levels of expenditures that would be dangerous to the organization’s financial health, the CFO should make the consequences and his or her opinions known to the Treasurer, the President and the Board. In this case, since verbal persuasion has failed, the CFO’s comments should be put in writing and circulated to the Board. If that does not change the picture, then the CFO should approach other organization members who would be present when any recommendations from the Board are voted upon at an annual meeting so they could raise their objections. The CFO’s written comments should be circulated to the membership, and/or at the annual meeting. Teaching suggestions The discussion could start by asking if a PA’s duties are different with a charitable organization compared to a profit-oriented one. The answer should be no, and then the class should be asked which stakeholders might benefit from a “stretch budget” (e.g., board members and board egos if the organization’s employees are really underperforming) and which might lose from a “stretch budget” (high performing employees, members and employees who might lose if the organization’s financial stability is jeopardized, etc.). Then the questions at the end of the case should be taken up. Discussion of ethical issues 1. What should the CFO do? The CFO should put his or her comments in writing and present a copy to the President and Board members. If they still wish to go ahead, he or she should communicate with members to apprise them of the risks, and to make the comments at the annual meeting before the vote on the budget. As a last resort, after the foregoing steps, the CFO may wish to resign. 2. Beyond resigning, how can the CFO protect him or herself? The best protection is to take the steps laid out above and to document the meetings held to try to persuade the President and others to change their unrealistic path. In addition, the CFO could consult a lawyer and/or the advisor on staff at his or her professional accounting body.

richard@qwconsultancy.com

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14. An Exotic Professional Accountant (Chapter 6, page 499) What this case has to offer The issues involved in this case are: •

The limits of damage to the profession’s reputation

•

The limits of damage to the PA’s reputation

•

Do activities on a Professional Accountant’s (PA’s) personal time matter and, if so, what kind of activities?

•

Does the profession’s code of conduct apply?

Both the reputation of a PA and the profession can be impacted by personal-time activities, for better or worse. For the professional, such activities can enhance reputation if the activities reflect high levels of the values of integrity, duty and so on, excellent judgment, or demonstrated competence in financial or organizational matters. They might diminish her or his personal reputation if the choices made were not respected. As far as the reputation of the profession is concerned, the impact of personal-time activities is of little consequence unless they are so far out of normal bounds as to raise questions about the judgment and processes of the profession for allowing the member to remain a member. For example, a PA who committed murder, or fraud, could not be expected to have sound judgment or be trustworthy, and should have his or her professional designation cancelled. Exotic dancing is probably in a grey area. Some clients or employers might view it as in bad taste, thus weakening the PA’s reputation, and some may even find it grounds for dismissal, but that would be an unlikely outcome. Similarly, most professional accounting bodies are unlikely to regard exotic dancing as endangering the profession’s reputation sufficiently to warrant expulsion, at least without a first warning to cease and desist. Teaching suggestions I would ask the two questions one at a time and entertain discussion and manage it to cover the points in the commentary above. •

Do activities on a Professional Accountant’s (PA’s) personal time matter, and if so what kind of activities?

•

Does the profession’s code of conduct apply?

Students will probably take a strong view that personal-time deeds shouldn’t matter, and will have to be brought to understand the implications for trust, judgment, and reputational impact, as well as the preference of employers for maintaining behavior in keeping with their version of integrity and other corporate values. Discussion of ethical issues 1. What advice would you give? A PA contemplating such a choice should consider: richard@qwconsultancy.com

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P a g e | 374 •

employer codes, values and guidelines

•

probable impact on personal reputation

•

the past practices of the professional body involved, and seek advice in advance from the professional body’s ethics or compliance officer (which is actually where this case came from)

•

personal preferences, values and the necessity involved

•

hiring a lawyer for advice, if necessary.

richard@qwconsultancy.com

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15. Freebie Services for Staff (Chapter 6, page 499) What this case has to offer The case examines the grey area of duty to employer, conflicts of interest (COI), how to combat frivolous charges related to them, and what red flags they might involve. Since the employer has no formal policy for the provision of services on personal time in regard to matters not directly affecting the town, it seems that an external lawyer has influenced the town manager to produce a conflict of interest complaint against a Professional Accountant (PA) on staff. Does the state or province have a COI policy that covers this type of complaint? Probably not, as it could be interpreted to be in violation of the PA’s human rights as the activity is beyond work hours and not related to the operations of the town. As long as the PA can show that she or he has the necessary expertise, then the code of the professional accounting body involved would not be offended. The PA does not seem to be acting contrary to the interests of his or her employer. Teaching suggestions Ask the class what the ethical issues are raised by the case. This should lead to a discussion of: •

What duty a PA owes his or her employer,

•

What constitutes a conflict of interest, and

•

What standards should be applied to decide upon the proper course of action. Based on this platform, the question of what advice to give can be raised. Discussion of ethical issues

1. What advice would you give to the Professional Accountant? The advice to the PA should include: •

Asking the town manager: o

to clarify what conflict of interest policy he is applying;

if he seeks to control activities undertaken on personal time for friends for no remuneration; and

how your free services affect the town’s interests.

•

Asking the town’s mayor and its lawyer for clarification

•

Asking the ethics adviser for your professional body for advice

•

Hiring a lawyer if all else fails.

In addition, the PA should consider if the town manager might have a conflict of interest if he is representing the interest of the external lawyer in such a manner, and

richard@qwconsultancy.com

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P a g e | 376 whether this potential conflict should be identified in discussions with the mayor and town lawyer. The PA should also consider what his or her relationship will be with the Town Manager (his or her boss) if s/he does or does not acquiesce to the request.

richard@qwconsultancy.com

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P a g e | 377 16. Summer Camp Holdback (Chapter 6, pages 499-500) What this case has to offer A Professional Accountant (PA) has been asked to agree to allow his or her employer to: • • •

retain monies (for General Sales Tax (GST) recoveries) belonging to customers, issue charitable receipts to give the customers partial credit (less than 100% depending on the deductibility of the donation), and mask the right of customers to get the monies back.

Ethically, PAs should not be associated with any misrepresentation according to their codes, or they would be undermining the reputation of the profession as well as themselves. Moreover, PAs are expected to demonstrate integrity, which they would not be doing if they covered up the right of getting back the GST recovered. Unless the right to reimbursement is made clear to the customers, and they agree to leave the money with the Camp as a donation, the plan for retention and issuance of charitable donation receipts is illegal. The GST recovery is money held in trust and does not belong to the Camp. Moreover, it is likely that an audit of the GST records of the Camp would find the illegal retention. Teaching suggestions The class should be asked to clarify what the PA has been asked to do. Then ask what is wrong with the proposed action from the perspective of the company and the PA. Based on this information, the question of what advice to give should be asked. Discussion of ethical issues 1. What is your advice? The company’s officers should be told that what they propose is illegal and could subject the company and possibly the officers to fines. There is a possibility that what they propose could go unnoticed by tax authorities. However, the PA should not go along with the proposal since it would be counter to ethical expectations for a PA and most PA codes of conduct for the reasons noted above. If the Camp decides to go ahead, the PA should resign and consider whistle blowing.

richard@qwconsultancy.com

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17.Theft Reimbursement, Twice (Chapter 6, pages 500-501) What this case has to offer The controller has instructed the assistant controller to deposit a second check for $16,583 into a high interest account to earn interest to defray legal and other costs of the related court case. He said that the funds would be returned to the insurance company after the court case was settled. The assistant controller wanted to return the check to the insurance company immediately since the bank had already sent a reimbursement check. The assistant controller is therefore confronted with a request to act unethically, but probably not illegally, if the money is returned reasonably promptly to the insurance company. Secrets of this nature don’t often stay secret, particularly given the mindset of the assistant controller. Teaching suggestions After eliciting the facts, the class could be asked if they thought the proposed action was unethical or illegal, or both. In the ensuing discussion, the class could be led to use the ethical challenges discussed in Chapters 3 and 4, such as: 1. Consider the consequences in the short and long term. 2. Consider the duty, rights and fairness involved. 3. Does the action demonstrate the virtues expected of PAs, and not-for-profit organization? The controller’s proposal may harm the reputation of the not-for-profit. If the proposal becomes publicly known, then relevant stakeholders of the organization may opt to no longer deal with the not-for-profit. They may not be pleased with the values demonstrated by the organization and its accounting staff. On balance, the risks of loss of reputation for the PAs and the not-for-profit seem to reduce the possible benefits from the proposal. The challenge, then, is to make this clear to the controller. There is always the risk that the controller will ultimately want to keep the money, but this would be illegal, and could result in sanctions for the PAs from their professional body. Based on this platform, the questions posed at the end of the case should be answered. Discussion of ethical issues 1. How would you answer the assistant controller? The assistant controller should be encouraged to perform the above analysis and come to the conclusions identified: that the proposal is probably not illegal but is unethical and not worth the risks involved. Armed with this information, she or he should explain the risks and rewards to the controller, and convince him or her to abandon the proposal. If the controller decides to keep the money, then the assistant controller should inform the officials of the not-for-profit. If the money is not ultimately returned, then she or he should resign and consider advising the insurance company. richard@qwconsultancy.com

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P a g e | 379 2. What advice would you give to the controller? As noted above, the controller should be provided with an understandable, abbreviated version of the analysis and conclusions that are noted above. 3. What aspects of the organization’s governance process and/or internal controls were flawed? The check preparation, authorization, and distribution systems are flawed because: •

One individual is responsible for the first and last stages and can take signed checks meant for others ➔ Split the duties between two people.

•

Checks are easily altered ➔ Consider protective machines and paper.

•

Consider direct-deposit ➔ that would do away with checks.

4. Should the directors be told about the fraud and/or any other matters? Yes. The directors have a right to know about the fraud and other matters related to insurance, faulty internal controls, and actions that could damage the reputation of the organization and/or generate potential loss of business or reputation. The controller should inform the directors, and the assistant controller should encourage that it be done. If the controller fails to do so, then the assistant controller should inform the directors.

richard@qwconsultancy.com

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Accounting & Auditing Dilemmas 18. Sino-Forest Fraud? Audit Challenges in China (Chapter 6, pages 501-506) What this case has to offer The Sino-Forest Fraud case presents the difficulties of auditing in a foreign jurisdiction and culture, the consequences of not meeting these challenges appropriately, and raises questions about how best to meet those challenges. The case also illustrates the difficulties for investors and capital markets participants where the operations of a company are in jurisdictions significantly different than in North America, the United Kingdom, Europe, Australia or New Zealand. The role of the board of directors also comes under scrutiny. Is it enough to rely upon the audit firm, or should other measures be taken to ensure the accuracy of financial reporting and the integrity of company operations? In addition, the case offers the opportunity to explore what “professional skepticism” means, and how it should be applied, as well as the correct audit steps that should have been taken in terms of staffing, risk identification, review, extent of evidence verification, and potential red flags in terms of conflicts of interest, multiple bank accounts, lax or non-existent record systems, and so on. The role and practices of a critic of the audit and financial reporting process are on display. This permits the class to speculate on whether individuals like Carson Block have a valid purpose and are useful, or whether their actions are tainted by self-interest and they are really trying to manipulate the stock prices of the target companies to maximize gains on the short positions they have taken in the stock. Finally, the class can consider the appropriate punishment for the operators of companies like Sino-Forest who reside outside the jurisdiction of the stock market regulator where the shares are traded, and how that punishment should be applied. Teaching suggestions It is useful to begin the Sino-Forest case discussion with the statement and question: Everyone knows that investing in the stock market is very risky, so why isn’t the Sino Forest Fraud considered just a case of “buyer beware” in which investors took a chance and have to suffer the loss without recourse? This will lead to questions on and discussion of: •

Facts of the case,

•

Reasonable risks an investor should expect to assume,

•

Safeguards that are supposedly in place to ensure that the investor is protected,

•

Safeguards that failed, and why,

•

Audit issues involved, and richard@qwconsultancy.com

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Punishments/penalties that should be levied.

In the process of these discussions, the students who have prepared answers to the following questions will do well. Discussion of ethical issues 1. Describe the fraud that allegedly occurred through Sino-Forest Corporation Inc.? Who benefited and how? These details are in the case. Essentially, operations were falsely inflated, records and systems were insufficient, legal frameworks were too loose or not in place, auditors failed to discover that the resulting financial statements they certified were incorrect, and the board of directors apparently never visited Chinese operations or questioned the integrity of management or the financial results. The entrepreneurs and management who share in the proceeds of the initial offering and early sales of stock, and early investors who sold their shares at overstated values benefitted. Money brought into the company through the issue of shares to North American was siphoned off through false transactions with shell companies, many of which were in the Caribbean, to the benefit of individuals who set out to defraud the investors. 2. Why did regulators not prevent this fraud from occurring? What were they relying on? Regulators were unaware of the fraud because they relied upon the work of a Big 4 audit firm, which was insufficient to discover the fraud. Also, the perpetrators of the fraud used a reverse takeover (RTO) to take over control of a reputable company that had operated with a proper audit, and had been traded on a North American stock exchange without incident for several years, so the normal reviews and examination of a new prospect for listing was not triggered. Essentially, the RTO allowed Sino-Forest to escape normal scrutiny before it was listed and made an IPO. 3. Why did the directors of Sino-Forest not prevent this fraud from occurring? What should they have done to discover the problems that were subsequently uncovered? The directors should have been more familiar with the risks in doing business in China. If they had been, they would probably have: (1) visited company operations and offices in China, (2) would have insisted on internal audit reviews of company records, systems and policies, (3) would have insisted on a risk assessment of the operation and background checks on senior and middle management, (4) would have insisted that several members of the board be able to speak Chinese, and be familiar with the local customs and legal systems, and (5) would have directed the external auditors to check questionable practices and would have questioned the audit partner on these investigations. Instead, the board (several of whom were retired North American audit partners) and the auditors presumed senior management and operations were ethical, and either they didn’t go deep enough to discover and act on problems, or they failed to recognize the red flags that appeared (such as the large number of bank accounts, absence of records, use of personal credit cards, lack of legal documentation, and so on). 4. Why did shareholders not foresee this fraud? What were they relying on?

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P a g e | 382 As stated above, the investors relied upon the auditors, as well as the board of directors and the stock exchange to be accountable for the activities of the company, and to ensure that information used by investors was accurate and timely. 5. Why did Carson Block author the Muddy Waters Research Report? Was he altruistic or selfinterested? What did his company stand to gain? Carson Block was probably both self-interested and altruistic. His company was established to provide information for investors, and the Sino-Forest report would have resulted in a reputation gain. The information might also have been used to benefit those who borrowed stock from a broker and sold it (i.e., sold it short) with the hope that it would decline in price so that it could be bought later to return the stock borrowed and realize the gain between the early selling price and the later purchase. Students should be encouraged to visit the Muddy Waters website (http://www.muddywatersresearch.com/ ) and assess the altruistic comments on speaking truth to power. 6. What basic assumptions were erroneously made by Ernst & Young that contributed to the audit problems of concern to the OSC? •

E & Y erroneously assumed that the entrepreneurs behind Sino-Forest and its management were honest and possessed integrity, so that they believed they could rely upon o

representations given by them

financial systems and records that were sound, so that the financial reports they generated could be relied upon

the land titles system in China being as well-defined and legally binding as in North America.

•

E&Y also erred in assuming that audit staff who could not speak Chinese or understand Chinese culture, legal, and business systems could audit Chinese operations effectively.

•

Finally, E&Y assumed that their retired partners, who served on the board of directors, were in touch with and understood Sino-Forest operations; would not be associated with fraudulent activities; and/or would warn E & Y if there were impending problems.

7. What audit risks become important when auditing in unfamiliar cultures? •

Mistaken assumptions: o

Ownership of assets—forests

Valuation of assets—forests

•

Improper recognition of revenue

•

Assets not safeguarded appropriately

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Complex financing structure (such as with a reverse take-over)

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P a g e | 383 8. If you had been on the audit team of Sino-Forest, how would you have avoided allegations of a lack of adequate professional skepticism? You would need to have: •

investigated any procedures or activities that differed from North American practice.

•

investigated until you understood any anomalies.

•

ensured that the systems, records, and personnel involved were sufficient to ensure accuracy and integrity would be maintained.

•

better identified audit risks and related follow-up.

•

ensured that instructions to audit staff would make them extra highly skeptical and on alert for fraudulent activities.

•

ensured that the members of the audit team were well-trained and experienced in audit work in North American and China.

9. If the Chinese system of recording property rights was known to be incomplete, how would you have performed the audit of Sino-Forest’s assets? Where there was significant uncertainty, multiple legal opinions should have been sought, in English, as to the ownership questions, and appraisals should have been sought from several appraisers who were known to the audit firm. Multiple sources of opinions and appraisals would have minimized the danger of conflicts of interest, and in receiving opinions that were misunderstood. Also, all payment transactions should have been reviewed to ascertain whether asset values were substantiated, and ownership documents should have been scrutinized. 10. What audit problem was caused by the Sino-Forest practice of selling timber without receiving cash payments, and how would you have resolved it? By selling timber without receiving cash payments, Sino-Forest made it almost impossible to establish the sale transaction value objectively. The value given in exchange would need to be rigorously examined with attention to the time lapse between transaction and examination. Appraisers could also be hired to provide an independent valuation of these transactions. 11. What would you do if you were a company director or auditor, and you were advised that your company had incomplete or inadequate record creation and retention practices and no integrated accounting system and that employees conducted company business from time to time using personal devices and non-corporate email addresses? It should be obvious that all of the inadequacies noted above are serious and threaten or undermine an investor’s ability to monitor a company’s performance and to rely upon its assets, and prior audit opinions. a. As a director, I would immediately ensure that my director’s and officer’s insurance was adequate, and either resign, or immediately cause the company richard@qwconsultancy.com

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P a g e | 384 to retain a reputable accounting firm (not the auditor) to recommend new policies for transactions and business practices, new record systems. The company should also immediately hire competent systems and accounting personnel and internal audit staff. As a director, I would also inform the company’s auditor and would advise the relevant securities regulator and stock exchange that financial reporting would have to be suspended until proper systems, records and personnel were in place. b. An auditor who discovers this situation should immediately inform the board of directors and recommend the measures stated above. Additional Issues Raised by Professor Dushyantkumar Vyas, Rotman School of Management Issue 1 Even before fraud allegations by Carson Block, could investors have used Sino Forest’s business/financing activities and financial reports to construct precursors or red flags indicating future financial troubles? For example, was reverse merger itself a big red-flag that should have warranted further analysis from investors? See articles by Pavlo (2011) and Chevreau (2011). Issue 2 What type of governance mechanisms should be in place within audit firms to encourage internal dissent and whistleblowing activities? It appears in this case that at least some E&Y employees had misgivings about the work conducted by Pöyry Forest. See article by McFarland, Hoffman and Gray (2012). Issue 3 Auditors often rely on evidence from independent third party agencies (e.g., valuation experts, surveyors, etc.) To what extent are they responsible for misrepresentation by such thirdparties? In this case, E&Y relied in part upon survey evidence provided by Pöyry Forest. See article by McFarland, Hoffman and Gray (2012).

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P a g e | 385 Issue 4 Consider the regulatory model: More generally, and beyond the case at hand, should there be greater oversight by North American regulators on the ground in China where the operations are based? Do you see any negligence by or culpability of Chinese regulators? See articles by Rapoport (2012) and Santiago (2014). Subsequent Events July 2014 Sino-Forest CFO, David Horsley, settles with OSC for $700,000 fine; is barred from directorships; might pay $5.6 million to shareholders, and must agree to testify at trials of other executives. (Lu 2014) August 2014 In a settlement with the Ontario Securities Commission (OSC), David Horsley— former CFO for Sino-Forest--is fined and prevented from ever again sitting as a director of a public company. Author Peter Koven writes, “Mr. Horsley was the only member of SinoForest’s senior management team who was based in Canada. He did not understand the firm’s business in China well enough…[and] admitted that he allowed the company to make ‘materially misleading’ disclosure.” (Koven 2014) Journalist Jeff Gray outlines the case against Sino-Forest and draws a comparison to the “…Bre-X Minerals Ltd. case, which rocked Bay Street in the 1990s after its gold-drilling results in Indonesia were faked…” and the OSC tried, unsuccessfully, to prove allegations made against the company. (Gray 2014) Useful Articles, Links, and Videos “Block Interview on Sino-Forest [video].” [June 6, 2011], Bloomberg Television, accessed at http://www.bloomberg.com/video/70530586-block-interview-on-sino-forest.html on September 22, 2014. [Link not active in 2020. Interview accessible at https://www.youtube.com/watch?v=s6pI1LPTk14. ] In this interview of Carson Block by Erik Schatzker on Bloomberg Television's "InsideTrack," Carson Block is questioned about Sino-Forest, his company’s short position, why Block considers Sino-Forest to be a Ponzi scheme and, Schatzker asks, why cable companies, with similar capital-raising requirements and negative cash flow, are not. Schatzker also questions Block’s company’s potential conflicts of interest. Chevreau, Jonathan (June 10, 2011). “Sino-Forest shows importance of doing your homework.” Financial Post, http://business.financialpost.com/2011/06/10/sino-forest-showsimportance-of-doing-your-homework/ Gray, Jeff (August. 31 2014). “Sino-Forest high-profile fraud hearing to begin.” The Globe and Mail, accessed at http://www.theglobeandmail.com/report-on-business/sino-forestfraud-hearing-begins/article20288244/ on September 22, 2014. Koven, Peter (July 21, 2014). “Sino-Forest CFO fined $700,000 and banned from boards in settlement with Ontario Securities Commission.” Financial Post, accessed at http://business.financialpost.com/2014/07/21/sino-forest-cfo-fined-700000-andrichard@qwconsultancy.com

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P a g e | 386 banned-from-boards-in-settlement-with-ontario-securities-commission/ on August 5, 2014. Lu, Vanessa (July 22, 2014). “Former Sino-Forest CFO barred from serving as director of public company.”The Toronto Star, accessed on July 22, 2014 at http://www.thestar.com/business/2014/07/21/former_sino_forest_cfo_barred_from_ser ving_as_director_of_public_company.html McFarland, Janet; Hoffman, Andy and Gray, Jeff (December 3, 2012). “OSC cracks down on Sino-Forest auditors.” Globe and Mail, http://www.theglobeandmail.com/globeinvestor/osc-cracks-down-on-sino-forest-auditors/article5913025/ McKenna, Barrie (May 27, 2012). “Sino-Forest case cries out for justice.” Globe and Mail, accessed at http://www.theglobeandmail.com/report-on-business/robcommentary/sino-forest-case-cries-out-for-justice/article4210097/ In this article, the author says, “Sino-Forest trumps Bre-X precisely because it happened after Bre-X…Twice, Canada’s fragmented and undermanned regulatory regime failed.” Pavlo, Walter (April 8, 2011). “Fraud in Chinese Reverse Mergers on American Exchanges -- And We're Surprised?” Forbes, http://www.forbes.com/sites/walterpavlo/2011/04/08/fraudin-chinese-reverse-mergers-on-american-exchanges-and-were-surprised/ Rapoport, Michael (September 21, 2012). “U.S. and China Reach Tentative Agreement on Audit Inspections.” Wall Street Journal, https://www.wsj.com/news/articles/SB100008723963904440324045780102939115808 74 Santiago, Patricia (February 26, 2014). “’Big Four’ Decision Shines Light on Regulatory Conflicts.” RegBlog, http://www.regblog.org/2014/02/26-santiago-big-four.html

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19. Massive Acquisition Write-Downs in the Mining Industry (Chapter 6, pages 506-507) What this case has to offer The case identifies the problem that several mining companies have purchased other companies, have absurdly found almost immediately that they paid too much, and so have written off the massive overpayments very quickly. There are several possible explanations, including the following. The purchasing-company executives… •

used the wrong valuation method to calculate the amount paid

•

used the wrong estimates as input to the calculations

•

knowingly overpaid for some fraudulent reason, or

•

wanted to write-off some of the asset values acquired so that their subsequent earnings would look better when compared to a lower asset base.

As a result, this is an excellent opportunity to review basic business valuation methods and their corresponding strengths, limitations and computation methodologies. The four most common methods are: 1. Asset based a. Adjusted book value approach 2. Earnings based a. Capitalized earnings approach b. Capitalized cash flow approach c. Discounted cash flow approach Teaching suggestions For each of the following valuation methods, have a student briefly summarize the computational methodology, the strength of the method, and the problematic assumptions. Then have the students debate which method they think provides the most accurate valuation and why. Have them pay careful attention to all the assumptions and estimates that are used in determining the valuation of a business. After that, discuss the ethical issues raised below. Adjusted Book Value •

Methodology: calculate a revised book value by adjusting net tangible assets and liabilities to their fair values or values in use.

•

Good for estimating value of the business at a given point in time.

•

Problematic assumptions: estimating fair values; estimating values in use; no growth in the business (static). Capitalized Earnings Approach richard@qwconsultancy.com

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P a g e | 388 •

Methodology: calculate normalized (sustainable) earnings by adjusting for non-recurring items, discontinued operations, non-arm’s length transactions, excessive compensation, and unreasonable estimates (e.g., amortization).

•

Good indication of the ability of the firm to earn profits in the future based on historic results.

•

Problematic assumptions: infinite life; constant growth; no additional working capital requirements; historic results may not be an indication of future operations; sustainable future investments may not equal amortization expense. Capitalized Cash Flows

•

Methodology: calculate after-tax cash flows by adjusting for non-cash revenue and expense items, tax shield, and current tax rate; capitalize that amount and adjust for present value of undepreciated capital items and redundant assets.

•

Recognizes importance of cash flows; not dependent on accounting policies; can adjust for different financing structures.

•

Problematic assumptions: determining the appropriate discount rate; infinite life; constant cash flows levels; consistent expense and revenue relationship. Discounted Cash Flows

•

Methodology: calculate year-by-year free cash flows (i.e., operating cash flows less required capital expenditures to maintain the cash flows); discount those amounts (normally using weighted average cost of capital).

•

Allows for non-constant growth; not dependent on accounting policies; can adjust for changes in strategy and financing structures.

•

Problematic assumptions: determining the appropriate discount rate; accurately estimating future years’ cash flows. Discussion of ethical issues

1. Should the CEOs of these mining companies be held accountable for commodity prices that have dropped precipitously while operating costs have soared? It is possible to argue either way. On the one hand, the CEO has ultimate responsibility for the investment decisions of the firm. The possibility of changing commodity prices should have been taken into account in the determination of the value of the business that was purchased. Therefore, the CEO should be held responsible. On the other hand, the CEO is only responsible for activities that are reasonably foreseeable. No one could have could have predicted the precipitous drop in commodity prices. As such, the CEO should not be held responsible. 2. Should Albanese be held responsible for the fact that the Chinese market did not open as he predicted and that the price of aluminum dropped precipitously? If not Albanese, then who should be held responsible?

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P a g e | 389 Similar arguments to those presented in question 1 above can be presented here to argue either way. The board of directors has the ultimate responsibility for the strategic decisions of the firm. If the CEO (Albanese) is not responsible, then the board of directors must be held responsible. 3. Because of the $14 billion write-down should Albanese be forced to forfeit his lucrative stock options? Part of the objective of stock options is to align the interests of management with those of the investor (agency theory). As a result of the $14 billion write-down, the share price of Rio Tinto’s stock fell. The investor lost money. Therefore, if the interests of the CEO and the investor are to be aligned, then Albanese should also suffer a financial loss as a result of the write-down. In terms of justice as fairness, his loss should be commensurate with the loss incurred by the shareholders. 4. Alcan was purchased in 2007, and there were two subsequent write-downs, reducing its value by more than half of its original purchase price. But Albanese did not resign until 2013. Was this resignation too late? When should a board of directors fire a CEO who has made a significant mistake? The board of directors has the responsibility to take corrective action when the board feels that the CEO is not behaving in the best interest of the firm. Corrective action should be just, fair, and timely. Without knowing all the details of what occurred within the boardroom of Rio Tinto, it appears that the firing of Albanese should have occurred must earlier. 5. The Rio Tinto executives made massive errors in judgment that cost the company billions. Were they treated too gently? Similar to the arguments presented in question 4, above, the board needs to act with fairness and justice when dealing with senior executives. Estimating the value of another business is a very inexact science. It is dependent upon a number of assumptions concerning future cash flows, interest rates, and (in the case of mining companies) commodity prices. Despite the uncertainty associated with predicting the future, executives need to use their skills, expertise and experiences to make reasonable assumptions about future cash flows. Consequently, executives should be held accountable for their decisions, and this means that they should be rewarded for good decision-making and penalized for poor decision-making. 6. Since several companies have written off massive amounts paid for their acquisitions, were each of these managements wrong for specific reasons, or were there common factors affecting them all? If so, what were they? The massive writes-offs that occurred throughout the mining industry indicate that this may be a systemic problem. Business valuations are tricky at the best of times. Perhaps the business valuation models that were employed in the mining industry failed to account for such exogenous factors as a precipitous decrease in commodity prices. Useful Articles, Links, and Videos

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P a g e | 390 See the Text. PwC (February 2014). “2014 Global Mining Deals Outlook and 2013 Review: Strategically Picking Up the Pace,” accessed at http://www.pwc.com/ca/en/mining/publications/pwc-m-a-industrybriefing-2014-02-en.pdf on September 23, 2014. This report outlines why 2013 was one of the mining industry’s worst year for mergers and acquisitions (M&A) and how that has made investors nervous and has changed M&A strategy and outlook.

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20.Accounting Rule Changes Increase Apple Computer’s Revenue (Chapter 6, pages 508-509) What this case has to offer This case describes Apple’s objection to subscription accounting, or deferred recognition of revenue, for the sale of iPhones, iPods, and other devices bundling hardware, software and technical support. When the accounting rule was changed, Apple’s income and stock price rose. This is a good case to discuss whether revenue recognition policy matters even when cash flows are the same under different accounting policies; whether the change in accounting policies resulted in fair financial reporting; and whether stock prices should react to changes in accounting policies. This case is related to the case on the impact of international GAAP on earnings, also included in this chapter. Teaching suggestions Before discussing this case, I ask students, “What is earnings management?” An interesting definition of earnings management widely used in the academic accounting literature is provided by Healy and Whalen (1999): “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.” An important issue for financial analysts, investors and corporate executives is how to distinguish between earnings manipulation that could be fraudulent and the day-to-day struggles of managers to keep costs within budgets or to get revenues to meet desired sales targets. Not all earnings management is misleading. Investors, for example, prefer separate persistent earnings rather than one-time shocks. Firms that manage earnings in order to allow investors to better distinguish between the two components do not distort earnings. On the contrary, they enhance the informational value of their reported earnings. Once the class discussion focuses on what is earnings management, I introduce the case facts and follow with the discussion of the two questions from the case. In order to discuss this case, it is important to understand the concept of multipledeliverables revenue arrangements. A sale with multiple deliverables may include both goods and services to be rendered over time. For example, cell phone contracts are sold including a phone and a service contract, including also subsequent software updates and technical support. Ideally, revenue has to be allocated separately to the phone and the contract based on their relative fair value. In addition, the revenue from long-term contracts may be deferred and amortized over the life of the contract. This deferred treatment helps to match revenue received upfront with the costs of providing services over time. The new rules changed the allocation rules, specifically exempting hardware plus software packages from the multiple-deliverables method. Discussion of ethical issues richard@qwconsultancy.com

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P a g e | 392 1. Do you think that Apple’s new accounting policy, that is consistent with the 2009 FASB statement, results in fair financial reporting? Using the accelerated revenue recognition method does not necessarily distort earnings, provided that the users of the information are aware of the existence and effect of long-term contracts on the company’s net income. Both policies should be equivalent if management is transparent about its revenue streams and if the revenue recognition rules follow the company’s business model. In a way, earning the revenue from the sale of an Apple device is typically not in question. If the customer has paid for it, the likelihood of a return is usually covered by a returns allowance. Nevertheless, if management uses the deferred revenue streams to artificially inflate sales, it seems like such action may distort earnings. Under this scenario, the accounting for the long-term contracts could give management the opportunity to mislead the users of the information. Moreover, this rule may create the incentive to recklessly push products out the door in order to recognize revenue as soon as possible, something that was not as easy when revenue was deferred over time. Finally, Apple adopted the rules change retrospectively and restated its past financials to make comparisons easier. Other similar companies like Amazon and RIM are also early adopters, but will be using the new rules on a going-forward basis. That makes comparisons more challenging and thus reduces the overall quality or fairness of the new policy. 2. Do you think that Apple’s share price should have gone up as a result of increased revenue due to a change in an accounting policy? If markets are efficient with respect to information (i.e., information about revenue and revenue recognition policies is fully available to market participants) and if earnings do not directly impact managerial compensation or other contracts, the method used to recognize revenue does not matter. Market participants can undo the effect of accounting policies. Under this view, there should not be a price impact from changing accounting, particularly because Apple disclosed net income under both policies before the change in standards in 2009. On the other side, if the market only focuses on earnings, and there is incomplete information about the long-term contracts, then the method used for revenue recognition matters. Revenue recognition is one of the most important accounting policies, and a large number of restatements and regulatory actions have focused on revenue recognition.

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P a g e | 393 Useful Articles, Links, and Videos See the Text. Healy, P., and J.M. Whalen. 1999. A Review of the Earnings Management Literature and its Implications for Standard Setting. Accounting Horizons 13: 365-384.

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21.The Impact of International GAAP on Earnings (Chapter 6, pages 509510) What this case has to offer This case describes a situation where a retailer’s net income decreased after the company switched to International Financial Reporting Standards (IFRS). Shoppers Drug Mart used to recognize, separately, sales and the effect of discounts given through a reward program. Under IFRS, sales have to be reported net of discounts in the form of a reward program. This change caused the company’s sales to decrease by approximately one to three percent. This is a good case to discuss: why, if the cash flows of the company remain the same, does the revenue recognition policy matter? This case is related to the Apple’s revenue recognition case, also included in this chapter. Teaching suggestions Before discussing this case, I ask students to define earnings management. An interesting definition, widely used in the academic accounting literature, is provided by Healy and Whalen (1999): “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.” An important issue for financial analysts, investors and corporate executives is how to distinguish between (a) earnings manipulation that could be fraudulent and (b) the day-to-day struggles of managers to keep costs within budgets or to get revenues to meet desired sales targets. Not all earnings management is misleading. Investors, for example, prefer to separate persistent earnings from one-time shocks. Firms that manage earnings in order to allow investors to better distinguish between the two components do not distort earnings. On the contrary, they enhance the informational value of their reported earnings. Once the class discussion focuses on what is earnings management, I introduce the case facts and follow with the discussion of the two questions from the case. In order to discuss this case, it is important to understand rewards or loyalty programs. IFRS interpretation IFRIC 13 “Customer Loyalty Programmes” (IFRIC 2007) states: “Customer loyalty programmes are used by entities to provide customers with incentives to buy their goods or services. If a customer buys goods or services, the entity grants the customer award credits (often described as 'points'). The customer can redeem the award credits for awards such as free or discounted goods or services. “The programmes operate in a variety of ways. Customers may be required to accumulate a specified minimum number or value of award credits before they are able to redeem them. Award credits may be linked to individual purchases or groups of purchases, or to continued custom over a specified period. The entity may operate the customer loyalty programme itself or participate in a programme operated by a third party. The awards richard@qwconsultancy.com

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P a g e | 395 offered may include goods or services supplied by the entity itself and/or rights to claim goods or services from a third party.” Discussion of ethical issues 1. Do you think that the gross value method distorts earnings because it overstates revenue? Using the gross value method does not necessarily distort earnings, provided that the users of the information are aware of the existence and magnitude of the rewards program. Both policies should be equivalent if management is transparent about the rewards program. Nevertheless, if management uses the rewards program to artificially inflate sales and at the same time buries the discounts in another line of the income statement, or even worse, defers the application of such discounts to other periods, it seems that such action distorts earnings. Under this scenario, the accounting for the rewards program could give management the opportunity to mislead the users of the information. 2. The total cash that the company receives is the same regardless of the method the company uses to report revenue. So, is one revenue recognition method just as good as any other? If markets are efficient with respect to information (i.e., information about the rewards program is fully available to market participants) and if earnings do not directly impact managerial compensation or other contracts, the method used to recognize revenue does not matter. Market participants can undo the effect of accounting policies. On the other side, if the market only focuses on earnings and there is incomplete information about the rewards program, then the method used for revenue recognition matters. Revenue recognition is one of the most important accounting policies and a large number of restatements and regulatory actions have focused on revenue recognition. The reason behind this revenue recognition standard is that before the issuance of IFRIC 13, companies lacked detailed guidance in this area and practices were different for each company. Some companies measured their obligation based on the value of the points to the customer. Others measured it at the (usually lower) cost to the entity of supplying the free or discounted goods or service. IFRIC 13 is based on a view that customers are implicitly paying for the points they receive when they buy the goods or services, and hence, some of that revenue should be allocated to the points. This standard requires companies to estimate the value of the points to the customer and defer this amount of revenue as a liability until they have fulfilled their obligations when the awards are redeemed. Useful Articles, Links, and Videos Healy, P., and J.M. Whalen. (1999). A Review of the Earnings Management Literature and its Implications for Standard Setting. Accounting Horizons 13: 365-384. IFRS [International Financial Reporting Standards] (2017). “IFRIC 13 Customer Loyalty Programmes.” http://www.ifrs.org/Current-Projects/IFRIC-Projects/IFRIC-13-CustomerLoyalty-Programmes/Pages/IFRIC-13-Customer-Loyalty-Programmes.aspx [Link not richard@qwconsultancy.com

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P a g e | 396 valid in 2020. Current material available at https://www.ifrs.org/issued-standards/listof-interpretations/ifric-13-customer-loyalty-programmes/. ] “Standards set by the International Accounting Standards Board [IASB] (the Board) are called IFRS Standards and are used by publicly accountable companies— those listed on a stock exchange and financial institutions, such as banks. Authoritative interpretations of the Standards, which provide further guidance on how to apply them, are developed by the IFRS Interpretations Committee and called IFRIC® Interpretations.” (From IFRS (2017). “About Us.” http://www.ifrs.org/About-us/Documents/Who-We-AreEnglish.pdf ) [Link not valid in 2020. Current material available at https://www.ifrs.org/about-us/ ] IFRIC [International Financial Reporting Interpretations Committee] (2007). [Standard] IFRIC 13: Customer Loyalty Programmes. http://www.ifrs.org/Current-Projects/IFRICProjects/IFRIC-13-Customer-Loyalty-Programmes/Pages/IFRIC-13-Customer-LoyaltyProgrammes.aspx [Link not valid in 2020. Current material available at https://www.ifrs.org/issued-standards/list-of-interpretations/ifric-13-customer-loyaltyprogrammes/. ] IFRIC standards and their interpretations are issued after approval by the IASB. Since the case was written, the International Financial Reporting Interpretations Committee (IFRIC) has been replaced by the IFRS Interpretations Committee, which is the interpretative body of the IFRS Foundation which, in turn, is the body that writes interpretations of standards developed by the International Accounting Standards Board (IASB). PricewaterhouseCoopers (2007). “IFRIC 13: Accounting for customer loyalty programmes.” http://www.pwc.com/gx/en/retail-consumer/pdf/ifric_13.pdf This PwC publication provided guidance on the IFRIC standard, focusing on retail and consumer companies.

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22. Auditor’s Dilemma (Chapter 6, pages 510-512) What this case has to offer This case presents a real problem faced by accounting students. The desire to always stay within time budgets often leads to understating the real time spent on audits or not to spending enough audit time to do a proper job. Teaching suggestions This case can begin with a discussion of budgeting: •

Why time budgets are important

•

The relationship between time budgets and the amount billed to the client

•

How time budgets should be prepared

•

The advantages and disadvantages of strict versus loose time budgets

•

Why management uses time budgets as a proxy for employee operational efficiency It is then useful to have a discussion of time pressures and how to deal with them.

•

For those who have auditing experience (e.g., co-op accounting students), ask if any of them have felt the need to write-off time and why. Discussion of ethical issues

From an ethical point of view, “the purpose of an audit is to enhance the degree of confidence” that users have in the financial statements by expressing an opinion “on whether the financial statements are presented fairly, in all material respects.” (Canadian Auditing Standard (CAS) CAS 200.03) Users include a wide variety of stakeholders, such as current and future shareholders, creditors, government agencies, unions, suppliers, as well as the media. An audit consists of obtaining sufficient appropriate evidence upon which to express an opinion. This requires the auditor to “identify and assess risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control.” (CAS 200.7) Identifying and assessing risks as well as testing internal controls is a labour-intensive exercise. The auditor is required to use professional judgment in determining how much time to spend on the audit. The audit needs to be conducted both effectively and efficiently. Spending too much time may be ineffective; too little time may be inefficient in identifying and assessing all the applicate risks.

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P a g e | 398 1. What should Arthur do? Why? Arthur understands time pressures and the need to be both efficient and effective when conducting an audit of inventory. Arthur has a responsibility to report his time accurately. Consequently, he should go to Stella, his supervisor, and explain to her what occurred last year. Arthur needs to ensure that he has enough time to gather sufficient, appropriate audit evidence to support his opinion about the accuracy of the Pine Crest inventory. Useful Articles, Links, and Videos Canadian Public Accountability Board [website], http://www.cpab-ccrc.ca From the website: “The Canadian Public Accountability Board is Canada’s recognized source of timely reporting on auditor oversight and audit quality. We contribute to thought leadership on enhancing audit quality through resources, insights, tools, research, outreach and communication. We also act as a catalyst for dialogue and engagement among key stakeholders on audit quality issues, domestically and globally.” Canadian Auditing Standards (CSA) (2014). CPA Canada Handbook—Assurance. Available at http://www.castore.ca/Catalogue/ShowSampleToc.aspx?productID=138&spID=62&expID=49 1408911~1 and https://www.cpacanada.ca/en/business-and-accounting-resources/cpacanada-handbook-the-standards-and-guidance-collection/cpa-canada-handbook-assurance. KPMG (2014a). “Highlights from KPMG Canada’s ACI [Audit Committee Institute] Roundtable Session, June 2014 in Toronto [video],” accessed at http://www.cpab-ccrc.ca/en/news-andpublications/SpeechesandPresentations/Pages/default.aspx, September 23, 2014. [Link no longer valid in 2020.] An overview of the KPMG roundtable on Enhancing Audit Quality (see KPMG 2014b, below), which discusses the impact of EU audit reforms-- including mandatory firm rotation, prohibited non-audit services--and their implications for auditors and audit committees in the EU and Canada. KPMG (2014b). “On the 2014 Agenda: Enhancing Audit Quality—KPMG: Canadian Audit Stakeholders Respond to EU Change. Spring 2014 Audit Committee Roundtable Report,” accessed at http://www.kpmg.com/Ca/en/services/Audit/AuditCommittee/Documents/aci-torontoroundtable-highlights-web.pdf . [Link no longer valid in 2020.] This roundtable, hosted by KPMG in June 2014, discusses the impact of EU audit reforms-- including mandatory firm rotation, prohibited non-audit services--and their implications for auditors and audit committees in the EU and Canada. This roundtable reminds auditors that their work will be reviewed by audit committees.

richard@qwconsultancy.com

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P a g e | 399

23.Management Choice (Chapter 6, page 512) What this Case has to Offer In this case the chief executive officer of a construction company wants to manage her earnings downward this year so that a steady growth pattern will continue. She has proposed two means of this management: one is to judge a lower profit percentage on expected contracts in progress, and the other is to expense some R&D costs which have apparently been buried in two jobs and are carried in inventory. This case will test the students understanding of their role, to whom they owe duties, the rationale for proper accounting choices, and what their options are if their senior management isn’t prepared to do what is right. Teaching Suggestions Since this case is quite straightforward, I would ask the class the questions that are listed at the bottom of the case. Identification of the stakeholders is important so that one can understand who has interests and what those interests are. As far as the ethical issues involved in the case are concerned, (case question 2), these should include: •

The conflicts of interests for Sue Fault between her duties as an employee and her duties as a professional accountant.

•

How to insure that the decisions to lower expected profits and expense the R&D costs are made in accordance with the fundamental values underlying the professional accountant’s code of conduct (fairness and the preservation of the integrity fundamental to the fiduciary responsibility which professional accountants bear).

•

What Sue should do if her CEO doesn’t want to do what Sue thinks is right.. Discussion of ethical issues

1. Who are the stakeholders involved in this decision? •

•

The most obvious stakeholders are these: o

Anne Distagne was the CEO of Linkage Construction Inc.

Sue Fault, the CFO of Linkage Construction Inc.

Then consider these stakeholders who could be affected by the decision made, particularly by an unethical decision: o

Clients (current and future) of Linkage Construction Inc.

Shareholders (current and future) of Linkage Construction Inc.

Banks Linkage Construction Inc. deals with to raise expansion capital

Employees of Linkage Construction Inc.

Sue’s professional accounting body (and the reputation of accountants)

Public trust.

2. What are the ethical issues involved? richard@qwconsultancy.com

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P a g e | 400 Conflicts of Interest The formal discussion of conflicts of interest is in the Text, Chapter 5, page 272ff. An important issue to clarify in this connection is that the nature of the professional accountant’s role involves inherent conflicts of interest which one must always be on guard against, including: self-interest related to standing with her CEO for future pay vs. her duty to the shareholders etc., and self-interest of the CEO vs. the shareholders’ interests. Students should understand their fiduciary role as a professional. Ethical Accounting Choices Underlying the development of accounting standards is the desire to provide disclosure which respects or is fair to the interests of shareholders and others who need to get their information for decisions from the financial statements. Standards offer guidance for the choice of accounting practice and disclosure which, if it is to support the objectives of the accounting standards, must also be fair. Fair presentation, then, must not hide or suppress information which could be harmful to one of the stakeholders of the company. Stakeholders to be considered should include current shareholders as well as future shareholders. Unfair presentation would trigger a right which would be enforceable in court for significant compensation. 3. What should Sue do? Correct Action in the Face of Unethical Behavior As the students learn in the Text, Chapter 5, their code of conduct prohibits them from involvement in disclosure which constitutes a misrepresentation. They may have to resign in order to avoid the involvement.

richard@qwconsultancy.com

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24.To Qualify or Not? (Chapter 6, pages 512-515) What this case has to offer This case is intended to introduce the students to a real life auditing dilemma where they’re being told to do something against their better judgment, where they believe that their senior professionals are acting out of self-interest and improperly, where the alternatives are unpalatable for themselves, for the firm and for the client firm. The case involves a cut-off problem where the decision to record an understatement could put the client company, Models Inc., in a bankruptcy, since it is suspected that recording the loss to show economic reality would trigger a decision of the bank as a sort of self-fulfilling prophecy. Students also have an opportunity to consider the importance of client credibility to the auditor, as well as decision making in the face of lack of audit evidence, and appropriate procedures when original audit techniques fall short, and finally loyalty to one’s employer and the role of a professional accountant. Teaching suggestions and discussion By way of introducing the case I would invite a student to recap the major issues that they had seen in it. Other students will chime in, and you can develop a list of issues. I would then ask the class whether Jane Ashley, the staff accountant, had any choice except to follow the direction of the partner on the job with regard to what happened on the job. This issue usually develops a rather interesting discussion with some students pointing out that as a new recruit they lack an understanding of the situation, they haven’t got as much at stake as the partner who is a fully qualified professional accountant and that they are an employee of the firm and thus owe a duty of loyalty to their employers. Some will argue that even if they participate in something which is erroneous, the fact that they’re not qualified will save them from any legal fall-out. What they don’t tend to understand is the opposing set of arguments which I take care to develop. First, as students in training they are owed a full explanation so that they will understand what issues they should address when they become fully qualified. Moreover, it is not in the profession’s interest to have audit staff that follow the dictum of the partner on the job in all circumstances. In fact, if it turns out Jane’s suppositions that this was not the appropriate way to proceed turn out to be true, then the partner’s ethical behavior will come into question. Most professional accounting bodies require someone to certify that students and accountants are ethically sound before admitting them to the profession, so a blemish on their record could prevent them from becoming fully qualified professional accountants. Having established the relevance of the case for the students, I ask the members of the class to outline their understanding of the cut-off problem that has developed and make sure that they appreciate the issues involved. It would appear that there is a shortage in inventory which Mrs. Hyst is attempting to cover through misrepresentation. The adding back of $150,000 to inventory would mean that profits were also increased by $150,000. This would allow the corporation to be favorably reviewed by a banker and probably avoid bankruptcy in the short run. The problem to be faced here is to whom should the auditor be loyal? Is the primary duty owed to her partner, the firm, Mrs. Hyst, or other financial statement users in the public, which would include the bank? (See the discussion in the Text in Chapter 5 (e.g., sections, richard@qwconsultancy.com

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P a g e | 402 Governance for Broad Stakeholder Accountability, page 263, and Duty Depends on a Person’s Role, page 278) and Chapter 6 (e.g., section Priority of Duty, Loyalty, & Trust in a Fiduciary, page 409) on the role of the auditor.)) At this stage, I ask what the fundamental principles underlying a professional accountant’s code of ethics are and we begin to discuss how these principles should be applied to this particular case. As we do this it becomes clear that the principles of accuracy and integrity and objectivity are all suffering, and in turn various stakeholders may suffer. If we give the benefit of the doubt to Mrs. Hyst, then the bank and other creditors potentially suffer. The auditing firm, if the company finally goes bankrupt, may also suffer. If we take a conservative approach and reflect the loss of $150,000, then we may be being unfair to Mrs. Hyst, but the bank may get more than they would by liquidating now as opposed to later. In the end, the students should see that the proper decision is to do the very best they can to apply the principles underlying the code. If it could be shown later that they were biased in some way and did not apply fundamental principles rigorously, then they would be open to legal liability by one or the other of the stakeholders. Their only hope is to apply the principles as rigorously, fairly and accurately as they can to escape this liability. Another issue that could be developed at this stage is fairness in presentation. The students should realize that this requires that information be presented so each can form reasonable decisions. Otherwise, flawed information will result in unfair transfers of wealth between stakeholders. Having come to decisions on these issues, the class should turn to think about what, if anything, Miss Jane Ashley should do under the circumstances. Again, a look at the stakeholders and their interests would suggest that she ought to approach Mr. Viccio for further consultation, and if not satisfied, consider approaching another partner or the senior partner in the firm to protect both herself and the firm. Written notes should be kept of these discussions. If the firm is not responsive to her interests, then she should consider whether she should consult an ethics officer or the professional body to which she is attached or a lawyer for advice. This would be to protect the profession from a scandal that could be developed if an improper judgment is made. These are matters of judgment based on the conviction of the individual, which is in turn based on Jane’s assessment of the situation. It is unlikely that a student would be held liable if they went to their partner again and to another partner in the firm. Going to a professional body or to a lawyer may be therefore considered idealistic, but is not far-fetched, particularly in the case of a newly qualified professional accountant. Discussion of other issues Fairness to All Stakeholders See above for discussion. This case can also be used with Chapter 2 of the Text so that students will develop an understanding of the role of professional accountants. If used with Chapter 6, they could also develop an appreciation of the ethical principles underlying the codes of conduct that have been evolved for the accounting profession. If it is used with later chapters there can be an interesting discussion of the appropriate choice of ethical decision-making framework to be applied. In the consideration of the 5-question framework, the issue of legalities can be taken to refer to the observance of generally accepted accounting principles. richard@qwconsultancy.com

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25.Team Player Problems (Chapter 6, page 515) What this case has to offer This case puts the professional accountant (PA) in the position of being on a multidisciplinary team as a player, not as the leader. This means that if any issue comes up that offends the PA’s ethical code, then the PA will have to decide what to do about it. If it were an audit scenario, there would be more agreement among the team as to the right set of ethical principles to use. In this case the PA is not even the team leader, so his or her principles may not dominate the situation. Whistleblowing and resignation may be required. Teaching suggestions I start the case with a brief introduction, setting the stage, as noted above, except for the last sentence. Also, we discuss the need to apply the PA’s code more broadly than on audit engagements. I then ask the class what parts of the PA’s code of ethics could be offended during the completion of the assignment. They come up with and we discuss the following: •

Misrepresentation—of facts through error or leaving out important issues,

•

Confidentiality—release of confidential client information,

•

Quality—of data gathering, analysis, reporting, staff supervision, expertise,

•

Area of expertise is beyond PA, and

•

Materiality of the issue involved. We then turn to the possible actions open to the PA, including:

•

Consider if the issue is material, and if so: o

Attempt to convince the team/team leader to do the right thing

Render a minority report

Go over the head of the team leader to his or her boss

Blow the whistle outside the firm

Discuss with superior in firm and/or lawyer and/or ethics advisor at firm or professional society

Resign

Discussion of ethical issues The discussion, above, and below, will lead to answering the case question:

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P a g e | 405 1. Answer the questions put to John in the case. Applicability of code The PA’s code of ethics would have to be applied if the PA were known to be a PA and was acting in a capacity known to utilize the expertise of a PA. This is because the client and users of the report could be said to be relying on the PA to exercise his or her fiduciary responsibilities as a PA. It is possible that this expectation could be dispensed with by contract, or by specific exception in the code. Materiality The general test of materiality (affecting the judgment of a lay person) would apply unless the report clearly stipulated a higher level. Even then, the PA should use his or her judgment about the nature of the impact that would be produced, and whether he or she agreed with the level of materiality stipulated in the report. Area of expertise The PA must take into consideration his or her expertise in the matters under review. If the team is on an assignment outside the normal areas of PA subject-expertise, and the PA is on the team to contribute generic skills of objective evidence gathering, analysis, report writing and disclosure, the PA may wish to defer to subject area experts on subject area issues. There can be no deferral, however, on issues related to generic PA skills. Choice of action A PA cannot be involved with a misrepresentation, or other breach of his or her code. If the team leader cannot be convinced to adopt the right practices, then the PA must act. The choice involves judgment. The discussion in the Text (e.g., Chapter 6, section Priority of Duty, Loyalty, & Trust in a Fiduciary on page 409ff) may be helpful here. This scenario is common today and will become even more common in the future as multidisciplinary teams become the norm in areas such as environmental assessment, auditing, and reporting; social impact reporting; and non-financial reporting on all levels.

richard@qwconsultancy.com

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26.Minimal Disclosure (Chapter 6, pages 515-516) What this Case has to Offer In this case, Ted, the manager on the audit of Smart Investments Limited, is briefing a partner on an upcoming meeting with the audit committee. In the briefing the manager raises a problem of conflict of interest wherein the CEO, CFO and some directors would not want to lessen their profits or present full information that might weaken their ability to exercise stock options profitably. The three disclosure choices are rather interesting: •

Should profit on trading of derivative securities qualify for segmented disclosure?

•

What is appropriate disclosure for a lawsuit? and

•

Anticipating whether a subsidiary that you do not audit will be let go broke with a significant impact on the consolidated statements which you do audit.

The case offers the student the opportunity to consider whether potential adjustments (audit choices) are simply technical or whether there is an ethical aspect inherent in the judgment process for making the audit adjustments. Teaching Suggestions and Discussion At the outset I call for a student to outline what she or he thought the major problem in the case was, and then I ask for students to clarify each of the three issues raised. This would be useful, for some may not have a full understanding of derivative securities or the desire for segmented disclosure. Others may not appreciate why there would be a need to disclose the significant amount of profit made through the trading of derivative securities, for segmented disclosure usually refers to revenue earned by geographic area or by line of business. The principles behind segmented disclosure, however, should be applied to significant sources of earning, and that means that the derivative securities’ profit of 55% of the total company profit ought to warrant disclosure. There is, however, the confounding factor that the profit for derivative securities may have been made, in part, as a result of hedging transactions to protect foreign currency positions. The argument here is that attributing 55% profit to derivative securities would be too high. Since the correct amount seems to be unknown or uncertain, no disclosure ought to be offered. The issue that should determine the disclosure (I would suggest) would be that of fairness to the stakeholders. Although fairness depends on accuracy, objectivity and integrity, there is a tendency to allow a strict interpretation of these principles to override the good that can come from some disclosure of the probable magnitude of contribution of this activity. Hence the concept of overall well-offness should also be considered. The decision should be taken to disclose if the amount could be reasonably determined or the total of 55% can be disclosed by note indicating the variety of sources involved. With regard to the second issue, the disclosure of a potential lawsuit would turn also on a balance of a desire to be as accurate as possible in fairness to the shareholders who are relying upon the auditor as their information agent. The client therefore should be pressed to come up with a proper calculation, but if it were not possible, or if appropriate wording could be found for the disclosure of the possibility of a lawsuit in the contingent liability note, then that disclosure might provide the best balance of fairness for current and future shareholders, as richard@qwconsultancy.com

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P a g e | 407 well as for the auditors and executives. It is very helpful in these kinds of decisions to recognize the ultimate client of the auditor is the public or the future shareholders, as well as current shareholders and, to some extent, other stakeholders who have been identified. Disclosure should be adequate to protect the interest of future shareholders, as well as the interests of current shareholders, so some judgment of the balance between shareholders is required. This is an ethical choice in line with the fiduciary duty of professional accountants. The final issue is that of reliance on another auditing firm who have given a clean opinion or on your own judgment as an auditor as to the financial viability of a subsidiary. Because the firm of Dodds & Co. is probably not one which operates within the United States, but just in the Bahamas, it is unlikely that they could withstand a significant lawsuit. Given current U.S. laws regarding joint and several legal liability Carl’s firm would be in the position of picking up the bill, even though they were not the primary auditor for the subsidiary. Consequently, it would be wise from a legal perspective for Carl to exercise his independent judgment on the financial liability of the subsidiary, which if material to the consolidation, would require disclosure at least in a note to be fair to the shareholders of the parent firm. It’s a tough call because disclosing the lack of viability of the subsidiary may trigger its downfall. This could be to the detriment of the current shareholders and management but could be in the interests of future shareholders—unless, of course, the current shareholders wished to continue to own the company after the subsidiary was straightened out. This discussion of what the action will do to stakeholders’ interests can be quite revealing to the students, and very lively. At the end of this case discussion, students should be reminded that their deliberations involved: identification of stakeholders, and reasoning about fairness to their interests, overall and individual well-offness, legal rights, and fiduciary duty. All of these are ethical concepts and are inherent in the choices accountants make. The use of an ethical decision-making framework from the outset, or reference to its important components, would ensure that each major ethical issue is given attention. 1. What should Carl, the partner, plan to do? Carl’s decisions depend on judgment, and that is an ethical concept. The class discussion of the points above should answer the question.

richard@qwconsultancy.com

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27.Opinion Shopping (Chapter 6, pages 516-517) What this case has to offer In Opinion Shopping, the student is confronted with the prospect of an auditor who has done his job in a proper and rigorous manner, but who is nonetheless going to be subjected to pressure, intimidation and possible loss of the client for his troubles. There is also the issue of why this activity is being engaged in, because the relatively new president is obviously concerned that the results may come out less than he expected. This introduces the problem of conflicts of interest and the chief financial officer is being put squarely in the middle. The students should play the role of the CFO. What should Bob do in order to be loyal to his chief executive officer and to the owners of the business, as well as to himself and to the incumbent auditor of the organization? These are interesting questions that the class will enjoy discussing. There is also the issue of gamesmanship between the client firm’s executives and the auditor, which is quite realistic, and which the students will ultimately face when they become professional accountants. Teaching Suggestions I would invite the class to answer the questions in the order they’re set out at the conclusion of the case. In the section above, I have identified most of the major stakeholders, and have indicated the ethical issues involved. The stakeholder list should also include the other auditors who are to be questioned, current and future shareholders, directors (particularly those on the Audit Committee), and the auditing profession. In addition, however, there is the issue of the proper conduct of Bill Page as the professional in charge of the audit, and the other auditors who are going to be consulted in the circumstances wither as a way of putting pressure on Bill, or as a preamble to opinion shopping to see who might get the audit in the future. What ethical considerations ought they to consider. When the class comes to consider whether the situation is unethical, the instructor may have to take the position as devil’s advocate, in order to elicit the range of comment which will provide understanding that is required. This is the area in which you should invite the class to consider which ethical decision framework to use (see Chapter 4), flowing from an analysis of stakeholders and their interests, and the impacts of the decision on these stakeholders. They should be asked to justify their choice, and to consider developing a hybrid framework. Question 4 presents a dilemma that John, the chief financial officer, should be alert to and should consider what to do in, if the problem develops. Discussion of ethical issues 1. Who are the major stakeholders involved in this situation? See above. 2. What are the ethical issues involved? Conflicts of Interest These are relatively obvious, with the main one being the self-interest of the president, the chief financial officer and the auditor and the owners of the business, as well as whoever else might be led astray if unsatisfactory disclosure practices get richard@qwconsultancy.com

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P a g e | 409 adopted and sanctioned by a new auditor. Who would benefit and who would be hurt by such a development? What position should the professional accountant take to maintain the integrity required of a fiduciary relationship? 3. Is this situation unethical? Why and why not? Opinion Shopping There is nothing wrong with informal discussions with other auditors on how issues might be handled, provided no misrepresentations were made as to the relationship of a particular decision to the awarding of the audit, and the likelihood that the audit would be awarded to someone new, or that the awarding of the audit would be related to the guarantee of a fixed audit fee regardless of audit difficulties for the next year or years. These situations would all be questionable from an ethical perspective because they might involve misrepresentation. The quotation of an absolute fee without regard to audit experience could lead to erosion or lowering of audit standards to make an adequate profit, and the implication that Bob, the chief financial officer, is interested only in the bottom line rather than the integrity of the financial disclosures included in the financial statements. Students should understand that an auditor cannot be dislodged without a formal vote of the shareholders, unless he or she chooses to resign, so informal discussions may not be regarded as disturbing by auditors who know that they will be able to appear before the board of directors and shareholders to tell their side of the story. One of the harmful aspects of carrying on informal discussions is that the level of trust between the auditor and the chief financial officer and other executives may diminish, thus perhaps requiring the auditor to do more audit testing than would otherwise be the case. Responsibility for Fair Disclosure The desire of the president to soften the auditor’s stand on several issues including obsolete inventory, an engine warranty problem, and the clean-up costs of a waste spill does not relieve the chief financial officer who is a qualified accountant from his responsibility to be satisfied with the disclosure on those three issues. It is unethical to be involved in a misrepresentation related to those or any other disclosure and accounting practice of the company. So John should be looking ahead not only at the problems that the president prescribes, but also on how he would like them disclosed. It will not be enough to hide behind the audit of an external auditor who makes a mistake. Bob will be charged with misconduct and may incur personal liability in the process. Choice of Ethical Decision Framework Provided the list of stakeholders is accurately identified, and their interests are also clearly understood, I would be comfortable with any of the three approaches listed in the Text, Chapter 4. I would perhaps lean to the use of the 5question framework or the Velasquez model because I don’t see the logic, at the level of chief financial officer, in worrying about such things as ground rule ethics: you should be setting the ground rules at that stage. I would also substitute the concept of the code of ethics for the consideration of legality in the 5-question framework. Ultimately, the consideration of the suggested action will boil down to a richard@qwconsultancy.com

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P a g e | 410 consideration of the well-offness, the impact on the rights and the fairness to each of the stakeholders who have been listed. 4. What should Jane do if Webster & Co. looks like the choice the Audit Committee will make and recommend to the board of directors? John, the chief financial officer, would have to consider in this case whether the interests of the directors and owners of the company would be adequately protected by Webster and Co. becoming the auditors. If he had serious concerns about the previous relationship between the president and Webster & Co., and about the potential for unethical action on the part of the new auditing firm, at the very least he should visit with one of the external directors on the Audit Committee who would be responsible for recommending the choice of auditor to the board of directors and, ultimately, to the shareholders for a vote at the annual meeting. Depending on the discussion with the external director, the matter might be taken to another external director or directly to the Audit Committee for further discussion. The problem with this approach, of course, is that John would come in conflict with his president and thus endanger his career at the company. Sometimes, however, a professional is called upon to make such sacrifices.

richard@qwconsultancy.com

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28.Lowballing a Fee Quotation (Chapter 6, page 517) What this case has to offer Note: Lowballing can occur when the fee quoted does not cover the costs of the engagement and provide a reasonable return, within a reasonable time frame. The Lowballing Case offers the opportunity to explore: •

The problem of agreeing to a fee which is too low to support usual or reasonable profit margins for the audit firm, thus usually leading to the skimping on audit procedures, the erosion of audit standards and the increase of risk that problems will escape the audit.

•

Under what conditions a lowball-fee quotation may be acceptable.

•

How audit professionals should approach problems which, if not properly controlled, would undermine their fundamental fiduciary function.

The class should be left with the understanding that inherent in the auditor’s function are many conflicts of interest that could undermine the audit function, such as: appointment by management to serve shareholders, payment of fees by management not shareholders, the audit of information provided by management, the conflict between doing a quality audit and making a profit on the engagement. These conflicts cannot be avoided entirely. However, they can be recognized, analyzed and controlled for. Teaching suggestions I would begin discussion of this case by eliciting the chain of reasoning set out in point 1 above, so that the class understands the problem (low bid ➔ cost cutting ➔ skimping on audit work ➔ erosion of audit quality ➔ audit errors ➔ failure to discharge duty to shareholders). Obviously, the shareholders are not the only stakeholders to be affected adversely, and I would get at this issue by asking the class to identify the stakeholders involved in this chain of events, and their interests. They should come up with: shareholders, management, other users of financial statements, the other audit partners who would lose profit and risk legal liability, the employees of the audit firm—particularly those who will be expected to work harder or not to charge all the time worked to this job, the professional in general, and the decision makers themselves. Each of these interests should be explored, but particularly those related to legal liability and the impact on audit staff. The class should be brought to understand that audit professionals cannot escape the pressures for profit and the inherent conflict this raises for adequate audit work. As a result, they should see that early recognition of such problems is essential, and proper ethical analysis is required to keep the professional on the right track, as is continued attention to control measures put in place. Having identified the stakeholders and their interests, I would select and apply one of the three ethical decision making (EDM) frameworks discussed in Chapter 4, or a hybrid of them. The choice of framework should be based on which addresses the problems most directly and efficiently. In this case, the issues of legality and sustainable development do not apply, but profitability does. As well, it would be useful to canvas the organizational culture to richard@qwconsultancy.com

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P a g e | 412 see if lowballing was a common practice in the firm, and that effective control practices had been developed. Consequently, I would probably use a hybrid approach, as follows: Well-offness •

For the audit firm (profit)

•

For the decision makers

•

For the shareholders and other stakeholders (broader costs and benefits) Rights

•

Of the shareholders (to expected levels of service by their agent)

•

Of the audit staff (to reasonable work conditions)

•

Of the other audit partners (audit risk and legal liability beyond normal and agreed levels) Fairness

•

To the audit staff (expectations to work too hard)

•

To the rest of the audit profession

•

To the decision-makers (higher personal risks for the projected return).

After the analysis, I would ask whether there is any way the ethical problems surfaced in this analysis can be offset or controlled by reasonable procedures. The analysis and discussion will not yield a conclusive solution but will provide a good basis of understanding of the questions to ask and the fine lines not to be crossed. Highlighting these would be my approach to the wrap-up of the case. Discussion of important issues Within the framework suggested above, the important issues to be addressed and their sub-components are: Balancing personal self-interest against the interests of others In the long run, personal self-interest will be affected by the interests of others. If the profitability of the firm suffers, the share of profit for each partner (including Tim) will diminish. If the audit risk is too high and legal liability is incurred, the cost to Tim and Andy will be severe because their poor judgment will be exposed. Leaving aside self-interest, a proper professional attitude would include the desire for reasonable profit, but would derive primary satisfaction from rendering good and useful service to clients. In the long run, this line of thinking maximizes the well-offness for all. Usually this conclusion is not arrived at because the participants’ analysis is too narrow. Profitability is too narrowly defined The analysis of profitability of the firm should take into account the opportunity cost of using your best staff on this job to maximize efficiency, but lose on other jobs which might have led to more satisfied customers, additional assignments and higher revenues. In richard@qwconsultancy.com

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P a g e | 413 addition, the negative impact on staff from pressing them too far may result in the loss of staff, or the lowering of their productivity. The increase in audit risk should also be included based on a discounted projection of potential liability costs. In this regard, recent cases are attracting settlements which are XXX times the audit fee or YYY times the equity of the client company. On the other hand, there may be direct savings in the overhead, planning or management components of a multiple audit engagement if a subsidiary previously audited by another audit firm is taken on as an audit client, as well as indirect savings in a lowering of audit risk by having control of audit standards. Are there occasions when lowballing is appropriate? On the assumption that each assignment must make a reasonable return within a reasonable time frame or unfortunate consequences will result, lowballing is not appropriate. However, there are occasions when lowballing may be acceptable, such as: •

when reasonable returns are made on a consolidated or co-owned group of companies taken as a whole, and staff are managed with this overall view in mind,

•

when the savings mentioned above outweigh the increased costs,

•

when the control practices in place can control the audit risk and negative consequences on staff.

Unfortunately, projected benefits associated with lowballing often do not materialize. What control strategies may be advisable? In order to protect the integrity of the audit, procedures must be in place which ensure that audit standards are not reduced beyond levels which would be used in similar but non-lowballed audits. These could include specific instructions to audit staff, reviews to ensure adequate time budgets, extra reviews of audit working papers to insure quality control, etc.

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Fundamental Accounting and Auditing Issues Cases 29.Societal Concerns (Chapter 6, pages 517-518) What this case has to offer This case is intended to allow students to explore the role of the accountant. As a professional, the accountant has a responsibility to the public and not just to whomever they think is their immediate client, such as the management of a corporation or the current shareholders. The case is also intended to get the students to assess what accountants have expertise in and thus what they might be able to comment on. Finally, the issue of the impact of a financial or managerial accounting scorecard on management is an area which the students should explore. Teaching suggestions This case is very transparent as to the basic issue involved, but it allows the students to develop their understanding of the issues as the discussion progresses. I would begin the discussion of the case by asking two students who would be stereotypical of the positions of Joan and Miguel in the case to speak to their respective positions. Of the two, I would ask the students who would be comfortable in arguing Miguel's case to lead off. I find that the students who would take Joan's case are usually greater in number and perhaps more involved in their position, and if you ask them to go first it truncates the discussion, because the other students are less willing to take the floor. After the two students have spoken, encourage the rest of the class to comment on the positions taken. Occasionally I ask that comments be given in support of Miguel's position after the first student makes his comments, with comments in support of Joan to be made by supporters immediately after she makes her comments. Discussion of ethical issues Responsibility to the public This issue is argued in the Text in Chapter 2 (see Arthur Andersen—An Organizational Culture Gone Awry, page 84, and the case Arthur Andersen’s Troubles) and principally in Chapter 6 where, for a variety of reasons, it is shown that the accounting professional, particularly the auditor, is ultimately responsible to the public. This issue is not something that most accounting students and even professionals have thought through, and this case provides a gentle way of moving into the arguments. The proposition of responsibility to the public can be supported in this case as a defensive measure to protect the mandate of the profession, to enhance the respect of the public for the professional and profession as a result of speaking out, and to develop an equivalence between the accounting profession and other professions mentioned, such as medical doctors or lawyers.

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P a g e | 415 Credibility Care must be taken—and this should be realized by the student–that a professional should not comment definitively on something beyond his or her expertise, nor should anything be promised beyond what can be delivered. This means that while we might wish companies to start disclosing their impacts on society, and particularly on our environment, we should recognize that we don't have all the answers with regard to how this should be done just yet. That is not to say that we shouldn't begin the debate and participate in it. Information Inductance The students should be made aware of the principal of information inductance which, commonly stated, suggests that management will be induced to better the scorecard that they are being judged by. As a consequence, if one wishes better impacts of corporations on society and particularly on our environment, then setting up a target for environmental impacts and exposing that target would be a useful first step in getting management to give proper attention to the problems. Basic and relative expertise of accountants Accountants are trained and educated to develop an understanding and skills in the area of evaluation and measurement of economic activities. Traditionally, these measurements are made in dollars, but there is no reason why the awareness of such principles as objectivity and consistency cannot be transferred to measurements made in terms of units or percentages and other factors which would be relevant in measuring environmental impacts. These basic elements of the accountant's expertise will permit the accountant to be useful in areas beyond the traditional financial statements, such as environmental impacts. While it is true that accountants may not know absolutely everything about environmental impacts, they have what could be described as relative expertise on measurement and auditing issues because of their basic expertise in a field which relies upon them. This relative expertise provides them a competitive advantage when they are asked to join environmental audit and disclosure teams. If accountants do speak out on issues about the impacts of a company on the environment, then they run the risk of some other profession springing up to take over their mandate. The Societal Concerns Case is intended to develop an awareness of the proper professional perspective which is necessary to serve the public and to maintain the rights accorded the professional accountants in society by properly discharging duties to the public. To the extent that accountants are reluctant to take the opportunities provided and discharge the responsibilities they have been given as professionals, it is possible that they will lose reputation and perhaps have to share their mandate with another profession that looks more broadly at the science and application of measurement in non-financial matters. The points that Joan and Miguel have raised are worthy of comment by accountants.

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30.Economic Realities or GAAP (Chapter 6, page 518) What this case has to offer This case is based on the Four Seasons Hotel’s use of the cost base basis for carrying an investment which attracted negative press in the Wall Street Journal during the winter and spring of 1994. The principal issues which the students should address are: •

The probable response by the investing public when the rationale for a generally accepted accounting principle/practice is not intuitively obvious.

•

The logic behind the development of a generally accepted accounting principle.

•

The desirability of going beyond the specific generally accepted accounting principle to make sure that financial statements capture the economic reality of the event being measured and so avoid unfairly presenting the activity. Teaching suggestions

I would start the class thinking about this case by asking about the logic of the accounting profession in creating accounting standards which are generally accepted as accounting principles. From this base I would ask the class what their understanding is of the cost basis for carrying investment, rather than incorporating their share of the investment’s/subsidiaries earnings or losses into their financial statements under the equity or consolidations methods. I would discuss this issue until it was clear what the rule implies and why 20.0% was selected as a cut-off, below which companies could carry investments on a cost basis. I would then ask the students whether there were circumstances under which a rule like 20% might be set aside or augmented by additional disclosure. What I would be getting at here is that generally accepted accounting principles are intended as guides to fair presentation and may occasionally be deviated from if unfair representations of the economic transactions of an enterprise are going to result. (Rule 1.320. AICPA 2016) In this case the 20% might be a poor one to apply, if for example, there were no other owners of the subsidiary Far East Hotels whose interest approached the 19.9% owned by Fine Line Hotels. If they had control of the Board of Directors and management, and intended to continue to operate the chain, Fine Line would therefore be the dominant owner. In this situation, if the loss were unlikely to be reversed, it should have been disclosed in the numbers or in a note to the financial statements. Having built this base, I would ask the class whether in this situation they would, as Janet, state that Fine Line Hotels should have used a cost basis, an equity basis or a consolidation basis or a note disclosure for carrying the investment and recording their share of the profit or loss on the variations of the subsidiary Far East Hotels.

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P a g e | 417 Discussion of issues General acceptance of accounting principles The concept of fair presentation of economic transactions relies upon the use of accounting rules and conventions that may apply to transactions in a consistent way that preparers and readers can understand. Since there is usually no single, right way to disclose the economic impact of a transaction, accountants have traditionally sorted out which rules are best applied in certain circumstances. Since accountants were not in a position to mandate by law which accounting principles should be used, they took pains to see that their deliberate determinations would be fully accepted by their colleagues. Even today judgment must be used to make choices or judgments as to when a transaction qualifies for one accounting treatment or another. The general acceptance of the methods used ensures the consistency referred to. Tough choices have to be made on occasion, and it is possible that two professionals can differ on the interpretation of a particular transaction and the application of particular generally accepted accounting principles. Fairness in presentation The ethical principle of fairness is one which is used an interesting way to control the disclosure of accounting transactions according to the financial statements of a corporation. If a transaction is unfairly presented, it is thought to convey an economic advantage or disadvantage to one stakeholder or another. For example, if the transaction is recorded at too low a value, then current shareholders may not find the earnings as high as they should be, and the price of the corporation’s stock may be undervalued. This would result in a transfer of value from current shareholders to future shareholders. It could also represent a shortchanging of the management of the corporation who would not make as much money on stock options or who would not be prepared to exercise them. The reverse is true of an overstatement. Inherent in the concept of fairness is that the students should understand that there is more than one stakeholder who will be affected by the disclosure of economic events and financial statements. Fairness should be thought of in a relatively broad context, because accountants have a duty to the public, not just to current shareholders or to management. Economic realities In this case, the point being made by Stan Jones is that the presentation using a cost basis for carrying the investment in the subsidiary Far East Hotels did not reflect the losses which have been made, because the company’s interests of 19.9% were just a hair underneath the 20% trigger for disclosure. He felt very disadvantaged due to a technicality. He felt the economic reality was that the large losses should have been shown. Janet, on the other hand, could argue that below a certain level, an investing company might not control the affairs of a subsidiary company like Far East Hotels, particularly if there were another investor with a larger-than-20% share that was calling the shots. The dominance of another investor would be identified by tests such as representation on the board of directors, determination of company policy and intention to hold the investment by Fine Line Hotels. If, for example, the losses described were expected to be reversed soon, there would be no need to show them in the financial statements or in notes to the financial statements. If the Fine Line Hotels intention was to hold the securities until the losses were made up, then recognition of the dilution of value due to the losses in the short run would be richard@qwconsultancy.com

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P a g e | 418 unnecessary. In other words, Janet could argue that the economic reality could depend on a number of factors that are not apparent from the case. She could argue that the intention behind GAAP was to provide a fair representation of reality, and that was usually accommodated by a cost base disclosure of investments and subsidiaries where the ownership was less than 20%. Credibility and trust in auditors The case implies that the auditors of Fine Line Hotels decided not to qualify their audit report and, therefore, either found the losses in the subsidiary not to be material, or believed that the rationale behind the 20% rule should apply. Moreover, after applying the 20% rule, thus allowing a cost base carrying of the investment, they decided that they could agree with management’s non-inclusion of the losses in the notes to the company’s financial statements. In weighing the decisions that the auditors must have taken, and that our students must take in the future, they should be aware of the potential damage they can do to the credibility of the profession and the trust the public puts in the profession. To avoid the profession losing credibility and therefore the trust of the public, care must be taken to see that the GAAP rules applied really do represent the economic realities of the transaction involved fairly. Useful Articles, Links, and Videos American Institute of Certified Public Accountants (AICPA) (2016). AICPA Code of Professional Conduct. http://pub.aicpa.org/codeofconduct/ethicsresources/et-cod.pdf This version of the Code was “Effective December 15, 2014, Updated for all Official Releases through October 31, 2016.” The most current version of the Code is available at https://www.aicpa.org/research/standards/codeofconduct.html .

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31.Multidisciplinary Practices—Ethical Challenges (Chapter 6, pages 518519) What this case has to offer Multidisciplinary practices (MDPs) are now the norm for assurance service-oriented firms, the result of a transformation from the narrower auditing, tax and consulting orientation that prevailed for decades, except for a short time after the introduction of the Sarbanes-Oxley Act of 2002. The case calls for the student to assume an organizational view of ethics rather than the view of an individual professional. To solve the problems of competing professional cultures and codes, the student will realize the need for the development and maintenance of an overall ethical culture for the MDP firm and will explore what this will entail. In the process, the accounting student will have to explore the differences between the professions of law, accounting, and engineering on the ethical dimensions of confidentiality, reporting of wrongdoing, and loyalty to external standards of integrity, rather than putting only the best case forward. Teaching suggestions This case offers an opportunity to discuss the emerging MDPs, and I would encourage the students to visit the websites of the Big 4 accounting firms and of the Esteban and Wilkins (2016) article (see Useful Articles, Links, and Videos, below) to provide a backgrounder for the students. I would then pose the questions embedded in the case and entertain discussion on each. In the process I would develop a chart of potential differences between the code of accountants, lawyers and engineers, as follows: ASPECT OF CODE/CULTURE

ACCOUNTANTS

LAWYERS

ENGINEERS

Primarily on…

Public interest

Rule of law

Public interest

Other

Client interest

Client to client

Strict

Strictest

Strict

External reporting of issues contrary to the public interest

No, except for a few

Yes—safety

Privileged communications

Yes

Principles

GAAP & GAAS

Courts

Statutes

Focus

Confidentiality

Loyalty to

Statutes

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P a g e | 420 Discussion of ethical issues 1. What are your answers to the questions raised in the case? Whose codes will predominate: lawyers, engineers or accountants? The codes of an individual professional cannot be obviated, so each will have to be followed. However, it is important that each professional understand the others, and that consultation/discussion takes place before one professional takes action that would breach the code of the others to forewarn them and allow judgments to be challenged. Moreover, where possible, the firm should develop a code that makes clear what the normal practices of the firm are. This code should allow engineers to report possible safety breaches even though it would not be what audit clients would like or are used to from auditors. Such practices should be explained to the client in advance if they are likely to occur. Where possible, the firm’s code should take the highest standard of practice and protection of the public interest as the norm. Do professionals report to one of their own or to a member from a different profession? The type of professional reported to is not as important as one might imagine. Each professional with a license to practice on the public is deemed to be competent, and professionals are expected to refuse work that they are not able to take on competently. Professionals differ in judgment and experience, and it is possible to find supervisory expertise for a job within a firm from a variety of personnel, so it may not be necessary for a higher level manager to be experienced and competent in all phases of all jobs. It follows that the higher-level manager need not be from the same profession as the front-line consultants provided adequate alternative quality controls are available. The ability to refer knotty problems to a committee of peers or senior professionals may also help ease friction, as would adherence to an agreed upon common firm code. Who would be sued? The professional who erred could be sued, but it is more likely that the firm and other deep-pocket partners would be sued, unless a limited partnership form was used. Won’t focus be on profit rather than serving the public interest? This is a real problem as the proportion of non-professionals in MDPs also grows. It will be vital to develop a firm-wide culture that enshrines integrity and serving the public interest as hallmarks of the enterprise. Otherwise, the MDP will cease to be a professional firm, and may have to try other profiles than that of a fiduciary taking care of its clients. The culture to be developed and maintained will have to be comprehensive and integrated into reward and sanction systems of the firm (see Chapter 2, Arthur Andersen—An Organizational Culture Gone Awry, page 84 in the Text). richard@qwconsultancy.com

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P a g e | 421 Useful Articles, Links, and Videos Esteban, Maria José and Wilkins, David B. (April 27, 2016). “The re-emergence of the Big 4 in law.” Thomson Reuters: Industry Trends. https://blogs.thomsonreuters.com/answerson/big-4-accounting-firms-legal-services/

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Tax and Regulatory Cases 32. Multinationals and Tax Planning (Chapter 6, pages 519-520) What this case has to offer This is a good case to debate a number of interesting questions concerning the nature of taxation and the link between minimizing expenses and exploiting tax loopholes. The central issue is that through the assignment of prices at which goods are transferred between parts of a company, profits can be shifted to jurisdictions with low or no taxes. Therefore, the company may be able to retain more of the profits that if they paid reasonable taxes in all of the jurisdictions in which they operate. Apple has been criticized for using tax-free status in Ireland to transfer profits there to avoid paying tax elsewhere, including in the U.S. (see Useful Articles, Links, and Videos, below). Teaching suggestions Have the students debate the following questions: 1. What is the purpose and nature of taxation? 2. Is adherence to tax laws the same as being ethically responsible? 3. Can strategies that are designed to reduce expenses, and thereby increase profits, be ethically problematic? Discussion of ethical issues 1. Do you consider transfer pricing to be an ethical means of reducing a business’s tax liability? Why, and why not? Transfer pricing is an attempt to assign a value to a non-arm’s length transaction. Because the transaction is non-arm’s length there is usually no objective market value that can be used; hence, the assigned value depends upon professional judgment. In this case, the question becomes: Is the assigned value a good approximation of its real value, or is the assigned value an arbitrary amount designed to minimize taxes? It can be argued, on the one hand, that the professional accountant should be looking out for company’s best interest. And since there is no ‘real’ transfer price, because there is no market price, the transfer price will somewhat arbitrary. Therefore, the professional accountant is free to choose a transfer price that minimizes the firm’s tax liability. On the other hand, it can be argued that the professional accountant has a responsibility to estimate a price that is a close or reasonable approximation to the real or market price. Arbitrary transfer prices that have no business purpose other than to minimize tax are not legitimate prices. They are also illegal. General anti-avoidance tax rules in the United States and Canada make illegal any transactions that have no business substance.

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P a g e | 423 2. At what level would a transfer price cease to become reasonable, and become unethical and probably illegal? As mentioned above, a transfer price that approximates its ‘true’ price is reasonable. As the price veers away from that reasonable amount, the transfer price becomes problematic. It becomes unethical when the transfer price is no longer a reasonable business amount. It is illegal when the amount is designed solely to minimize taxes. 3. Does transfer pricing impose an ethically unfair tax burden on non-multinationals that cannot engage in such a scheme because they do not have international operations? Justice as fairness says that equals should be treated equally, and unequals should be treated unequally in proportion to their inequalities. The default position is that all are equal. Therefore, the onus is on the person who wants to claim inequalities: that individual must provide strong arguments to show that, in this case, these parties are not equal. Consequently, students have to decide between two questions. •

Are all business equal and therefore there should be no preferential treatment given to multinationals?

•

What are the relevant inequalities such that preferential treatment should be given to multinationals?

4. Do governments have an ethical responsibility to harmonize tax rates around the world? Some students may argue that governments have responsibilities to set tax policies and regulations that provide for the social welfare of their citizens. Tax planning then becomes a simple cost-benefit analysis. It is possible to argue that a government should set low tax rates when (a) the reduction in tax revenue received from the multinational is (b) more than offset by the increase in benefits to the economy by having a multinational operate within the country. Other students may argue that governments have responsibilities beyond their national borders. Consequently, there should be harmonization of tax rates so that all countries benefit from multinationals that contribute to a global economy. Useful Articles, Links, and Videos Income Research Team (June 16, 2014). “Apple’s Tax Avoidance Draws Scrutiny [video]”. Wall Street Daily at http://www.wallstreetdaily.com/2014/06/16/apple-tax-avoidance/ [Link no longer valid in 2020.] Lew, Jacob (September 21, 2014). “US closing press conference G20 Finance Ministers and Central Bank Governors meeting, Cairns [transcript].” G20 Australia 2014, http://www.g20australia.org/news/transcripts/us_treasury_secretary_jacob_lew_financ e_ministers_and_central_bank_governors.html [Link no longer valid in 2020.]

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P a g e | 424 The transcript (and video) of the closing speech of the G20 meeting on another step in “eliminating the risk that any firm is too big to fail” and business tax reforms, including inversions (see references, below). Gray, Jeff (September 20, 2014). “Global watchdogs take on the corporate tax dodgers,” Globe and Mail, http://www.theglobeandmail.com/report-on-business/global-watchdogstake-on-the-tax-avoidance-villains/article20710670/ This article reports on the meeting in September 2014 of the “finance ministers and central bank governors from the world’s 20 largest economies” and their “… proposals, called “revolutionary” and “historic,” [that] aim to plug the gaping loopholes in the international tax system that allow multinationals to slide substantial profits into tax havens or low-tax countries, depriving governments of badly-needed revenue.” Associated Press (September 23, 2014). “Tim Hortons, Burger King merger fallout: U.S. cracks down on tax inversions.” CBC News, http://www.cbc.ca/news/business/tim-hortonsburger-king-merger-fallout-u-s-cracks-down-on-tax-inversions-1.2774913 The article reports on the Obama administration’s reforms affecting “tax inversions” resulting from “…certain overseas corporate mergers and acquisitions, aiming to curb American companies from shifting their ownership abroad to shirk paying U.S. taxes.” Hickey, Walter (May 21, 2013). “Apple Avoids Paying $17 Million in Taxes Every Day Through a Ballsy but Genius Tax Avoidance Scheme.” Business Insider, http://www.businessinsider.com/how-apple-reduces-what-it-pays-in-taxes-20135#ixzz3DDBvlPI5http://www.businessinsider.com/how-apple-reduces-what-it-pays-intaxes-2013-5

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33. KPMG’s Questionable Tax Shelters (Chapter 6, pages 520-521) What this case has to offer This case raises questions on whether tax accountants serve or endanger the public interest in what they do and whether they should change their practices before public opinion seriously erodes the reputation of the accounting profession, particularly since the “Panama Papers,” in April 2016, shone a spotlight on suspected tax cheats. Teaching Suggestions Other cases also look at tax issues, for example, Case #37 Providing Tax Advice in this chapter (Text, Chapter 6, pages 526-528 in the Text), and can be used in conjunction with this case to allow students to ask fundamental questions, such as: •

What is the public interest?

•

Why do we have a tax system?

•

Is the tax system designed to harm the wealthy or to help the poor?

The questions at the end of this case focus, primarily, on the public interest. Discussion of ethical issues 1. Are offshore tax havens that are technically legal but socially unacceptable in the public interest? The wealthy, who are better able to pay a proportion of their income than the poor or middle class, are the usual beneficiaries of offshore tax havens. By reducing the amount of tax they pay, one might argue that they are not paying their “fair share” in their own country to support government expenditures that support the common good. If tax shelters are considered legal, they may be; but it is possible that the tax authorities have not yet explored the tax shelters and deemed them as evasive; that is, having no economic good other than avoiding taxes, so they may be legal until that time. The following questions help to determine whether or not the tax plan is in the public interest. •

Is the tax strategy available to all taxpayers who find themselves in similar circumstances?

•

Is there an economic benefit, such as an increase in the economic welfare of society as a whole, to the tax strategy beyond saving tax for the taxpayer?

•

Is the strategy consistent with the letter of the law? Is it consistent with the spirit of the law?

If the answers to these questions are yes, then the strategy is not contrary to the public interest. richard@qwconsultancy.com

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P a g e | 426 2. Are tax accountants promoting the public interest when they design, promote, and sell tax shelters that reduce or eliminate paying taxes by the wealthiest members of society? It depends. Professional accountants have an obligation to serve the public interest. This means that the activities of the accountant should promote the general welfare, or at least do no harm to it. With respect to taxation, the tax plans and strategies that the accountant recommends should not be to the detriment of society as a whole, unless they are allowable in order to protect the legal rights of the clients. Theoretically, a client has the right to minimize tax payable using all legal means to do so—a property right that is considered to be in the public interest although it may not be additive to it. Great care should be taken to ensure that activities and advice given just for the benefit of a few select individuals are within legal bounds. The questions offered in the answer to question 1 can be used again to determine whether or not the tax plan is in the public interest. 3. Is there a difference between tax planning strategies that use legally sanctioned shelters, such as retirement savings accounts, different from tax planning strategies that use questionable offshore tax havens? Yes. Tax planning strategies that use legally sanctioned shelters, such as retirement savings accounts, have been approved as being in the public interest, and are available to all taxpayers who find themselves in similar circumstances. These shelters have economic benefits that contribute to the economic welfare of society as a whole, rather than just saving tax for the taxpayer. Retirement savings accounts, for example, reduce future burden on society, because retirees with savings will require less assistance from the state than retirees without savings. 4. Do you think that government tax enforcement officers should or should not socialize with tax policy committees of the accounting profession and/ or directly with practitioners? While government tax enforcement officers might learn of ways in which tax money can be sheltered and so be more vigilant in investigating shelters that are not in the public interest, the optics of tax enforcement officers socializing with practitioners may be akin to lobbying on the part of practitioners. As well, the practical problems of enforcement may be discussed and improved, thereby saving time and costs in the future. However, in order to avoid the appearance of undue influence and conflict of interest (and perhaps the occurrence of them), perhaps the tax authorities might make a summary of such meetings available. Because both parties should have as their primary role the serving of the public interest, socializing between government tax enforcement officers and accountants on tax policy committees should be acceptable provided they observe a published protocol designed to avoid the concerns expressed above. They may even collaborate on ways to identify principles that practitioners should follow to reduce self-interest and promote the public interest.

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34.Italian Tax Mores (Chapter 6, pages 522-523) What this case has to offer The Italian Tax Mores case provides a fascinating glimpse of the pressures facing business to subscribe to local patterns of conduct, and therefore ethical behavior that differs from established norms in other parts of the world. The case was copyrighted in the same year the Foreign Corrupt Practices Act (FCPA) of 1977 was enacted in the United States, so it offers a chance to discuss the real and potential impact of the Act. Moreover, the Italian government was a signatory to the Organisation for Economic Co-operation and Development (OECD) AntiBribery Convention of 1999 (OECD 2016) in which the OECD member countries agreed to enact anti-bribery/corruption laws covering their own corporations, thereby creating a somewhat level playing field for U.S. corporations that were governed by the FCPA and reducing the corruption of foreign government officials around the world. In April 2006, 36 countries had ratified the Convention; in 2016, 41 countries (35 OECD countries and six non-OECD countries) had ratified the convention (OECD 2016). Practices are slow to change, but corporations and their directors and executives should understand that past local practices are not a safe guide for current practices that seem unethical. It is no longer ethically or legally safe to automatically take the view that “When in Rome, do what the Romans do.” This case offers the opportunity to explore the differences between facilitating payments (which are nominal and are paid to speed up something you are going get anyway) and bribes (which are larger-than-nominal and are paid to change someone’s mind and/or actions). Using an agent, as is proposed in the case, is not a perfect solution either, since large payments to the agent are considered to include a bribe. The case can also be used to cover the responsibility for •

Considering and making pre-action decisions about the payment of bribes and the reporting of bribes.

•

Giving instructions to staff going on assignment in foreign countries.

•

Manipulating of foreign financial reports directly by using GAAP, or by using foreign accounting conventions.

The case is real, and the reported outcome was that the Italian bank settled unfavorably, and the Italian Branch Manager was summoned home to New York and fired. However, this outcome would in all probability have been different after the FCPA was introduced, and even less likely after the OECD Anti-Bribery Convention was introduced. Teaching suggestions This case lends itself to quasi-role-playing, and after questioning the class on the details of the case, I often nominate students to the following roles: 1. Italian Bank Branch Manager—a man; 2. Chief Legal Officer (CLO)/General Counsel (GC)—a man or woman; 3. CEO in New York—a woman; and richard@qwconsultancy.com

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P a g e | 428 4. Chair of the Board—a woman or man. I then ask the questions presented at the end of the case—one question at a time in the order set out—to each of the 4 students in turn. After each has answered question 1, I ask for the class’ reactions and discuss the issues. We then go on to the next question in the same manner, and so on. If I don’t use role assignment, I ask for a summary of the case, and then ask each question in turn and discuss the issues raised before moving on to the next question. I end up with a summary much like that presented in the “What this case has to offer section” above. Discussion of ethical issues 1. Should the Italian bank’s general manager hire a commercialista and pay busterella? The problem at the heart of this case is whether the normal Italian bargain-and-bribery approach should be taken, instead of the proper financial statement and pay the computed income tax route. If a commercialista is hired, the busterella (bribe) is sure to follow unless specific instructions are given. Even then, a proper FCPA investigation should turn up any large questionable payments, because the FCPA requires corporations to maintain sufficient records to allow full investigation, or face sanction. Many students will adopt the “When in Rome” model, and not recall that the FCPA exists or what its requirements are. They should be reminded that the “Paying the Computed Tax Approach” will likely now produce a win, even in the Italian courts in current times, given the introduction of the OECD Anti-Bribery Convention.

However, I do not force or permit an overall conclusion on this question at this point because I wish to see what the answers are for the other questions, and I do not want to foreclose discussion on them. 2. Should the general manager phone the bank’s American CEO in New York and ask for advice? Here the issues would include: •

the bank’s code of conduct—does it cover this?

•

should the Chief Legal Officer (CLO) or General Counsel (GC) be called first?

•

what if the Italian branch manager doesn’t agree with the CLO/GC?

As indicated above, I do not force or permit an overall conclusion on this question at this point, because I wish to see what the answers are for the other questions, and I do not want to foreclose discussion on them. 3. If you were the bank’s American CEO, would you want to receive the phone call for advice? Here I am looking for an appreciation of whether: richard@qwconsultancy.com

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P a g e | 429 •

The CEO is interested in the bribery route, or is on an ethical path,

•

She understands the relevance of an ethical corporate culture and its components, and

•

If she understands the FCPA issues.

I usually toy with the Italian branch manager and the American CEO a little bit here, after I get their answers, to bring out the issues, as follows: •

Italian branch manager—Will the CEO think him indecisive?

•

CLO/GC—Was the earlier advice to hire a commercialista legally sound?

•

CEO in New York—Does she want to maintain ignorance/deniability for a FCPA offense?

•

Chair of the Board—What does she really want her people to do—risk cheating and damage to reputation, or play by the rules?

I have used this case for years with wonderful results. The students like it a lot, and there are many opportunities for the flashbulbs of real learning to blaze. Useful Articles, Links, and Videos OECD (2016). OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. http://www.oecd.org/corruption/oecdantibriberyconvention.htm “The OECD Anti-Bribery Convention establishes legally binding standards to criminalise bribery of foreign public officials in international business transactions and provides for a host of related measures that make this effective. It is the first and only international anti-corruption instrument focused on the ‘supply side’ of the bribery transaction.”

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35. Tax Return Complications (Chapter 6, page 524) What this case has to offer This case provides a scenario where a client is attempting to take inappropriate deductions from taxable income and threatens to tell another client that the service he is getting is poor. At the same time, a slip-up is discovered in the handling of the second client's tax affairs. This slip-up can be covered over with modest risk, but the penalty if it found out could result in the loss of the ability to practice. The case gives the student a perspective on the application of ethical standards in the area of tax services, in the following ways: •

involvement with misrepresentations in audited and unaudited data

•

confidentiality on client matters

•

false statements

•

leading to a slippery slope

•

reasoning based on worst-case, rather than optimistic, projections. Teaching suggestions

I would follow the questions asked at the end of the case. The ethical issues for question 1 (Identify the ethical issues Bill Adams should address) are summarized above, and a suggested solution to question 2 about the specific tax issues (What would you do about these issues if you were Bill?) is set out below. Personal Expenses Bill must inform Dr. Rim that the Firm cannot associate itself with tax returns that it knows have not been properly prepared, i.e., have deviated from the rules. If Dr. Rim refuses to cooperate in ensuring that his return is properly prepared, then his information should be returned to him with a letter stating that the Firm will not be preparing his return and why. The audit disclaimer on the return does not relieve the Firm from its responsibility not to associate itself with information it knows or should know to be erroneous or misleading. To maintain his relationship with Dan, Bill should inform Dan that the Firm will not be preparing his brother's tax return for the current year. Due to confidentiality, Dan should not be given any of the details. Late Notice of Objection Bill has two options: 1. Inform Dan that the deadline was missed and rely on past service and the strong relationships of members of the Firm with Zentor Inc. to maintain Zentor Inc. as a client. 2. Agree to the back-dating of the document. Zentor Inc. may sign the document without noticing the date and no one need know the date was missed. The risks under option #1. are as follows: •

The Firm may lose Zentor Inc. as a client. richard@qwconsultancy.com

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P a g e | 431 •

The Firm may have to reimburse Zentor Inc. for the $1,200,000 in taxes.

•

Bill may not be promoted to Partner; in fact, he may be fired. The risks under option #2. are as follows:

•

Zentor Inc. may notice that they are being asked to sign a back-dated document and realize the significance of the back-dating, i.e., that the deadline was missed.

•

The Firm may lose Zentor Inc. as a client and will have to pay the $1,200,000 in taxes.

•

Zentor Inc. may commence legal action against the Firm for trying to involve them in an illegal act.

•

Bill may lose his accountant designation, as well as being fired from the Firm.

The Firm should not be involved in back-dating documents. Bill should inform the junior of this and reprimand him for discussing such a thing with the Tax Department. Bill should inform Dan that the deadline was missed and that steps will be taken to try to rectify the situation. Attempts should be made to convince the Tax Department that it would be just and equitable to allow an extension of the deadline in this case.

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36.Marketing Aggressive Tax Shelters (Chapter 6, pages 525-526) What this case has to offer This case allows the students to discuss marketing ethics in the context of tax practitioners who sell tax shelters. It raises issues concerning: •

What is a reasonable shelter as opposed to an aggressive shelter?

•

The obligations when providing investment advice and investment recommendations.

•

That tax professionals need to always uphold the public interest.

•

Whether or not is possible to actually outlaw aggressive tax shelters. Teaching suggestions This is a good opportunity to review the ethical theory of justice as fairness.

•

Is it fair that sophisticated tax planning schemes are only available to the rich and not to the poor?

•

Are these tax schemes for the mutual benefit of society? Reductions in taxes for the super-rich may not lead to equitable allocation of resources throughout society.

•

Are these being marketed to emotionally vulnerable people? There is a high emotional content to taxes. Most do not want to pay any taxes. Is a scheme that reduces taxes a temptation that these people cannot resists because of their negative attitude towards paying taxes?

•

Is it fair that the poor continue to pay taxes while the super-rich pay no taxes? Is this equitable? Discussion of ethical issues

1. What differentiates very aggressive tax shelters from reasonable tax shelters? A reasonable tax shelter is a plan that has a more-likely-than-not probability of success if challenged by the taxing authority. An aggressive tax shelter is one that does not have a more-likely-than-not chance of being accepted by the taxing authority, provided tax auditors are assumed to audit with reasonable due diligence. However, it is not always apparent which tax shelters will be accepted, and which ones will not. This means that the tax professional must use professional judgment when estimating the likelihood of success.

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P a g e | 433 2. As a result of the E&Y and KPMG tax fiascos, the large accounting firms have become wary of marketing very aggressive tax shelters. Now, most shelters are being sold by tax “boutiques” that operate on a much smaller scale and so are less likely to be investigated by the IRS. a. Is it right that accountants market aggressive tax shelter plans? Some investors are more aggressive than others. Those who are more aggressive are willing to assume greater risk in order to reap potentially higher rewards. More conservative investors desire low-risk investments. It is ethically incorrect for accountants to market aggressive tax shelters when •

They are sold on the basis that they are safe or of only moderate risk, and

•

The investor is not informed of all the risks associated with the shelter?

Sales of any product, including tax shelters, become ethically questionable when the sale is based on misrepresentation or deception; that is, when pertinent information is concealed. Concealing information is unfair because it does not treat all parties to the transaction equally. Some have more information about the potential risks than others. Concealing information in order to make a sale is deceptive. b. Are tax shelter plans in the public interest? Economic theory argues that the buyer is the best judge of what is in the buyer’s best interests. The expression ‘buyers beware’ puts the onus on purchasers—not on vendors–to know what is in the purchasers’ best interests. However, tax is extremely complex, and the nuances of the implications of intricate tax shelters are beyond the pale of most investors. Hence, investors rely on advisers for advice and recommendations. As such, professional advisers have an additional duty to make sure that the investment is appropriate for the investor. This is more than paternalism. It is the duty of the professional tax accountant to ensure that the tax shelter is in the buyer’s best interests. Professional accountants have a legal and ethical duty to uphold the public interest. Not providing candid and straightforward advice is a violation of the public interest. Additional Question 3. Should tax shelters be outlawed? An Income Tax Act is like a rule book. It defines transactions that are taxable and transactions that are allowable as a deduction for tax purposes. However, not every transaction can possibly be covered by the Act. As a result, many transactions are ‘grey’ in that the Act is not clear on whether or not the item is subject to tax, or whether or not the item is an allowable deduction. This makes it impossible for the government to outlaw aggressive tax shelters in advance of their assessment. No matter how many shelters the Act specifies as unacceptable, there are others that tax professionals dream up after the Act is written that are not covered by the Act. However, governments do have the power of the general anti-avoidance rules (GAAR). GAAR says that any transaction that has no economic purpose other than to richard@qwconsultancy.com

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P a g e | 434 avoid tax is in contravention of the Income Tax Act. This rule is intended to deter or counteract transactions that are simply designed as tax avoidance ploys. Tax avoidance is defined as not paying tax, or paying less tax or paying tax later than would otherwise be the case. However, these are very broad principles that require sober judgment in the interpretation of whether or not a transaction has any economic or commercial substance. Useful Articles, Links, and Videos Browning, Lynnley (December 1, 2008). “Prosecutors Pass on Chance to Revive Tax Shelter Case.” New York Times, http://www.nytimes.com/2008/12/02/business/02kpmg.html?_r=1&ref=business Browning, Lynnley (May 31, 2007). “Four Charged in Tax Shelter Case.” New York Times, http://www.nytimes.com/2007/05/31/business/31shelter-web.html?pagewanted=1 Gleckman, Howard; Borrus, Amy; and McNamee, Mike (September 1, 2005) “Inside the KPMG Mess.” Bloomberg Businessweek, http://www.businessweek.com/bwdaily/dnflash/sep2005/nf2005091_2144_db016.htm [Link no longer valid in 2020. Reprint available at https://www.bloomberg.com/news/articles/2005-08-31/inside-the-kpmg-mess. ] IRS [U.S. Internal Revenue Service] (August 29, 2005). “KPMG to Pay $456 Million for Criminal Violations.” IRS, https://www.irs.gov/uac/kpmg-to-pay-456-million-for-criminalviolations [Link no longer valid in 2020. Announcement available at https://www.justice.gov/archive/opa/pr/2005/August/05_ag_433.html. ]

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37.Providing Tax Advice (Chapter 6, pages 526-528) What this case has to offer This case allows students to ask some fundamental questions. •

What is the public interest?

•

Why do we have a tax system?

•

Is the tax system designed to harm the wealthy or to help the poor?

•

Do tax professionals only help the wealthy who can afford their services?

I have found that some of the best classroom ethical discussions centre on tax issues. This may be, in part, because tax is so emotional to so many people. Teaching suggestions I begin this case by asking the students why there are taxes. The two normal arguments are: •

So that the government can afford to provide goods and services, and

•

To redistribute wealth.

Students who use the first reason tend to explain this in terms of social obligations to help the less fortunate. Those who use the second reason tend to explain this as an unfair government grab to take more away from the wealthy. I then ask the students the following three questions. •

Do you have a legal obligation to pay taxes?

•

Do you have a social obligation to pay taxes?

•

Do you have an ethical obligation to pay taxes?

See how many students have their hands up after the third questions. Then ask them to explain why they think so. The reasons will normally be linked back to one of the two reasons for taxation. Discussion of important issues 1. Is there a basic conflict of interest between upholding the public interest and providing tax advice that reduces the amount of money taxpayers pay to the government? Why or why not? Public Interest and Tax Planning Professional accountants have an obligation to uphold the public interest. This means that the activities of the accountant should be for the common good or to promote the general welfare. Their activities and advice should not be just for the benefit a few select individuals. Financial statements are a common good because, although the cost of preparing them is borne by the firm, anyone, even those who are not richard@qwconsultancy.com

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P a g e | 436 shareholders of the firm, can read them and make financial decisions based on them. With respect to taxation, the tax plans and strategies that the accountant recommends should not be to the detriment of society. The following questions help to determine whether or not the tax plan is in the public interest. •

Is the tax strategy available to all taxpayers who find themselves in similar circumstances?

•

Is there an economic benefit, such as an increase in the economic welfare of society as a whole, to the tax strategy beyond saving tax for the taxpayer?

•

Is the strategy consistent with the letter of the law? Is it consistent with the spirit of the law?

If the answers to these questions are yes, then the strategy is not contrary to the public interest. 2. How can professional accountants maintain the support of the public while giving tax advice? Is providing tax advice that only benefits the wealthy, who can afford to pay for tax advice, in the public interest? Is this fair? Is providing highly specialized tax advice to naive clients being paternalistic? Tax Advice for the Wealthy The reality is that there are more tax savings strategies available for the wealthy than for the poor. Single parents can only receive the basic deductions because they normally do not receive multiple sources of revenue. Wealthy entrepreneurs normally have numerous sources of revenue with a variety of deductions available for the various sources of revenue. As such, there is normally more opportunity for providing tax advice to wealthy people than to poor people. As long as the tax advice does not advocate breaking either the letter or the spirit of the law, then the advice provided would be in the public interest. Paternalism There is a huge information asymmetry problem with respect to taxation. The income tax laws are voluminous, complex and occasionally vague. It takes a high level of expertise to understand the law and provide sound tax advice. As a result of this information asymmetry, the professional accountant may be seen as an authority figure who must be obeyed. If the tax professional tells the client that is what the client should do, then that is a form of paternalism, where the client is obeying simply because of the knowledge and power imbalance between the tax professional and the client. The negative consequences of paternalism can be avoided when the tax professional provides the less-informed client with sufficient detail for the client to make a rational business decision. 3. If a tax specialist spends only one hour devising a tax plan that saves a client $1 million, is it ethically acceptable for the tax specialist to charge that client more than the one-hour billing rate? Fees for Services richard@qwconsultancy.com

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P a g e | 437 Contingency fees are fees that are collected only in the event of a favorable outcome, which may bias the professional accountant’s judgment to take a position that is in the accountant’s best interest, not in the client’s. The accountant may no longer be independent and objective. Therefore, professional accountants are prohibited from charging contingency fees for professional services. Instead, the accountant is to charge the regular billing rate unless the work is so complex and intricate that a higher hourly billing rate is justified. 4. Is it ethically correct for a corporation to pay $350,000 to tax consultants so that the corporation can save a million in taxes? Pay $35 to Save $100 in Tax Different arguments can be provided. The System is Unfair The purpose of taxation is to raise money so that the government can provide goods and services to all citizens. All citizens utilize the infrastructures provided by the government, but the less fortunate members of society tend to use more of the other government services than the rich. If the government’s revenue from taxation is reduced, then the government is less able to provide those goods and services, services normally used by the less fortunate. So, the poor suffer by having fewer services and the rich benefit by paying lower taxes. This is unfair and not equitable. Another argument is that only the rich can afford to hire a professional tax accountant. So, the poor are penalized further. Because of their poverty they cannot get access to the tax advice that is available to the rich person. The System is Fair Fairness is not an absolute concept; there is often a range of outcomes that can be considered more or less fair. In that context, some may argue that it is probable that the poor use much more of the public infrastructure than they pay for, so they are relatively well off, even if the rich have opportunities to reduce taxes payable. Secondly, the middle class—who make up the majority of taxpayers and probably pay the largest part of the load–can often access tax advice, so they are not badly off. Finally, the rich can be said to take more risks and opportunities that lead to the creation of value for society (jobs, etc.), so leaving them with tax collars to spend may be good for society.

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P a g e | 438 The Firm is For-Profit An alternative argument is that the accountant is not responsible for drafting the income tax rules. The professional accountant’s job is to understand those rules. The professional accountant works for a for-profit firm. The firm earns its revenue by charging a fair fee to provide that specialized tax knowledge to anyone who is willing to pay. Accountants pay tax on the fees they charge for providing tax advice. A Single Tax? Another argument might be that the fairest approach would be to charge no personal income tax, just corporate tax. However, this requires a strong argument for why corporate taxes are fair and personal taxes are unfair.

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38.Risk Management of Taxes Payable—Is It Ethical? (Chapter 6, page 528) What this case has to offer This case is based on real-life data. Students may have different reactions to the case, including: 1. not understanding why this practice could be unethical 2. realizing it could be unethical but believing that sometimes being unethical could be good business 3. thinking “it is OK because everyone is doing it.” The case points out that there is more than one risk to be considered when dealing with tax authorities, including, at least: A. The risk that the accounting treatment to be chosen could be considered to be: •

questionable, and therefore subject to debate and reversal

•

illegal, and therefore subject to fines, or worse, for tax evasion.

B. The risk that the offense will be caught, due to a poor tax audit or too few tax auditors. Teaching suggestions I begin this case by asking if there is any ethical problem with the aspect of risk management suggested in the case. Discussion ensues, and I tease out the positions noted above as #1, #2, and #3. I promote the discussion by playing devil’s advocate on items #2 and #3. We then address the question of what risks are involved in tax practice and develop items A and B, exploring the unethical aspects of each. Discussion of ethical issues The pressure for profit and for good client relations is very strong, but the temptation for short-term gain must be considered against the longer-term potential for loss. Nature of the advice given Care should be taken not to give misleading advice that would lead the client (and/or the employer of the professional accountant (PA)) to believe that an illegal act was OK, or that he might get away with it. Such advice would be leading the client into a deception based on an illegality, which would represent fostering fraudulent tax evasion. See the discussion in the Text in Chapter 6, section Priority of Duty, Loyalty, & Trust in a Fiduciary, page 409ff and section Circular 230: Tax Accountants Need to Act Professionally, page 455ff. Misrepresentations and Illegalities PAs cannot be involved in either misrepresentations or illegalities, according to their codes. richard@qwconsultancy.com

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P a g e | 440 It is unlikely that the client will keep quiet about your advice if the taxation authorities begin to go hard on him/her, so being found out is a definite prospect. Alternatively, rather than blaming you on your advice, your client may realize that s/he has you at their mercy when s/he wants another favor. You won’t be able to refuse unless you are willing to risk the disclosure of your earlier advice. Everybody’s doing it This is a poor defense against an unethical or illegal act, because you will probably be able to find a group of people doing almost anything. You should always think through the act for yourself based on sound ethical principles. The courts and professional discipline committees will not be impressed when you argue that you were one of many. Also, be aware that the trend may change, leaving you even more exposed.

Chapter 7—Managing Ethics Risks & Opportunities Chapter Questions and Case Solutions richard@qwconsultancy.com

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Chapter Questions..................................................................2 Case Solutions.........................................................................8

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Chapter Questions 1. In what ways do ethics risk and opportunity management, as described in this chapter, go beyond the scope of traditional risk management? Risk management is currently usually narrowly focused on financial matters. Even where the more robust enterprise risk management (ERM) is employed, ethics risks are treated as reputation risks and are now searched for in a haphazard manner. Chapter 7 of the Text provides an organized, systematic approach to defining ethics risks and for identifying and evaluating them. 2. If a corporation’s governance process does not involve ethics risk management, what unfortunate consequences might befall a corporation? Unexpected consequences leading to embarrassment, loss of reputation, trust, credibility, and finally the ability to retain employees and conduct business normally—or sometimes all. 3. How will the U.S. external auditor’s mindset change in order to discharge the duties contemplated by SAS 99 on finding fraud? Statement of Auditing Standards (SAS) 99 requires the U.S. external auditor to focus more on finding fraud, which is an unethical act. In the past, auditors have reviewed the corporation’s system of internal controls as a basis for their audit opinion, but this review has been focused on the assessment of material errors in the accounts and financial reports. The new focus on discovering fraud will broaden this focus to surface transactions that, in themselves, may not be material in a financial sense, but may indicate patterns of misbehavior that could affect the company’s future fortunes, not its past transactions. The intent of transactions, and how they are transacted, will become relevant rather than just the outcome. 4. Corporate reporting to stakeholders other than shareholders has exploded. Why is this? Can stakeholders really make good use of all the information now available? Why: Understanding and being accountable to stakeholders are extremely important topics, covered in Chapters 1, 2, 4, 5, and 7 of the Text. (See Text, page xviii for a thumbnail of coverage of each chapter.) •

Stakeholder support for organizations is now well recognized as essential to achievement of strategic objectives. o

“…[H]eightened accountability has been forced by stakeholders who have recognized that errant corporate directors and managers and professional accountants have failed the public interest with catastrophic and lasting impacts.” (Text, page xiii.)

“…[T]he practices of multinational corporations or firms [are] increasingly scrutinized globally by stakeholders active in major consumer and capital markets and in regulatory arenas around the world.” (Text, page xvii.)

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•

The linkage between ethics, reputation, and trust is now better understood, so it is vital for corporations to upgrade their accountability, disclosure and governance frameworks to ensure continued support (Text, page xiv). Relevant nonfinancial frameworks for meaningful disclosure of sustainability (GRI, U.N. Principles, etc.) and CSR performance have now been developed, and over 90% of large companies are making these disclosures by using aspects of these frameworks. Financial information, while valuable for investment, is recognized as end-of-process historical lag-type info, subject to arcane accounting valuations, whereas nonfinancial reporting provides earlier data on performance, and often more relevant data on climate action, etc. o

•

Stakeholders sensitized to repeated ethical, environmental, human rights, and other failures are looking for information from corporations on values, sustainability, corporate social responsibility (CSR), etc.

“The reputation of corporations is recognized as being connected with the degree to which stakeholders trust that corporations will do the right thing. In other words, there is now a concern for both what a corporation does and how it is done.” (Text, page xvi.) ▪

Refer to Figure 7.2 (Ethics Risk & Opportunity Identification & Assessment (ERISA), Text, page 535): A corporation’s stakeholder support depends upon garnering trust [that the corporation will do the right thing] in order to earn respect by meeting stakeholder values, interests, and expectations for behavior (e.g., an ethical culture/culture of integrity).

▪

“…[P]rofessional accountants can be important agents for ensuring trust. They are expected to serve in the public interest and must do so to preserve the trust placed in them by a society that expects them to behave as professionals.” (Text, page xiv.) They are often responsible for internal and external reporting on indicators of performance, which are supported by ethical behavior, acceptable corporate values, and disclosure of relevant information. While financial reporting is important, it is historical, whereas nonfinancial reporting can provide earlier, additional, and often more relevant data on sustainability-, CSR, climate-action performance, etc.

Yes, stakeholders can benefit from all the new information available: o

Directly, by assessing a corporation’s sustainability practices, treatment of the environment, human rights record, and contributions to society, etc. and comparing to their own interests and expectations.

Indirectly, through the efforts of expert analysts who provide informed, focused reports using the new disclosures.

5. How could a corporation utilize stakeholder analysis to formulate strategies? richard@qwconsultancy.com

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P a g e | 444 Stakeholder interest assessment and impact analysis, and the utilization of frameworks such as that in the Text, Figure 7.4 (Diagnostic Typology of Organizational Stakeholders), can inform corporate strategists on those strategies that will lead to greater and more sustained support by stakeholders that are identified as key to the company’s future. 6. Descriptive commentary about corporate social performance is sometimes included in annual reports. Is this indicative of good performance, or is it just window dressing? How can the credibility of such commentary be enhanced?

Sometimes such disclosures are window-dressing, but continued disclosures often become more and more detailed and can have a driving affect on performance. The credibility of such disclosure can be enhanced by including as much hard measurement data as possible, and by comparing the actual performance data with standards set in advance and operational plans to achieve the next stage of improvement. External independent verification may also improve credibility. 7. Why should a corporation make use of a comprehensive framework for considering, managing and reporting corporate social performance? How should they do so? Corporate social reporting (CSR) is growing in importance since it has become expected, particularly of larger companies. This means that there is greater vulnerability now for oversights and mistakes, in the form of criticism and loss of the support of stakeholders. Referring to a comprehensive framework for CSR will help ensure that nothing is missed and that comparisons to established practice are made. There are a number of comprehensive models and related reports emerging, including the Global Reporting Imitative (GRI G3) and AccountAbility approaches that could provide a useful template against which a company’s CSR performance can be compared.

8. Do professional accountants have the expertise to audit corporate social performance reports? Absolutely! They possess skills at seeking out relevant evidence, avoiding measurement faults, and organizing and disclosing it. Present audit practices involve using experts where necessary—such as engineers, or gemologists, etc.–so this aspect should come as no surprise. The new audits may well need a team approach that involves several experts, but the expertise developed by professional accountants will be needed, and it is not part of the training of other professionals.

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P a g e | 445 9. What would you list as the five most important ethical guidelines for dealing with North American employees? Guidelines leading to the five major items in Table 7.11 (Employee Rights Themes in North America). 10. Is trust really important—can’t employees work effectively for someone they are afraid of or at least where there is some “creative tension”?

Yes, but if they have an opportunity to leave, they may view the “grass to be greener” elsewhere and take the opportunity. They may also look for another opportunity. It is better to fulfil or meet an excellent employee’s needs, than to attack them. Trust is important if the organization is one that relies upon employees to share new ideas without fear of ridicule or retribution, or to perform at high levels of initiative and performance without supervision. Employees that prefer ego and social need stimulation (Maslow’s system of human needs) will respond well to trust situations. However, some workers prefer a system where they are under constant, independence-relieving supervision. Creative tension can be positive in these situations, and where an employee is not self-motivated. All employees, however, will respond to systems they can trust to be fair. 11. Should a North American corporation operating abroad respect each foreign culture encountered, or insist that all employees and agents follow only one corporate culture?

This is currently being researched, so there isn’t a correct answer yet, but the trend is toward a unified culture. The best approach is for a company to articulate its values in a code of conduct for its employees to follow, and be prepared to abandon an opportunity where these values would be so compromised as to lead to the loss of support from stakeholder groups such as: decision makers, consumers, and capital providers. Moral imagination can sometimes help, such as was the case in the illustration of operations in China in Chapter 4 (Bribery or Opportunity in China, Text, page 229). Also, a company may sometimes take the view that they are better to stay in a foreign country because they are making a contribution to the betterment of life there, even though they don’t agree with all the policies of the country. If hypernorms can be developed through future research, we will all benefit and will avoid practicing cultural imperialism. 12. What should a North American company do in a foreign country where women are regarded as secondary to men and are not allowed to negotiate contracts or undertake senior corporate positions?

The answer to question 11 (above) is also relevant here. If possible, the company may be able to promote women from that country to positions in other countries where traditions are more compatible with company policies. It goes without saying that women from North America should not be put into jobs in the foreign country where their career or personal outlook would be damaged. Such a posting might be richard@qwconsultancy.com

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made as a short-term learning experience, with the prior agreement of the individual. 13. The #MeToo Movement has finally succeeded in getting women’s allegations of sexual abuse to be taken seriously by management and boards of directors. Why did it take so long for this tipping point to be reached? See the answer to question 7, Chapter 1, Text, page 32: “Why didn’t some corporations protect women employees from sexual abuse before 2017–2019?” Essentially, “…[C]hange in moral sensitivity has [resulted in] recognition by the general public and corporate community of the seriousness of sexual violence and abuse against women in the workplace.” (Text, page 5.) Additionally, only recently have the strictures imposed by the legal process been circumvented that made it difficult to get offenders into court—bias against women (blaming the victim), police bias, statute of limitations issues (time elapsed, jurisdiction), evidentiary problems (for example, if women had been drugged or were drunk and could not provide clear evidence, as in the cases against celebrity Bill Cosby)), and patterns of crime were not allowed to be presented (e.g., in the cases against film producer Harvey Weinstein)2324. In addition, public pressure has now forced major companies to take action on allegations, not just proven offences (e.g., McDonald’s CEO Steve Easterbrook, Fox News host Bill O’Reilly, and many more). Before the #MeToo movement helped to bring many high-profile cases to light, payoffs were frequent and attached to secrecy clauses, and “catch and kill” tactics were common to control news stories. 14. How would you advise your company’s personnel to act with regard to expectations of guanxi in China? The advice should be to act in accordance with company policy having in mind that the new extraterritorial reach of the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act may now apply in China even if Chinese regulations do not. Increasingly there will be penalties for guanxi that is beyond reasonable limits, and these limits should be set by top management, not left to the judgment of employees lower down. If such employees get faced with a guanxi situation, they should be advised to ask for clarification from their boss, or a central authority that is well-informed on company policy, as well as legal and ethical trends. 15. What would you advise that corporations do to recognize the new worldwide reach of antibribery enforcement related to the FCPA and the U.K. Bribery Act?

Take the new statutory provisions into account as noted above in question 14.

Eric Levenson, “Harvey Weinstein's trial is closely tracking Bill Cosby's. But there's 1 major difference,” CNN.com, January 28, 2020, https://www.cnn.com/2020/01/28/us/harvey-weinstein-bill-cosby-trial/index.html. 24 Mike Hayes and Meg Wagner, “Harvey Weinstein found guilty,” CNN.com, February 24, 2020, https://www.cnn.com/us/live-news/harvey-weinstein-verdict/index.html. 23

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16. If a company is to be sentenced for paying bribes 10 years ago, should the company be banned from all government contracts for 10 years, just made to pay a fine, or both? Consider the impacts on all stakeholder groups, including current and past shareholders, current employees and their families, people who paid the bribes, and current and past members of the board of directors, as well as competitors from other countries that may just have to pay a fine. The answer depends on many factors. Consider these questions: Are the real culprits going to be punished (bribers, executives responsible, board responsible, shareholders who benefited, etc.), or will the penalties fall on current innocent incumbents, or penalize current workers? Such a ban from government contracts on the country prosecuting the company may penalize investors, directors, workers and executives who had nothing to do with the malfeasance. Also, if the bribing company’s competitors in countries where bribes are commonplace might be fined (or not), but not be shut out of large government contracts, the competitors will be deriving a competitive advantage that will further penalize the out-of-country bribing company. Instead of reducing bribery, the out-of-country bribing company might move its operations and jobs to the jurisdiction that is more lenient on bribery. Such an action would further penalize current workers in countries where bribes did not take place. 17. Why should ethical decision making be incorporated into crisis management? The decisions taken during crises usually shape the ongoing operations of a corporation to a greater degree than day-to-day decisions, so they are critical. Ethics, we have shown, ought to be part of day to day activities, so why not also in the more important crisis decisions. The downside of non-ethical crisis decisions will be more difficult to counter because they have such a lasting impact on corporate reputation.

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Case Solutions Corporate Social Responsibility (CSR) Cases— Environmental Issues 1. Harry Potter and the Green Brigade (Chapter 7, pages 595-596) What this case has to offer This case examines how Harry Potter books came to be printed on recycled paper and identifies the significant environmental savings resulting from this decision. This case discusses the roles of the books’ author, J. K. Rowling, the publisher Rainforest Books, and the Rainforest Alliance in enabling the change to the more environmentally friendly recycled paper. This case is a good example of the potential costs and benefits that may be considered when taking an ethical business decision. Teaching suggestions I start this case asking students what factors may motivate a company to switch to more environmentally friendly products and technologies. Following, I ask students what factors may deter a company from switching to more environmentally friendly products and technologies. Finally, I discuss the pros and cons of switching to recycled paper in the Harry Potter case and ask students if the publisher’s decision makes sense from the ethical and business perspectives. At the end of the discussion, I ask students to take a vote on whether or not they would support this decision as shareholders of the publishing company. Discussion of ethical issues 1. If the cost of printing Harry Potter books on recycled paper added 3% to the cost, was the publishing company really serving the interest of its shareholders, given that the demand for Potter books was so high that all copies would probably have been sold in spite of any boycott? Explain why and why not, and come to a conclusion. If the publisher only cared about the one-off profits from the sale of the new edition of the Harry Potter books, it would be value-destroying to increase costs while expected revenues remain the same; however, there are long-term benefits from this move. This move is likely to improve the publisher’s reputation and may bring the following benefits: •

Attract consumers that prefer books printed on recycled paper; and,

•

Attract authors that want their books printed on recycled paper, including future J.K. Rowling/Harry Potter books and reprints of Harry Potter’s older editions.

•

Lead to premium pricing to permit cost recovery with later publications.

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P a g e | 449 2. There is the possibility of huge environmental savings by shifting to recycled paper. Would the savings be even greater if books were published in digital format? Should publishers move to the 100% digital mode immediately? Why and why not? Going 100% digital is a complex business decision, not only driven by potential environmental savings, but also by consumer preferences. The shift may take time and is more likely to happen gradually instead of being an immediate shift. The following reasons may motivate a publisher to go 100% digital: •

Relatively new technologies, such as portable tablets and hand-held devices, are enabling readers to access digital formats in an easier way, and this may help in changing consumer preferences.

•

Libraries are starting to offer digital contents to their users and a 100% digital publisher could exploit that niche market.

•

Moving to 100% digital before other companies may become a competitive advantage in terms of being ahead in the learning curve and creating consumer awareness.

•

The digital format may attract consumers and authors that are environmentally conscious, and a 100% digital publisher could exploit that niche market.

•

The digital format may enable interactive content and improve the reader’s experience.

•

The digital format may be more profitable than the paper format, given the large cost savings and the possibility to generate a higher percentage operating margin, even after offering the digital books at a lower price than the printed books.

However, there are some negative aspects that a publisher should consider before going 100% digital: •

There are additional costs of setting up the infrastructure needed to go digital.

•

Printing and distributing books is a different business than producing and distributing digital content.

•

The copyright of digital content is more difficult to enforce, as it is really easy to copy and distribute unlicensed copies of digital content.

•

There is still demand for books printed in paper.

•

Competitors in the book publishing business have a mixed model, offering both printed and digital books.

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P a g e | 450 3. What do you think would be a reasonable environmental strategy to recommend to authors and publishers for books to be published in the next five years? A reasonable environmental strategy may include the following aspects: •

Increase the percentage of recycled material in printed books.

•

Source paper from environmentally friendly suppliers.

•

Move progressively into the digital publishing business.

•

Offer mixed editions of books with paper and digital content, for example, sell paper textbooks with online questions and exercises

•

Offer premium environmentally friendly paper versions as well as digital versions to raise reputational awareness on this issue.

richard@qwconsultancy.com

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2. The Carbon Footprint of British Airways (Chapter 7, pages 596-597) What this case has to offer This case discusses the actions taken by British Airways (BA) to be a more responsible company, focusing on reducing emissions by modernizing its airplane fleet and increasing efficiency, as well as other socially responsible initiatives. Nevertheless, contrary to these actions, the company launched a new business service between London and New York that flies 32 passengers across the Atlantic Ocean in an airplane that normally holds 100 passengers. This is a good case to discuss how a company needs to balance business and ethical practices. Teaching suggestions I start this case by discussing the actions taken by BA to be a more responsible company, and I ask students whether the company’s actions were motivated by business reasons. Following that, I ask students whether the new business class flight to New York contradicts the overall responsibility objective stated by BA and how could the company reconcile its for-profit objective with its responsibility goals. Overall, it is unlikely that the company will cancel this flight, but it is possible for BA to take other actions to be responsible and offset the incremental emissions from the new business class flight. Discussion of ethical issues 1. Do you think that British Airways is being hypocritical? Arguably, the new business class flight between London and New York is against the company’s goals regarding the reduction of its overall carbon emissions. This seems hypocritical. But, BA may be able to go on with this business decision, motivated by the profitability of this new flight, if the company commits to offsetting the incremental emissions with further actions to reduce its total emissions. At present [2011], the company offers a service to calculate individual emissions at the moment of purchasing a ticket and allow the company’s customers to buy carbon credits. “British Airways was the first airline to introduce a voluntary passenger carbon offset scheme in 2005 and were also the first airline to achieve the UK Governments Quality of Assurance. We strive to make it as easy as possible for you to offset the impact of your journey when buying a ticket with us on ba.com. Contributions are automatically calculated based on the volume of carbon dioxide your flight produces and the cost of carbon per tonne at the time of your booking. Payments can be made safely and securely via credit or debit card, with the money raised going to help fund hydro-electric power plants and wind farms around the world.” This is a good step, but it is obviously not good enough. The company needs to show its commitment with further actions to reduce emissions.

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P a g e | 452 2. British Airways is attempting to reduce its carbon footprint by flying more fuel-efficient airplanes, such as the A318. The carbon footprint per passenger is lower if 100 people occupy the A318 rather than only 32 people. Does the airline also have a responsibility to reduce each passenger’s carbon footprint? In general, the company is responsible for reducing the overall emissions for a given level of activity. This means that if the company grows in both size and number of flights, then total emissions will increase as a result of a higher level of activity. Scaling total emissions by the number of passengers results in a useful benchmark; however, this benchmark is also subject to the different characteristics of each flight including number of seats sold, distance, type of aircraft, etc. It is difficult to make complex business decisions based on a single benchmark. The company should clearly state reasonable goals in terms of reducing carbon emissions and show progress towards achieving its goals. This may demonstrate to the company’s stakeholders that BA is actually committed to being responsible. 3. The passengers who fly on the Club World London City flight pay a substantial premium for the luxury accommodation. Do you think that the increased premium they pay offsets the increased carbon footprint of having only 32 passengers in the airplane? In simple terms, the additional emissions would be covered by the increased premium under two conditions: 1) The price of this new business flight is over three times the price of a regular flight; and, 2) Emissions have a price in dollars, considered as part of the total price of the ticket. Under the carbon credit system suggested by the Kyoto Protocol, if carbon emissions had a price considered as part of the cost of making a product or providing a service, similar to a carbon tax, then companies would be aware of that cost and would offset it by buying credits or by reducing total emissions. 4. Is it socially responsible for British Airways to fly 32 passengers in an aircraft that can normally hold 100 passengers? Not from the point of view of the carbon emissions; however, the company also has a responsibility to be profitable and compete in the marketplace. As suggested in the answer to question 1, the company may undertake other actions to offset the incremental emissions from the business class flights.

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P a g e | 453 Useful Articles, Links, and Videos British Airways. Climate change - Carbon offsetting. 2011. http://www.britishairways.com/travel/csr-your-footprint/public/en_gb [Link no longer valid in 2020.] British Airways. [2011?] Corporate Responsibility Report 2010/2011. https://www.britishairways.com/cms/global/pdfs/environment/ba_corporate_responsib ility_report_2010-2011.pdf

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3. Pollution Caused by Cruise Ships (Chapter 7, pages 597-599) What this case has to offer This case examines whether cruise ships that sail through two countries should dump their “grey water” in the country that has the more relaxed pollution standards. In addition, this case discusses the trade-off between enforcing tougher environmental standards and the incremental cost to business and travellers using cruise ships. Teaching suggestions I start this case by asking students how a company would behave if there are two different environmental standards with different compliance costs. Moreover, I remind students that barely complying with laws and regulations may not be enough to act ethically. Once the sea is polluted, it is practically impossible to clean up afterwards, and the damages to the marine life have vast implications. The videos on the pacific sea garbage patch, available at www.youtube.com, are an excellent resource to support this point. Discussion of ethical issues 1. If the laws are strict in one country, but lax in another country, do cruise ship companies have an ethical obligation to follow the stricter laws even when they are temporarily sailing through the waters of a country with more lax regulations? Cruise ships companies have an ethical obligation beyond complying with existing laws and regulations. If all jurisdictions had the same restrictions on dumping sewage water and air pollution, the cruise ship companies would have to install treatment plants on board and switch to cleaner fuel. The cost of cruise travel should include the additional costs of operating cleaner ships. It is not acceptable to act as if it were free to pollute the oceans. 2. Many cruise ships travel outside the 200-mile limits set by the United States and Canada. Do these ships have any environmental responsibilities when they are sailing in international waters? The answer to this question is related to the answer of the previous one. It is not ethical to pollute the ocean waters just because the cruise ship is far from the coast. Ultimately, pollution comes back to land through ocean currents, and it directly affects marine life. 3. How much should port cities compromise on pollution standards in order to generate tourism? Allowing cruise ships to pollute the air and water of a port city based on shortterm economic gains is short-sighted. Port cities should set comprehensive plans to move towards tougher environmental standards. Eventually, cruises have to stop along a coast, and it just takes a sufficient number of cities agreeing on pollution standards to change what are considered acceptable business practices. Port cities may even demand an environmental fee or environmental tax added to each cruise ticket. Such fees would make consumers aware of the environmental consequences of cruise travel. richard@qwconsultancy.com

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Workplace Ethics Cases—Discrimination and Abuse 4. Texaco’s Jelly Beans (Chapter 7, pages 599-604) What this case has to offer This case examines the role of corporate culture in fostering racial discrimination against people of color. It was apparently common for top management to depreciate and hold back employees from promotion and pay raises based on their color. This treatment became evident when a whistleblower who was caught up in another unsavory Texaco practice—losing his job just before retirement—came forward. This scenario happens frequently, so students will benefit from experiencing the problems before they are caught up in them themselves. The benefits of whistleblowing within the company can be debated, as well as the remedies that Texaco put in place to provide for a wholesome future. Other issues include: the cost of getting caught is usually misunderstood to be much lower than it actually turns out to be; the ethics of lawyers and others who sometimes counsel getting rid of documents; executive responsibility to shareholders via derivative actions; and the ethics of the press for publishing possibly erroneous details of taped conversations, thus damaging the reputations of the company and its executives. Teaching suggestions/Discussion of ethical issues Following a brief introduction to the case that stresses the frequency the events of the case are repeated, I ask for discussion on: 1. In a company as progressive as Texaco, what permitted such discrimination to occur? Question 1 brings up a discussion of the role of several elements of Texaco’s corporate culture. We then explore the elements of corporate culture in general to give the students a complete picture—see the discussion in the Text, Chapter 5, at pages 279306. 2. How could such discrimination have been prevented? Question 2 about prevention is then asked. Of course, there are the issues raised in the terms of settlement of the Texaco lawsuit. In addition, I am looking for a discussion of the role of top management in making sure they do not condone such behavior. In fact, they should make it very clear that they do not agree with such discrimination. This could involve discipline in any cases found, news articles supporting the promotion of employees of merit regardless of race, stories highlighting those promoted, record keeping of the number of white/non-white hires and promotions, the setting of area-byarea objectives in these areas, and the inclusion of such factors in the set of performance goals that lead to salary and promotion decisions for managers.

3. Is whistleblowing ethical? richard@qwconsultancy.com

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P a g e | 457 Question 3 is a good one because condoning or encouraging whistleblowing is counter to the norm in many cultures, including those in North America. We are just not raised to “snitch, rat, or tell on” our friends or enemies. However, if the executives of a company want their employees to act ethically, they would benefit when whistleblowers come forward within the company so that questionable practices can be checked, and unethical practices and be stopped. Executives cannot be everywhere themselves, so they need to rely on as many others as possible. It is just too costly to repair the damage after the problem becomes public in terms of fines, loss of executive time and company reputation, and lost morale causing loss of efficiency and opportunities. In an atmosphere permitting discrimination, it is unlikely that sufficient trust exists in company practices for important practices involving vulnerability (like sharing ideas and developing innovations) to be successful. 4. Could a protected whistleblowing mechanism or conscientious ombudsperson have helped? Question 4 is aimed at getting across to the students that companies must encourage whistleblowing or else it will not occur. You would have to be an ethical hero or a fool to come forward if you thought the prospect of further discrimination against the whistleblower was likely. Consequently, a protected whistleblowing scheme and/or a conscientious ombudsperson would be attractive. The Text deals with protected whistleblowing programs in Chapters 2, 7, and in the article by Singer (Chapter 1, pages 67-75). I then discuss the following: Loss of stakeholder support results in even larger losses Normally executives do not appreciate the fact that fiascos like the Texaco discrimination case have another even more expensive cost that the fines and other items described. They fail to realize that when the problem becomes public, the company risks losing the support of the stakeholder group(s) adversely affected and offended. This often results in a consumer boycott thus losing millions more than the combined fines and reparations. Legal ethics Destruction of documents is a questionable practice if they are accurate. It could make the lawyer liable for aiding in a felony. Expecting these documents to stay secret is naive. Executive duty to shareholders/derivative actions Shareholders have the right to expect executives to demonstrate their fiduciary duty by acting responsibly, ethically and legally. If this responsibility is not properly discharged, a derivative action against the company and its directors may be successful.

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P a g e | 458 Ethics of the press Was the initial transcription of the tape recording erroneous? If so, the press is guilty of unethical behavior leading to defamation of character. If not, they can prove it. Useful Articles, Links, and Videos Singer, A. W. 1992. “The Whistle-Blower: Patriot or Bounty Hunter?” Across the Board, 16–22. [See also Text, Chapter 1, pages 67-75.] White, Jack E. (November 18, 1996) “Texaco’s White-Collar Bigots: Top Executives, Confronting a Discrimination Suit, Talk About Shredding Documents.” Time, http://content.time.com/time/magazine/article/0,9171,985551,00.html “Texaco Discrimination Settlement Endorsed.” (March 26, 1997). New York Times, http://www.nytimes.com/1997/03/26/business/texaco-discrimination-settlementendorsed.html C-Span (March 24, 1997). “Texaco Discrimination Issues [video].” Council of Institutional Investors. http://www.c-spanvideo.org/program/79911-1 Mr. Bijur discusses the 1994 incident in which Texaco employees were taped in a meeting making negative remarks about black employees. He turns to examine an antidiscrimination plan proposed by the Texaco and later takes questions from the audience.

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5. Gender Discrimination at Dell Inc. (Chapter 7, page 604) What this case has to offer This case describes a $9.1 million class-action settlement after Dell incurred in a systemic pattern of gender discrimination. The company was accused of compensating female employees less than their male counterparts; segregating female employees into lower paying grade levels than their male counterparts; denying female employees development, placement, promotion, and advancement opportunities resulting in their remaining in lower classification and compensation levels; and disproportionately terminating female employees compared with their male counterparts. This is a good case to identify the controls should be in place to ensure equal treatment when hiring, retaining, and promoting employees. Teaching suggestions I start this case by asking students what constitutes sexual discrimination, and how a company’s top management and/or directors may uncover cases of sexual discrimination. While discussing the solution to the case’s questions, I make sure that the students focus on the causes and consequences of sexual discrimination, as well as on the potential controls that could be put in place to avoid this problem Discussion of ethical issues 1. What factors contribute to a firm engaging in sexual discrimination? As explained in Chapter 7, concerning hiring and firing decisions, the key principle is that decisions must be based upon a person’s ability to do the job. Providing different working conditions, salaries, hiring, promotion or bonus criteria to women and men based on gender and not on personal abilities is a form of sexual discrimination. Several factors may contribute to a firm engaging in sexual discrimination, for example: •

Wrong attitudes from top management (weak tone at the top) with respect to fairness in the workplace

•

Lack of an ethical policy addressing sexual discrimination

•

Cultural stereotypes against female employees, for example viewing women as having lower levels of competency compared to men doing the same job

2. What factors should the board of directors consider if there is an internal complaint of sex discrimination on the basis of pay and promotion? A complaint of sexual discrimination should be taken very seriously. The following factors may be important in addressing a complaint: •

Whether the complaint refers to a single individual in a position of power, or if it is a widespread problem

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P a g e | 460 •

Whether there are other similar complaints

•

What evidence is provided by the affected individual and whether that person needs a safe environment to provide more details about the case

•

What steps are necessary to investigate the complaint further

•

What steps should be taken in order to fix the problem

3. What other costs might Dell incur because of its practice of discrimination? Other costs that may follow this lawsuit may result from: •

Additional lawsuits by other affected individuals

•

Managerial time and company resources devoted to correct the issue

•

Loss of reputation resulting in: o

qualified female employees leaving the company

qualified female employees not applying for jobs at the company,

low employee morale and loss of productivity

loss of sales from consumers that may react strongly against sexual discrimination

4. How can a firm ensure that it does not engage in sexual discrimination? Several actions may help a company to avoid engaging in sexual discrimination and other forms of discrimination. •

Management should have an intolerant attitude towards all forms of discrimination (tone at the top). Management should be aware of the possible repercussions and seriousness of discrimination; for example, class action discrimination lawsuits have become more prominent and more costly in recent years. Discrimination may cause low employee morale and loss of productivity.

•

Management should make a concerted effort to hire a diversified workforce.

•

The company should adopt a whistleblower policy for discrimination cases.

•

The company should adopt a code of conduct and ethics policy that address sexual discrimination (and other forms of discrimination based on the basis of race, religion, age, etc.) for directors, executives and all other employees of the company. This policy should clearly state the company’s commitment not to tolerate discrimination, bullying or harassment.

•

The company should establish internal controls avoiding discrimination, for example:

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Managers should make new employees aware of the policies prohibiting discrimination when joining the company, and this should be noted in all employee contracts.

Provide training to all employees to help them to clearly understand discrimination, bullying and harassment, and that these behaviors will not be tolerated.

Develop open and well-understood procedures for hiring, promoting and firing employees.

Maintain job descriptions and documentation regarding hiring, promoting and firing decisions; for example, a point-scoring interview system could be implemented to ensure that the best performer is awarded the job.

Develop monitoring controls to keep track of hiring, promoting and firing decisions by gender, race, religion, age, etc. Conduct pay audits to uncover and address unexplained pay disparities.

Report statistics on hiring, promoting and firing decisions by gender, race, religion, age, etc.

Create a special office or designate an impartial person within the company to deal with discrimination cases.

richard@qwconsultancy.com

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6. Novartis $250+ Million Gender Discrimination Case (Chapter 7, pages 605-606) What this case has to offer Novartis, a Swiss-headquartered drug company, was found guilty of discriminating against women, and in May 2010, the jury awarded total punitive damages of $250 million: about $44,000 for each of the 5,600 women represented in the class action. This was the largest award of punitive damages for any discrimination case in the United States. The amount was equal to 2.6% of the $9.5 billion revenue Novartis reported in 2009. After the verdict, Novartis indicated they would appeal, and on July 2010 a $152.5 million settlement was announced, subject to verification by a judge. According to the jury of five women and four men, Novartis engaged in a specific pattern of discrimination against pregnant women, with respect to the terms and conditions of their employment, and also engaged in a general pattern of discrimination against female representatives, with respect to pay and promotions. This is a good case to discuss the consequences of sexual discrimination and the controls should be in place to ensure equal treatment when hiring, retaining, and promoting employees. Teaching suggestions I start this case by asking students what constitutes sexual discrimination and how a company’s top management and directors may uncover cases of sexual discrimination. While discussing the solution to the case’s questions, I make sure that the students focus on the very high costs of sexual discrimination, as well as on the potential controls that could be put in place to avoid this problem. In addition, this case raises awareness about the way punitive damages are determined, and about the large legal fees involved in class-action lawsuits. Discussion of ethical issues 1. Was the verdict fair? It is very difficult to determine what constitutes a fair verdict in a case were pervasive actions have a general impact over a large number of people; however, the verdict should send a clear message to the company and all other companies that discrimination should not be tolerated. It should motivate the management of all companies, not just Novartis, to take corrective actions to ensure that discrimination of all kinds does not occur. Moreover, a fair verdict should compensate the affected women in terms of differential pay and promotions. Almost 15 percent of the total damages were designated to improve the company’s controls, and two thirds of the total damages were designated to compensate the women promoting the class action lawsuit.

2. Will this verdict cause other companies to review for and remedy any systematic discrimination uncovered?

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P a g e | 463 This case may motivate other companies to review their policies on discrimination and harassment, particularly in the pharmaceutical industry, where similar practices may be prevalent. 3. How should systemic discrimination be prevented? There are several actions that may help a company to avoid engaging in sexual discrimination, including: •

Management should have the right attitude towards sexual discrimination (tone at the top), and not underplay the importance of this issue.

•

Management should be aware of the possible repercussions and seriousness of sexual discrimination: class action sexual discrimination lawsuits have become more prominent and more costly in recent years. Moreover, discrimination may cause low employee morale and loss of productivity.

•

Management should make a concerted effort to hire a diversified workforce.

•

The company should adopt a whistleblower policy for sexual discrimination cases.

•

The company should adopt a code of conduct and ethics policy that addresses sexual discrimination (and other forms of discrimination based on the basis of race, religion, age, etc.) for directors, executives and all other employees of the company, this policy should clearly state the company’s commitment not to tolerate discrimination, bullying or harassment.

•

The company should establish internal controls avoiding discrimination, for example: o

Managers should make new employees aware of the policies prohibiting discrimination when joining the company and this should be noted in all employee contracts.

Provide training to all employees to help them understand exactly what discrimination, bullying, and harassment are and that these behaviors will not be tolerated.

Develop open and well-understood procedures for hiring, promoting and firing employees.

Maintain job descriptions and documentation regarding hiring, promoting and firing decisions, for example, a point-scoring interview system could be implemented to ensure that the best performer is awarded the job.

Develop monitoring controls to keep track of hiring, promoting and firing decisions by gender, race, religion, age, etc. Conducting pay audits to uncover and address unexplained pay disparities.

richard@qwconsultancy.com

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Report statistics on hiring, promoting and firing decisions by gender, race, religion, age, etc.

Create a special office or designate a person within the company to deal with sexual discrimination issues.

4. Were the lawyer’s fees fair? More than one fourth of the total damages went to legal fees. On average, every woman was awarded an amount between $15,000 and $20,000, while the partners of the legal firm representing them shared $40 million. Fees so high may motivate lawyers to take on other class action lawsuits without merit. On the other side, given the complexity of this case, its length, and the legal resources available to Novartis, the lawyers’ fee may be commensurate to the skills and effort necessary to win the largest gender discrimination case to ever go to trial. Sanford, Wittels & Heisler LLP represented employees in a number of discrimination cases: •

Bayer Gender Discrimination Case

•

CIGNA Healthcare Gender Discrimination Case

•

Dell Gender Discrimination Matter

•

Eaton Corporation Gender Discrimination Matter

•

Fairfield Resorts Gender Discrimination & Sexual Harassment Class Action

•

General Electric Gender Discrimination Matter

•

KPMG Gender Discrimination Case

•

Novartis Pharmaceutical Gender Discrimination Class Action

•

Publicis Groupe and MSL Discrimination Matter

•

Sanofi-Aventis Gender Discrimination Class Action

•

Toshiba Gender Discrimination Case

5. Could this case have been successfully prosecuted if it were not a class action? It would have been very difficult for a single person to prove sexual discrimination. Moreover, it would have been difficult to attract and retain the services of a large legal firm to aid a single plaintiff. Useful Articles, Links, and Videos Sanford, Wittels & Heisler LLP [website]. 2011. Our Cases. http://www.swhlegal.com/cases.html?category_id=62600&f^81=152&searchon=1 [Link not valid in 2020. New firm website accessible at https://sanfordheisler.com/case/ ]

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P a g e | 465 [Access to the case description available at https://sanfordheisler.com/?s=novartis&post_type=case and https://sanfordheisler.com/case/novartis-pharmaceutical-wage-hour-class-action/] Sanford Heisler LLP [website]. 2017. Cases: See How We Help Those in Need. https://sanfordheisler.com/case/

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7. Downsize or Bonus Allocation Decisions (Chapter 7, page 606) What this case has to offer This case forces the class to consider a common scenario involving often gut-wrenching decisions. In the process of making these decisions, students must confront their biases. They should also be aware that their decisions are signaling to the work team what the manager’s values are, or at least how the manager wishes to interpret the company’s values. These values will impact on the motivation of the employees in the future, because they will indicate what the team’s shared values should be and what level of trust to count on. I also use the case to illustrate how moral imagination can be triggered and be very helpful. From the corporate perspective, the impact of how downsizing and bonus decisions are designed is shown to have a direct impact on how the corporate culture is perceived. Teaching suggestions 1. What would your answers be, and what would your reasoning be for each? To answer question 1, I usually use the question of downsizing first. I ask which employee the class would choose, and why. Usually there will be a range of choices and I encourage this range by playing devil’s advocate by indicating that their choice signals that they are ignoring or don’t care about a value that one of the other choices represents. This forces the student to defend his/her choice and encourages other students to speak about their choices. For example, the individuals listed are proxies for the following values based on the person to be cut: •

Carol: Performance relative to salary counts, family doesn’t

•

Gord: Seniority counts and possibly personality and family, performance doesn’t

•

Jane:

•

Ralph: Performance relative to salary counts, seniority and family do not

•

Hilary: Performance counts, family does not

Ability to withstand impact counts, performance and seniority may not

Seniority can also be considered a proxy for loyal performance. In the end, students realize that trade-offs must be made. I ask for a vote on which staff member to cut just to drive home that different decisions can be made by reasonable people. The important question is what kind of a team is needed to fulfill the company’s goals. Should the team be focused on meritorious performance at work only, or loyalty, or performance that will make allowances for the personal and family lives of the team members, or personality issues, or favoritism? Students rarely make the ethical link and realize that their decisions show their value choices and govern future performance. Values determine motivation.

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P a g e | 467 Sometimes I push the class to use their moral imagination to come up with a different and perhaps better solution favoring shared values. If the class does not come forward with a suggestion, I indicate that the manager might call a meeting of the team and ask for their input. One of the staff may step forward since they may wish to retire or have another opportunity they could move to. The team may also wish to share a cut in salary so that no one needs to be discharged. The decision of which staff to bonus is less rich a learning experience, but does offer the same opportunity to signal values. Consequently, what kind of culture and values is wanted should be part of the decision process.

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Workplace Ethics Cases—Spying 8. Barclays Bank: How Not to Deal with Whistleblowing (Chapter 7, pages 607-608) What this case has to offer This is a great case for starting a conversation about the challenges of reporting corporate wrongdoing, as well as for identifying procedures that should be followed and those that should be avoided. The students can also think about how they would structure a reporting system to minimize the risks and chances of an ethical, operational or financial disaster from occurring at their own firms. Teaching suggestions I begin by asking the students about factors that engender trust within an organization. These could include: •

Acting with integrity

•

Preserving dignity and respect

•

Keeping commitments

•

Keeping staff informed

•

Opening two-way communication

•

Listening with respect

•

Creating mechanisms for dissent

We then talk about what it would be like to work in an environment in which these factors were not present. I conclude by asking, “If you were the CEO and sole shareholder in a company, would you want to know about a potential ethical or operational risk in advance, or would you want to run the risk of an issue becoming a financial or operational scandal reported on by the media?” I then ask, “If the former, how would you encourage your employees to talk openly and honestly with you about potential risks?”

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P a g e | 469 Discussion of ethical issues 1. Do you think that future whistleblowers will be less likely to report corporate wrongdoing at Barclays? Whistleblowing programs—for the reporting of corporate wrongdoing–are only successful if they are based on trust. The whistleblower—the reporter–must be able to assume that the report will be considered fairly, and that no retaliation or stigmatization will be directed at the reporter. The program must encourage the reporting of corporate misconduct while protecting the identity of the reporter. In this case, the message was ignored and, instead, Staley went out of his way to identify the reporter, with the obvious intent to retaliate or undermine. Such a situation does not engender trust. This is a variation of the fallacious ad hominem strategy where, instead of listening to the message, the character and motive of the person delivering the message are attacked and questioned. 2. Do you think that Jes Staley’s penalty was appropriate or inappropriate? Why? Students may vary in their analysis. Some may argue that Staley lost his bonus, so he was financially penalized. Others will argue that the CEO represents the values of the organization. Because he was not forced out, Barclays’ board sent the message that his behavior was not inconsistent with the values of the bank. This may encourage others within the bank to also engage in inappropriate behavior. Students may argue that this is the first step on a slippery slope, so the punishment should have been much harsher: he should have been fired. 3. How do you think that Jes Staley should have behaved? Staley should have followed the bank’s protocols. He should have let the compliance office investigate the matter. He should have then followed whatever the board of directors recommended. He should not have tried to identify the whistleblower, nor have made the obvious attempt to harm the messenger and/or undermine the message. Furthermore, the following of preauthorized protocols would enhance the chances of employees reporting instances of corporate wrongdoing in the future. Without a trustworthy ethics program, the company is exposed to significant ethical and operational risks. Useful Articles, Links, and Videos See the Text. Freeman, R. Edward, and Lisa Stewart. Developing Ethical Leadership. Business Roundtable Institute for Corporate Ethics, 2006.

Workplace Ethics Cases—White Collar Crime

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9. Danske Bank’s Money-Laundering Scandal (Chapter 7, pages 608-610) What this case has to offer Money laundering is a pervasive problem that facilitates illegal activities and costs governments billion of dollars. This case explains how money laundering works and how employees are coerced or incented to become involved. The case allows students to think about ways to curtail the practice. Teaching suggestions I begin by asking students to define money laundering and to speculate on who would be interested in laundering money. I then ask them to speculate why bank employees would collude with money launderers rather than stop them. These questions lead into the discussion of ethical issues below. Discussion of ethical issues 1. What is the purpose of money laundering, how does it work, and why would people want to do it? Money laundering is “…designed to move wealth from weak currencies to strong ones or to move wealth obtained by crime into bank accounts that can be accessed for legitimate purposes, such as purchases of real estate in stable economies.” (Text, page 583.) It works, because bank employees can be bribed or coerced into cooperating with the money launderer. It works best in countries with poor banking regulations and weak enforcement of those regulations. Money laundering is used by people who have obtained their wealth from illegal or questionable activities, as well as by those who want to hide their money from government authorities, such as taxation agencies. 2. How would you characterize Danske Bank’s preparedness to identify and root out money laundering? Danske Bank was singularly ill-prepared to identify money-laundering activities: •

•

The Estonia branch had: o

poor internal controls.

a compliance attitude, not a questioning attitude.

its own IT system, operated independently of the bank’s main IT system, which means that the bank’s oversight system was flawed.

some employees who colluded with their customers.

The board of directors: o

chose to ignore internal warnings of wrongdoing.

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P a g e | 471 o •

put too much faith in the explanations of CEO Thomas Borgen, who had formerly overseen the Estonia branch.

Internal reports were delayed or ignored or not finalized or “laundered” to obfuscate their findings and risks.

3. Why were the bank employees not interested in pursuing money laundering? Students may speculate that the money launderers handsomely paid the bank employees or coerced them to collude. They may also speculate that because of lax enforcement of the laws by Estonia regulators, bank employees thought they would never be caught. Danske Bank may have compared the possible fine of $32,000 to the millions in fees garnered from money laundering and may have decided that the downside risk was worth taking. Therefore, the bank’s internal anti-money-laundering control system was kept impotent. 4. How would you characterize the bank’s governance system? Who should have identified the red flag warnings? As mentioned in the analysis of question 2, above, the branch had poor internal controls, and the board chose to ignore red flag warnings. It was the responsibility of the line managers at the branch level to ensure that branch employees were following the bank’s anti-money-laundering procedures and protocols. It was the responsibility of the board to challenge and question the explanations of the CEO, and not to ignore the complaints of a whistleblower. 5. Would strict enforcement of a “know your client” policy have thwarted the money laundering? Strict enforcement of anti-money-laundering procedures and protocols may have enabled the detection of potential problems and being able to address them before they became major international scandals. Strict enforcement may have caused money launderers to seek more “friendly” banks. 6. What policies should the bank put in place to identify and avoid money laundering? The bank should implement a series of procedures and protocols. It should: •

Ask in-depth questions of customers, including the source of the funds they are passing through the branch, the purposes of the transaction, and customers’ nationalities.

•

Identify and analyze the probable sources of the massive flows of funds through its banking system and through one of its smallest branches, in particular.

•

Check whether customers have been sanctioned for money laundering by governments in other jurisdictions.

•

Prohibit branches from having their own independent IT platforms.

•

Participate actively with international, police-sponsored anti-money-laundering programs.

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P a g e | 472 Useful Articles, Links, and Videos See the Text.

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10. QuadrigaCX—A Cryptocurrency Fiasco (Chapter 7, pages 610-612) What this case has to offer This case offers an opportunity to understand the cryptocurrency market, the risks inherent in it, the nature of its users and investors, the lack of proper controls and regulation to safeguard assets, and the dangers of virtual transactions from a verification, follow-up and audit perspective. This case brings new meaning to the phrase “Trust but verify,” which should really be “Verify first, and then trust.” Teaching suggestions I begin with a discussion of cryptocurrency, how it works, how it is stored and valued, and who and why people are attracted to it. This involves a discussion of money laundering and tax evasion, and perhaps reference to the Danske Bank Case (Text, pages 608-610). I then discuss what kinds of mechanisms, controls and processes should be in place before it is wise to invest funds, or to entrust your investment to a company or individual. I stress the principle that trust should never be given without thorough investigation (and what that entails). The background discussion leads to a discussion of the ethical issues involved in the case, and the following questions. Discussion of ethical issues 1. If you were a forensic accountant with EY, how would you proceed to: •

•

Ensure the client claims for currency recovery were legitimate? o

This question is relevant given the shady individuals who might be interested in cryptocurrency (crypto) investments. Such claims would have to be supported by receipts that could be matched with cash or crypto inflows, by size and date, from an analysis of QuadrigaCX hot and cold wallets, as well as proof of the invested funds’ origin (provenance).

Identity verification investigations.

Delay disbursement until all claims are known and assessed for duplication.

Discover where the cryptocurrencies QuadrigaCX had accepted went? o

•

The crypto network provides a tracking feature, but when funds transferred become co-mingled with other funds, knowing for sure if and what portions of the funds are used or transferred onward becomes difficult/speculative.

Recover any cryptocurrency rightfully owed QuadrigaCX? o

A subpoena can be issued to the crypto exchange to which the transfer can be traced. However, while the subpoena is enforceable in developed

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P a g e | 474 countries, it may be ignored in emerging countries where the rule of law is not as strong. o

A legal claim can be launched against any identified crypto exchange, but enforcement is not certain given the jurisdiction involved, and even then, the funds transferred may have been used, misappropriated, gambled away, or transferred back to the original exchange manager under a different identity through a different exchange (i.e., in this case back to Cotten or his associates).

Other?

2. What other procedures, investigations, or steps should a forensic accountant follow? •

Using DNA analysis, identify the remains buried in Nova Scotia as Mr. Cotten’s.

•

Monitor the activities of Cotten’s wife, who may be in touch with Cotten if he is still alive, and who may access “lost” funds.

3. If you were an investor: •

Why would you buy cryptocurrency and place it with an exchange such as QuadrigaCX? o

•

You would not unless you wanted to engage in extremely risky speculation. No normal financial or security controls were in place. The volatility of cryptocurrency is extraordinarily high, but the potential for disappearance adds additional risk.

What should you check out before using an exchange such as QuadrigaCX? o

Is the exchange regulated, and by which regulator? Is the exchange in good standing with that regulator?

Who are the principals (owners and operators), and are they upstanding citizens?

What are the exchange policies about trading with other exchanges outside jurisdictions which strictly observe the rule of law?

Is there a financial statement for the exchange and an audit opinion by an accredited auditor that you can review and check out?

Who has access to the crypto wallets, and are the internal controls sufficient to ensure the protection of your investment?

4. What missing pieces of evidence would prevent an audit from being completed successfully? •

Lack of paper-based evidence and traceable, owner-identifiable, electronic data

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P a g e | 475 •

Lack of traceability of customers and counterparties o An expert in forensic accounting commented, “In Quadriga's case, tracing transactions or confirming customer accounts would be a nightmare, since Quadriga funneled investment money into one giant mixer account (similar to [Bernie] Madoff [famous for his Ponzi scheme]). Cotten used a separate record keeping system on his computer issuing "Quadriga bucks" to investors. (Again, similar to Madoff, a separate system was used to track investor accounts.) The only person knew how many Quadriga bucks were issued, to whom they were issued, and what a Quadriga buck might be worth, was Cotten. In Quadriga's case, there was no connection between a particular investor's investment and his cryptocurrency holdings. Further, Cotten was also the only one who knew what was (or wasn't) in the company's ‘wallets.’”25

•

Potential inability to confirm/verify fund balances held offshore and/or in cold wallets

•

Accounting records and supporting documents

•

Financial reports prepared monthly, and timely reconciliations/investigations of any anomalies

5. If an audit could be completed, what would its value be in the case of a cryptocurrency exchange such as QuadrigaCX? •

A successfully completed audit (one with no qualifications) would lend reality to the nature and specifics of the assets and liabilities of the exchange, and indirectly provide a positive assessment of the worthiness of the internal controls and policies in place to safeguard the assets of customers and the exchange.

•

It should be noted that audits are not expected to find all frauds being perpetrated, but the audit process should examine for common fraud possibilities that represent audit risks.

6. Do you think that the new NOCLAR rules included in the IESBA International Code of Ethics for Professional Accountants will help such situations? •

The new NOCLAR standards mandate a reporting process for professional accountants who discover or suspect that their employer or client is not complying with laws or regulations in a significant matter. However, NOCLAR standards have not been fully adopted by many jurisdictions and may not be fully adopted in the future. If, for example, a jurisdiction adopts only the need to report within the employer or firm (as does Japan), and does not require external reporting (i.e., to a banking or securities regulator or stock exchange), and if the internal reporting fails

Ari Kashton, CPA, CA, CBV, IFA, CFF, CFE, CAMS, MFAcc, Toronto, Canada, personal communication with author, March 2020.

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P a g e | 476 to produce a correction/remediation, then the problems at QuadrigaCX would not become known to potential customers, and the public would not be protected as intended. In this case, there was no regulator to report to in Canada, and in many other jurisdictions around the world, whereas in the United States, the SEC regulates cryptocurrency exchanges. Also, in the QuadrigaCX case, reporting to the management would not have produced any benefit because they were involved or knowledgeable about the frauds. Of course, even where internal or external reporting may be effective, the professional accountant who discovers the noncompliance may not judge it to be sufficiently significant to report, or not have enough moral courage to report in the face of potential discrimination/stigmatization that could ensue. Useful Articles, Links, and Videos See the Text.

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11.

Walt Pavlo’s MCI Scams and Frauds (Chapter 7, pages 613-615) What this case has to offer

This case illustrates some of the techniques that fraudsters can use in order to hide their fraudulent activities. These include: •

kiting payments,

•

falsifying documents,

•

lapping payments, and

•

recording false transactions.

Students who want to become auditors need to know about these techniques so that, when conducting audits, they will be alert to signs of their presence. Referred to as ‘red flags’ these indicators may be internal control weaknesses in the firm’s accounting and/or operating systems. Teaching suggestions Have the students read the case in advance of the discussion. If any students have auditing experience ask them about the importance of internal controls, and how they would test the strength of an internal control system. If they encountered any problems or weaknesses in the system, ask them how they addressed these weaknesses. Discussion of ethical issues 1. What aspects of the schemes described in this case were a) unethical? b) illegal? c) fraudulent? a) There are a variety of ethical aspects to the case, including greed, deception and treating people as a means to achieve personal objectives. •

Walt’s deceptive accounting policies were designed to mislead his superiors into think that he was managing his department well. He was presenting false and deceptive information about the collectability of the accounts receivable and loans receivable. He did not care that his superiors were making important business decisions based on incorrect information.

•

Walt demonstrated greed. He stole from MCI and MCI’s customers in order to pay for a lifestyle that was beyond his means.

•

He treated people as a means to his end. Customers and his employer were used to further Walt’s narrow self-interest.

b) Contributing to false financial statements, stealing money that did not belong to him, and lying to the National Bank of Canada are all illegal activities.

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P a g e | 478 c) Fraudulent behavior, according to the Institute of Internal Auditors26, involves: “Any illegal acts characterized by deceit, concealment, or violation of trust.” According to the AICPA and PCAOB, “The primary factor that distinguishes fraud from error is whether the underlying action is intentional or unintentional.” 27 Consequently, all of the activities Walt was involved with wherein he purposely misled management or his employees or external parties, could be considered fraudulent. 2. When would a healthy skepticism by senior management or professional skepticism by an accounting or legal professional have been useful in combating the opportunities faced by Walt? Skepticism means that an individual does not accept explanations at their face value, but continuously challenges and compares what people say to other credible evidence. For example, an auditor could gather sufficient appropriate evidence to substantiate the explanations of the economic transactions of the firm. In the case of Pavlo’s accounting shenanigans, the auditors obviously did not gather sufficient evidence to substantiate the collectability of the accounts receivable and the loans receivable. Nor did they verify the veracity of the allowance for doubtful accounts. Management, on the other hand, may be more willing to accept the verbal explanations of subordinates. Nevertheless, management should maintain a skeptical mindset and periodically ask for some evidence to substantiate the activities of subordinates. In this situation, management should have asked for detailed explanations of the various programs that Walt was operating, such as the Rapid Advancement Program, and should have thought through the reality and risks involved for themselves. 3. Was the Hilby caper a victimless crime and therefore okay? “Victimless crime” is a euphemism to pretend that no one (that matters) is significantly harmed or that if the victim is not readily observable, then there is no victim. Pavlo and Mann cheated MCI out of $2 million that was owed to MCI by Hilby’s company Simple Access. MCI was not considered to be harmed by the Hilby caper because Pavlo and Mann assumed that MCI would not be able to collect anyway. Since MCI had already lost the receivable, it could not be a victim of further actions. MCI was not given any choice in this matter, however, and Pavlo took his salary on the basis that he would continue to collect MCI’s receivables. Ultimately the interests of MCI’s shareholder and creditors were jeopardized. Also, because Pavlo and Mann considered Hilby to be a ‘hustler’ they therefore considered him not to be a worthy victim of their illegal activity, and so they considered it to be a victimless crime. However, even hustlers are people and need to be treated as such. The reality is that there are no victimless crimes. Both hustlers and corporations can be victims.

International Standards for the professional Practice of Internal Auditing, Institute of Internal Auditors, 2004. 27 SAS No. 99, Consideration of Fraud in Financial Statement Audit, AICPA, New York, 2002, Rules 3200T and 3500T; PCAOB, 2004, 143-144. 26

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P a g e | 479 4. What ethical issues should have occurred to Walt and MCI in regard to the schemes described? The major ethical issue in this case is cheating, putting personal interest ahead of all other considerations. Walt was only thinking of himself and the lifestyle that money could buy. He gave insufficient thought to taking advantage of other people and organizations in order to achieve his self-centered goals. 5. What governance measures might have protected MCI if they had been in place and enforced? There are numerous governance mechanisms that might have prevented this fraud from occurring. •

Management is responsible for setting a positive ethical attitude. If the tone at the top is based only on self-interest, then employees will mimic that attitude and only look out for their personal welfare. The objective of management was to show high net income, regardless of the means, in order to make their stock options more profitable. A more balanced attitude, that profits are important but need to be generated in a legitimate fashion, might have helped.

•

Management needs to set realistic goals and incentive schemes that motivate ethical actions. Making the numbers is a worthwhile objective, as long as the budget numbers are reasonable. An unreasonable ceiling on bad debts and the allowance for doubtful accounts encourages employees to make the numbers by illegal and unethical means.

•

Management needs to listen to employees. Management is ultimately responsible for setting the budget, but management needs accurate and truthful input from subordinates in order to set a reasonable budget. Management at MCI was not willing to listen to Walt’s objections to the unrealistically low allowance that his department was being given.

•

Both internal and external audits need to gather sufficient appropriate evidence, rather than to accept management assertions at their face value. If they had thoroughly investigated the collectability of the accounts and loans receivable the auditors would have realized that extent of the bad debt and collectability problems.

•

Firms need to have clear lines of authority and responsibility and to make those well known. Bank lending agreements, such as the one Walt signed with the National Bank of Canada, need proper approval and authorization.

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P a g e | 480 6. What is the role of internal auditors in regard to such schemes? Depending upon the size of the firm and the internal audit staff, internal auditors have a variety of responsibilities. At a large firm, such as MCI, they would be responsible for evaluating the firm’s internal controls to ensure that they were not flawed and were operating effectively. This would include conducting routine consideration of the wholesomeness of and risk management protection afforded by company policies, and compliance audits of both the accounting and operating systems, especially the computer systems. Also, they would be responsible for ensuring that the financial statements are presented fairly. Because they are full-time employees of the company, internal auditors have the time and responsibility to gain an in-depth knowledge of the firm’s operations, internal controls and information systems. It would appear that at MCI, the internal auditors either (a) did not gain a sufficient level of expertise about the firm’s collection routines, or (b) did not have sufficient time and/or staff to conduct thorough compliance audits of Walt’s department, or (c) did not report concerns to an appropriate executive or to the Audit Committee of the board. Useful Articles, Links, and Videos Bashir, Martin (January 30, 2006) “Walt Pavlo: The Visiting Fellow of Fraud” ABC News, http://abcnews.go.com/Nightline/Business/story?id=1557957 Weinberg, Neil (October 6, 2002) “Aggressive Accounting: Ring of Thieves” Forbes, http://www.forbes.com/forbes/2002/0610/064.html

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Bribery & International Operations Cases 12.

Jail and a German Subcontractor (Chapter 7, page 615) What this case has to offer

This is a real-life example, with the names changed. The case is useful in pointing out the differences in legality and culture that executives can face in foreign countries. Companies must be aware of these differences and advise their executives accordingly. In turn, the executives must make sure that their employees and even their sub-contractors comply with the relevant local laws and customs, or else the company should pull out of the engagement. Teaching suggestions In a brief introduction to the case, I stress that foreign operations are not always in jurisdictions of lower levels of legality. A real effort should be made to find out and respect those aspects of foreign legal and ethical custom that are important and that do not offend the company’s corporate culture and values. Where they do offend the company’s culture, specific decisions should be made as to the company’s actions before problems arise. These decisions are necessary to prepare the executives in question as to how to respond to problems, and which executives to pick for foreign duty, based on a proper match of their values with the country or corporate culture to be followed. Discussion of ethical issues a) Is this a fair law? Question 1 asks about the fairness of the German law. The point of the question is that it doesn’t matter whether it is fair or not. Laws ignored or belittled, thus inducing employees and sub-contractors to ignore them, probably will trigger prosecution, and that should be expected. Arguing later that it is an unfair law usually has no positive affect. b) If you were Harold Johns, how would you ensure that Baranca executives and Baranca itself would never be vulnerable to such problems again? Question 2 gets the class thinking about how to prepare the executives and the company to keep out of trouble. This would involve actions such as: •

Collecting knowledge about local legalities and customs

•

Raising the awareness of executives and employees to the problem areas and to the recognition of sensitive areas

•

Design of a code of conduct that integrates desired behavior

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P a g e | 482 •

Sign off of the code by new employees and suppliers, and also annual sign off

•

Training sessions and other notifications to reinforce expectations of proper behavior

•

Verification that company policies were followed by internal auditors or other means

•

Inclusion in remuneration considerations

•

Linkage to strategic planning to consider long-run attractiveness of operation, and changes to the company’s overall code of conduct.

In addition to the issues dealt with above, students should be made aware of the comments by Tom Donaldson and Richard De George on guidelines and general principles of conduct (Text, Chapter 7, section Guidelines for Ethical Practice for Foreign Operations, pages 583-584). The readings (Text, page 594) by Donaldson and Roth are very good.

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13.

AIDS Medication in South Africa (Chapter 7, page 616) What this case has to offer

This case presents a dilemma that will confront directors and executives repeatedly in the future—the problem of political leaders who over-ride legally protected corporate property rights because of a declared national emergency. The nations involved will not always be from the developing world. The Canadian government decided (when faced with post-9/11 terrorism threats) to go ahead and manufacture an anthrax remedy (CIPRO) through a low-cost Canadian manufacturer instead of buying from a multinational (Bayer) at a higher price (and some delay). They later settled with Bayer, after strong urging. Corporations have the power of life and death tied up in their property rights, and politicians will be unable to resist the cry of their people for action. There is no effective world police force for the violation of corporate property rights at present. Legal rights will give way to human needs, unless corporations develop programs that are seen to be responsive and humanitarian, and political leaders develop an understanding that respect for property rights is warranted in the light of those programs. Political leaders have the power to change local laws to suit their perceived needs. As a result, students will realize that legal behavior is different from ethical and/or moral behavior. They will also realize the need for a long-term, corporate global strategy, rather than local, domestic or foreign strategies, and the need to preserve corporate reputation by doing— and appearing to do–the right thing for all stakeholders, not just current shareholders. Teaching suggestions I ask the students to read the case in advance. After recapping the case details, I ask the class to provide and discuss answers to the first two questions listed at the end of the case. Inevitably, the class is uncertain of the differences between moral and ethical behavior—some don’t see the difference form legal behavior either, but they are rapidly declining in number. To resolve the discussion over differences, I offer the class the following scheme for discussion: Legal behavior - compliance with laws—usually the difference between domestic and local foreign laws is quickly pointed out, leading to a discussion of the need for corporations to pre-determine their policy as to which they will follow. Moral behavior—compliance with morals—morals comes from ‘mores’ or habits in Latin. Here again the class will note the potential differences in domestic, local and foreign morals and the need for corporate strategy clarification. I also point out that morals/mores change over time—slavery was OK once, as was the persecution of certain religious groups, but not now. Ethical behavior—compliance with ethical standards: here I note that ethical behavior involves compliance with ethical principles. I like to have the class focus on the fact that ethical principles are relative, have changed /do change over time, and have shown a trend toward greater respect for the interests of stakeholders in regard to life and health. I like to point the class to the principles that are emerging along this trend line to focus on as ethical principles. richard@qwconsultancy.com

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P a g e | 484 A progression emerges from legal to moral to ethical behavior which is good for business folk to reflect upon. They would not build a plant based on a one-to-two year projection of conditions, so why should they create corporate strategy/policy on a short-term basis? It would be unsound. Discussion of ethical issues The answers to the questions posed at the end of the case are as follows: 1. Is it legal, moral or ethical for South Africa to override aids medication patents? See discussion above. Currently, legality depends upon the definition of a “national emergency.” However, the Government of South Africa can change their laws to make their interpretation legal. It would be illegal based on World Trade Organization (WTO) rules, but this is unlikely to be enforced except in the long term. I would say that as more and more nations override patents for humanitarian reasons, it will be considered both moral and ethical. 2. Is it legal, moral or ethical for drug patent holders to resist? While it may be legal, resistance without a humanitarian alternative program is likely to be considered immoral and unethical. While the costs of R & D need to be recovered and a reasonable return earned for shareholders, to induce them to continue to support innovation, new humanitarian programs must respond to real needs as they arise. Otherwise, drug patent holders will continue to lose in the court of public opinion. 3. If you were a senior executive in an affected drug patent holder, what solution would you suggest? Here, I am looking for a discussion of alternative humanitarian programs, and all ideas are welcome. Continual scan of the WTO and major drug company websites will provide access to their solutions. See also the Simmons and Lafraniere articles (below). Useful Articles, Links, and Videos Simmons, Anne M. (April 20, 2001). “South Africa, Manufacturers Settle Over AIDS Medication.” The Tech 121 (19), http://tech.mit.edu/V121/N19/aids_19.19w.html Lafraniere, Sharon (November 20, 2003). “South Africa Approves Plan to Offer Free AIDS Medication.” New York Times, http://www.nytimes.com/2003/11/20/world/south-africaapproves-plan-to-offer-free-aids-medication.html “Head-to-head: Aids drugs.” ( April 19, 2001). BBC News, http://www.simonbaker.me/2/hi/africa/1285677.stm Swarns, Rachel (March 12, 2001). “South Africa May Cite Crisis to Lower Cost of AIDS Drugs.” New York Times, https://www.nytimes.com/2001/03/12/world/south-africa-may-citecrisis-to-lower-cost-of-aids-drugs.html

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Risk & Crisis Management Cases 14.

BP’s Gulf Oil Spill Risk Management (Chapter 7, pages 616-620) What this case has to offer

This case documents how BP, their consultants, and suppliers mismanaged the risks leading to the extremely tragic 2010 Deep Horizon/Macondo oil spill. This is a good case to discuss the elements of a risk management system. BP’s risk management system systematically failed to assess, mitigate and monitor risks. This case is related to the following two other cases in the Text: •

BP’s Gulf Oil Spill Costs (Chapter 4, page 239), discussing the potential costs of the oil spill and whether it is possible to estimate all the relevant costs in a situation with a high degree of uncertainty; and,

•

BP’s Corporate Culture (Chapter 7, page 620), discussing the problems within the company’s culture and attitudes towards risk. Teaching suggestions

I start by asking students, “What are the elements of a comprehensive risk management system?” Following that, I list how BP failed to assess, mitigate and monitor risk—with disastrous consequences. Ultimately, it is interesting to try to figure out who was responsible for the oil spill and whether or not it could have been avoided if reasonable controls and safety measures had been in place. BP’s history of negligence is thoroughly examined in the PBS documentary The Spill, which I assign before beginning to discuss the case. Furthermore, the Final Report on the Investigation of the Macondo Well Blowout, prepared by The Deepwater Horizon Study Group (DHSG) in 2011, constitutes an excellent resource on the technical details and poor risk management practices that led to the crisis. Discussion of ethical issues 1. Why did BP fail its oversight and decision capabilities? BP’s history of negligence is thoroughly examined in the PBS documentary The Spill. There were some specific issues with the Macondo well project, mainly that the project was over budget in 2010, and several safety measures were skipped to cut costs. Moreover, safety issues were magnified by major technological challenges involved in deep sea drilling. In addition, there were several systemic issues that led to a continuous disregard to safety within the company: •

BP’s board of directors operated in a continuous “crisis mode.”

•

BP grew too fast through a strategy of mergers and acquisitions.

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P a g e | 486 •

BP took too many risks.

•

BP’s executives pushed for aggressive cost-cutting with little regard for safety.

•

There were strong stock-market incentives to keep cutting costs, even after Tony Hayward replaced John Browne as CEO.

•

Liability penalties were capped by the U.S. Government to encourage deepwater drilling in the Gulf of Mexico.

•

BP valued profits more than safety.

•

BP repeatedly ignored red flags, including the previous accidents at the Texas City refinery in 2004 and 2005, a leak at the company’s oil complex in Alaska in 2006, and the damages sustained by the Thunder Horse platform in 2005.

•

BP not only ignored a number of red flags, but also paid large amounts of money to potential whistleblowers to keep them quiet about poor safety practices that led to BP’s numerous accidents.

According to the Final Report on the Investigation of the Macondo Well Blowout, prepared by The Deepwater Horizon Study Group (DHSG) in 2011, the disaster was preventable and had its roots on a culture of complacency (page. 9): “This disaster was preventable if existing progressive guidelines and practices been followed—the Best Available and Safest Technology. BP’s organizations and operating teams did not possess a functional Safety Culture. Their system was not propelled toward the goal of maximum safety in all of its manifestations but was rather geared toward a ‘trip-and-fall’ compliance mentality rather than being focused on the Big-Picture. It has been observed that BP’s system “forgot to be afraid.” The system was not reflective of one having well-informed reporting, or just cultures. The system showed little evidence of being a highreliability organization possessing a rapid learning culture that had the willingness and competence to draw the right conclusions from the system’s safety signals. The Macondo well disaster was an organizational accident whose roots were deeply embedded in gross imbalances between the BP’s provisions for production and those for protection.”

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P a g e | 487 2. Describe your vision of a good risk management process that BP should have been following. 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

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P a g e | 488 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.”

3. What aspects of a good risk management process appear does BP not appear to have been using? BP’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 BP failed to properly assess the major technological challenges involved in deep sea drilling. The DHGS’ report (2011, page 11) summarizes some major risks resulting from deep sea drilling” “These operations pose risks (likelihoods and consequences of major system failures) much greater than generally recognized. The significant increases in risks are due to: 1) complexities of hardware and human systems and emergent technologies used in these operations, 2) increased hazards posed by the ultra-deep water marine environment (geologic, oceanographic), 3) increased hazards posed by the hydrocarbon reservoirs (very high potential productivities, pressures, temperatures, gasoil ratios, and low strength formations), and 4) the sensitivity of the marine environment to introduction of very large quantities of hydrocarbons.”

Moreover, BP ignored not only the inherent risks of its activities, but also the consequences of skipping safety measures to cut costs in the Macondo well project. The lack of risk management processes is described in the DHGS’ report (2011, page 86):

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P a g e | 489 “The available evidence does not indicate that any one person or group was keeping tabs on the accumulation of risks that accompanied the individual decisions and subsequent actions or inactions. Apparently it was concluded by those involved in this operation (BP, MMS, Transocean, Halliburton) that there were no significant challenges to safety. A realistic, rigorous Risk Analysis and Management (RAM) process and Management of Change (MOC) process (for changing modes from drilling to completion) appears not to have been performed. The result was a serious compromise of process safety.” Finally, BP repeatedly ignored red flags raised by previous accidents. •

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. BP failed to take several possible necessary actions to mitigate its risks, for example, meet or exceed industry safety standards. Moreover, the company showed that it had a poor crisis management system after trying several different approaches unsuccessfully to plug the well.

•

Problems with risk monitoring: BP’s management and board of directors failed to understand and monitor risks.

4. Has BP had other ecological disasters since 2000 that should have alerted the company to improve its risk management process? The company experienced at least three previous incidents that should have raised red flags regarding the deficiencies in the company’s risk management system: •

An accident at the company’s Texas City refinery in 2005, where 15 people lost their lives, over 180 people were injured, and the company spent $1 billion in damages, was preceded by another fire in 2004 and 22 employee fatalities over 30 years.

•

An oil leak in BP’s oil complex in Alaska in 2006, was caused by carelessly extending the lifetime of equipment, delaying maintenance, and inadequately training personnel.

•

A company’s oil platform nearly sank after a hurricane in 2006 as a result of careless technical work.

Useful Articles, Links, and Videos Committee of Sponsoring Organizations of the Treadway Commission (COSO) (2009). “Effective Enterprise Risk Management Oversight: The Role of the Board of Directors.” http://www.coso.org/guidance.htm [Link active in 2020; content is current not historical.] Committee of Sponsoring Organizations of the Treadway Commission (COSO). (2004). “Enterprise Risk Management —Integrated Framework.” richard@qwconsultancy.com

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P a g e | 490 http://www.coso.org/guidance.htm [Link active in 2020; content is current not historical.] Deepwater Horizon Study Group (DHSG) (2011). Final Report on the Investigation of the Macondo Well Blowout. http://ccrm.berkeley.edu/pdfs_papers/bea_pdfs/DHSGFinalReport-March2011-tag.pdf PBS. “The Spill [video].” 2010. http://video.pbs.org/video/1625293496/

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15.

BP’s Corporate Culture (Chapter 7, page 620) What this case has to offer

This case examines a number of weaknesses in BP’s corporate culture and a continuous disregard for safety practices. Moreover, it fosters the discussion of the factors that may motivate systemic issues within a company’s culture. This case is related to two other cases in the book: •

•

BP’s Gulf Oil Spill Risk Management (Chapter 7, page 620), discussing the failures in the company’s operating controls and risk management process. Teaching suggestions

BP’s history of negligence is thoroughly examined in the PBS documentary The Spill, at http://www.pbs.org/video/1625293496/ which I assign before discussing the case. I begin the discussion by asking students whether companies that act unethically in one case will likely continue doing so in other cases. Three additional questions that are central to the discussion of this case are: What happened? How did the company allow such big issues to continue unnoticed? How could the company change its culture after the Gulf oil spill? Discussion of ethical issues 1. Analyze whether BP’s corporate culture was ethical. The PBS documentary highlights several issues that shaped a culture of unethical standards and continuous disregard to safety within the company: •

BP’s board of directors operated in a continuous “crisis mode.”

•

BP grew too fast through a strategy of mergers and acquisitions.

•

BP took too many risks.

•

BP’s executives pushed for aggressive cost-cutting with little regard for safety.

•

There were strong stock market incentives to keep cutting costs, even after Tony Hayward replaced John Browne as CEO.

•

Liability penalties were capped by the U.S. Government to encourage deep water drilling in the Gulf of Mexico.

•

BP valued profits more than safety.

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P a g e | 492 •

BP not only ignored a number of red flags, but also paid large amounts of money to potential whistleblowers to keep them quiet about poor safety practices that led to BP’s numerous accidents.

•

BP repeatedly ignored red flags, including: o

An accident occurred at the company’s Texas City refinery in 2005, where 15 people lost their lives, over 180 people were injured, and the company spent $1 billion in damages. This accident was preceded by another fire in 2004 and 22 employee fatalities over 30 years.

An oil leak in BP’s oil complex in Alaska in 2006 was caused by carelessly extending the lifetime of equipment, delaying maintenance, and inadequately training personnel.

A company’s oil platform nearly sank after a hurricane in 2006 as a result of careless technical work.

The Macondo well project in the Gulf of Mexico was over budget in 2010 and several safety measures were skipped to cut costs.

2. Why has BP`s culture developed as it has? There could be several factors influencing BP’s culture: •

Lack of ethical leadership and clarity about the importance of safety as a fundamental value for the company

•

Quick growth through mergers and acquisitions created a large and complex organization dealing with difficult technical issues such as deep-water drilling.

•

A vision to “be the first” in deep water drilling

•

Management is narrowly focused on short-term profits: o

Strong stock market pressures to deliver short-term profits

Short-term-oriented executive compensation

•

The company outsourced some of the technical tasks to other companies, and BP’s executives might have thought that outsourcing somehow shielded BP from repercussions.

•

A misguided understanding of business and ethical immaturity

•

Soft penalties or weak enforcement by the US Environmental Protection Agency (EPA) and other regulatory bodies

3. How would you suggest changing its culture?

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P a g e | 493 As explained in Chapter 5, appropriate guidance reinforced by feedback mechanisms must be given to management, and that must be reinforced by an ethical corporate culture, or else management can honestly say that no one told them what boundaries they should be operating within. This guidance will influence the preparation of financial reports and other sources of feedback and, also, the behavior exhibited in dealings with customers, employees, and other stakeholders. People make things happen, so it is essential that their motivations are aligned with stakeholder expectations, which can only be reliably accomplished by ensuring that the values underlying corporate motivational elements (i.e., corporate culture, codes, policies, etc.) are similarly aligned. A number of things have to change within the company: •

Management needs to change its attitude towards operating controls, including their views on safety. The company should not try to downplay any red flags that point out new operational risks after this major accident.

•

The company’s code of conduct should highlight the need for change of ethical standards.

•

Management should make a strong statement that this situation will be resolved and should take the necessary steps to reform the company’s reputation.

The company needs to invest in safety measures and commit to meet or exceed industry standards. •

The company should establish a strong foundation for monitoring of internal controls, including: o

Require support from top management (tone at the top).

Assign monitoring roles to people with appropriate capabilities, objectivity and authority.

Set a starting point or “baseline” of known effective internal control from which ongoing monitoring and separate evaluations can be implemented (for example, “meet the industry safety standards”).

Design and implement monitoring procedures focused on key controls that mitigate risks.

Assess and report results, including the evaluation of the severity of any identified deficiencies, and the reporting of monitoring results to the appropriate personnel and to the board for timely action and follow-up if needed.

It is not easy to remediate severe weaknesses in the company’s culture. It takes managerial leadership and significant time and economic resources. From the pure

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P a g e | 494 cost-benefit perspective, the company has already suffered significant economic losses as a result of this accident. 4. What roles should the CEO and the Board of Directors play in making this change? The Board of Directors has the responsibility to oversee the company’s management in developing and implementing a turnaround program to change the company’s culture, to ensure that management commits to meet or exceed industry operating standards, to monitor management’s risk-taking behavior, and to set an appropriate compensations scheme that effectively balances motivation to deliver profits and risk-taking behavior. The CEO must set the tone from the top, be vocal about, and demonstrate, the ethical corporate culture and ethical values the corporation or organization expects. If this is not done, employees will take the view that the only value that matters is making a profit. If the executives or leaders are silent on ethical matters, even if they are personally ethical, their reputation will be at considerable risk, as will be the corporation’s. 5. How could this change in culture be measured? One way to measure the change in culture is by conducting an extensive investigation that determines the main issues and maybe benchmarks the company against some desired target (e.g., in general “be a responsible company that exceeds industry standards”). First, the company can compile a list of issues, identified after the investigation, and rank them according to their importance (e.g., high, medium and low). Following that, the company can develop a detailed action plan to remedy every issue, including the time and resources necessary for the remediation; and finally, the company needs to report on the progress of the remediation effort at the appropriate levels of authority and ultimately to the Board of Directors. Useful Articles, Links, and Videos Committee of Sponsoring Organizations of the Treadway Commission (COSO) (2009). “Effective Enterprise Risk Management Oversight: The Role of the Board of Directors.” http://www.coso.org/guidance.htm [Link active in 2020; content is current not historical.] Committee of Sponsoring Organizations of the Treadway Commission (COSO). (2004). “Enterprise Risk Management —Integrated Framework.” http://www.coso.org/guidance.htm [Link active in 2020; content is current not historical.] Deepwater Horizon Study Group (DHSG) (2011). Final Report on the Investigation of the Macondo Well Blowout. http://ccrm.berkeley.edu/pdfs_papers/bea_pdfs/DHSGFinalReport-March2011-tag.pdf PBS. “The Spill [video].” 2010. http://video.pbs.org/video/1625293496/

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16.

Toyota’s Recall Problems (Chapter 7, pages 621-624) What this case has to offer

This case is an example of a major company handling an ethical crisis that will have an immense impact on the company. Many would argue that it was not handled optimally, so there are many lessons to be learned. The case is about the integrity of a corporation and how that integrity should be defended, protected, and managed during a crisis and in normal times. Teaching suggestions A good way to start the case discussion is to inquire if anyone in the class owns or drives a Toyota. Then you can ask if they have been or are concerned about their safety, and why. After that, the questions laid out below can be asked. This case is a good one to use to illustrate the stages of a crisis as discussed in the Text, Chapter 7, e.g., Figure 7.11: Phases of a Crisis). Discussion of ethical issues 1. Did Toyota handle its recalls ethically? Why and why not? Toyota was slow to respond to complaints and to develop specific recall programs. In the case of the allegations of stuck gas pedals and/or faulty accelerator linkages, the company did not effectively counter the many harrowing stories of jammed gas pedals, so the prevailing opinion was that the company was guilty or did not have a plan to check into the allegations further. In any event, public opinion surged against Toyota before meaningful response was made. The delay was unethical in the sense that many stakeholders lost confidence and became afraid of driving their Toyota. Shareholders suffered lost value. To the extent that this delay was due to poor or secretive communications practices, it was unethical. On the other hand, the company should not have responded so quickly that they were not ready to deliver on a plan for investigation. That would have been unethical. Actually, to the extent that Toyota did not have a data collection/early warning system, and a plan for rapid and effective investigation with appropriate feedback, their preparations and the resulting delay were unethical. 2. What changes would you recommend to Toyota’s crisis management approach? Why? An effective crisis management approach depends upon a rapid and effective response to control the problem, minimize the impact, and begin remediation of damaged reputation. Pre-planning is essential (see above) so that early red flags can be quickly reacted to and investigated. If Toyota had known about the existence of the “black boxes”, they could have announced that they would begin an investigation immediately. They could have released results early so that the mounting stories would have been countered rather than let grow in impact. Observers would have seen that they were taking effective action and that the results did not reflect poor Toyota safety practices. Confidence would have been restored. One of the question marks is whether Toyota’s secretive culture resulted in a slow transmission of data to top executives, or whether the top executives were

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P a g e | 496 reluctant to react quickly rather than stonewall (as was the old recall practice). If any of these was the case, then the governance structure should be changed. 3. Do you think that Mr. Toyoda’s testimony on February 24, 2010 was effective? How might it be improved? Yes, I do. He was contrite, and took the blame, with a potential explanation and a pledge to do better, and to restore the company’s good reputation. This approach was not likely to find favor with Mr. Toyoda’s old-line predecessors, but he did a good job. In the old days, the motto was, “Never complain and never explain.” But that approach doesn’t work anymore—it just makes matters worse. One point of improvement could have been a reference to the black box investigation and its findings. 4. Toyota did not immediately disclose that each car carried an airplane-style “black box” that recorded details on how the car was functioning. Was this timing appropriate? I would argue that the existence of the black box should have been disclosed earlier, but if the data had proven that Toyota was at fault, then the lawsuits might have been stirred up and damning evidence provided. Such evidence would likely have ultimately come out anyway. 5. What possible reasons could account for Toyota’s delay in advising the NHTSA of the problems known on September 29, 2009? Several reasons could account for the delay in reporting: •

A belief that the faults were driver-related, not auto-related

•

A desire to gather more evidence before reporting unnecessarily

•

A culture of stonewalling and secrecy

•

Lack of compelling evidence to report

•

Misunderstanding of the need for quick compliance—possibly due to the low penalties for not complying

•

Toyota engineers had included a very difficult-to-ignore warning attached to the winter mats (sold to new car buyers) not to double-stack a winter and a summer mat or the gas pedal would stick, so they may have considered that they had dealt with the problem. Note: The author bought a 2009 Toyota Camry Hybrid in March 2009 and encountered significant difficulty in detaching the warning from the winter mats.

•

Legal advisers may have counseled a delay in compliance to reduce legal costs.

•

Incentive schemes may have incorrectly penalized bringing such disclosures forward.

6. Can Toyota recover from these recall problems? If so, how long will that take? What would Toyota have to do to recover fully? richard@qwconsultancy.com

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P a g e | 497 Toyota can recover, but only if it can restore its reputation for trustworthiness and safety. Customers who would have bought a Toyota, may have switched to another brand, and will not come back for many years until they buy another vehicle. Toyota may be able to come back with a stronger reputation than before if (1) the evidence that is emerging can be used very effectively, and (2) confidence is restored in the company’s investigative processes, safety-minded culture, and its reputation. This would require an aggressive approach to dealing with the problems. Perhaps such an approach will emerge after the production headaches associated with the Japanese earthquake and nuclear disasters have subsided and production is available for sale. People both inside and outside Toyota must once again respect Toyota’s integrity and believe that its priorities really are: “First, Safety; Second, Quality; and Third, Volume.” Useful Articles, Links, and Videos Costello, Tom (April19, 2010). “Toyota to pay record $16.4 million recall fine [video].” NBC News, http://www.nbcnews.com/id/36634661/ns/business-autos/ Decker, Jon (March 9, 2010). “Runaway Prius in California [video].” Reuters, http://www.reuters.com/video/2010/03/09/runaway-prius-incalifornia?videoId=54378733 Akio Toyoda, Prepared Testimony of Akio Toyoda, President, Toyota Motor Corporation, February 24, 2010, http://www.toyota.co.jp/announcement/0224_2.pdf The complete transcript is downloadable from www.cengagebrain.com in Digital Resources for Chapter 7.

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17. Digoxin Overdose—The Need for Skepticism, Courage, and Persistence (Chapter 7, pages 625-626) What this case has to offer This case is about what is required to prevent and mediate many crises. It describes a tragic crisis that took some time to unfold. If any of the people in the chain of action (and therefore chain of decision making) had done the job expected of them, in terms of the following characteristics or virtues, the baby would be alive today: •

Doctor—accuracy, skepticism, due care

•

Resident—accuracy, skepticism, due care, persistence

•

Pharmacist—skepticism, persistence, due care, accuracy

•

Technician—skepticism, persistence, due care

•

Nurse 1—skepticism, persistence, courage, due care

•

Resident on call—competence, accuracy, skepticism, due care

•

Nurse 2—skepticism, due care

After the original mistake was made, six other people had a chance to correct it and failed to do so, although two were quite concerned (Pharmacist, Nurse 1). Prevention and mediation of crises often depends on finding and rectifying problems before they become critical. That in turn depends upon the actions of people with competence, a skeptical mindset that is always questioning actions, motivations and outcomes, as well as the courage to raise concerns and to stick to their guns in the pursuit of the correct answer. It is incumbent on leaders to encourage their people to have and demonstrate these characteristics and mindsets. Moreover, it is incumbent on corporations and other organizations to develop cultures, policies and practices that will prevent such tragedies. Teaching suggestions An interesting way to start the discussion would be to ask which of the people who made decisions had a chance to correct the problem before it became critical. That would lead to the list above. Then the class could be asked, “Which of the people in the chain were most to blame?” This would provoke a debate that would show that all those who were competent had a primary responsibility. At this stage the class could be asked why each of the people in the list failed to stop the tragedy, and the list of missing characteristics could be developed. Then, based on this background, the questions at the end of the case could be answered.

Discussion of ethical issues

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P a g e | 499 1. What should the individuals involved have done? They should have exercised adequate or due care to ensure the calculations were accurate, and if they weren’t convinced, they should not have done their part of the process until they were, even if this meant going back to the original doctor with a specific request pointing to their correct calculation. Many were partially skeptical, but didn’t discharge their full responsibility, perhaps because of a lack of understanding, or of persistence, or of courage. 2. How can the Hermann Hospital ensure that individuals do what they should? Training sessions, examples—both positive and negative, constant encouragement, a supportive culture, and discipline and punishment where appropriate. 3. Should the doctor, residents, pharmacist and nurses involved in this tragedy be fired? If not, should they be sanctioned, and if so, how? This should provoke a good debate that should expose the following issues: •

People make mistakes, so firing is too harsh a punishment in this case unless the individual has a record of mistakes.

•

The tragedy is too horrific to ignore, so some heads will have to roll, but which ones, and what will be the impact on others?

•

Individuals involved will suffer enough, would not make another mistake like this, and therefore don’t need to be fired.

•

Light sanctions, such as suspensions with or without pay, would allow the individuals time to think about their shortcomings and would signal to the rest of the hospital a reminder about the hospital’s values.

•

The hospital’s culture and policies were the real culprits because they did not make it mandatory to obtain a definite answer that gave comfort to the questioner. Nor was there reference to a chief resident or doctor-in-charge, in the case of lingering concern.

4. Should such health care failures be made public? I would argue yes, because of the positive impact on the rest of the health workers who would take greater care and exercise greater diligence, and other hospitals would improve their culture and policies so that best practices would improve. Also, the public have a right to know about the record of a hospital, if not the individuals, so they can make informed choices when seeking health care. This would contribute to the improvement of health care, even though it would add pressure to the people involved in this decision. I would, however, not disclose to the public their names. This was a mistake, and unless people are charged, the individuals should be protected.

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18.

The Exxon Valdez (Chapter 7, pages 627-630) What this case has to offer

The Exxon Valdez case presents the story of a legendary environmental tragedy. It offers an opportunity to review the multiplicity of problems that often incredibly occur when a crisis hits. In this case, negligence and unpreparedness are evident on shipboard, in Exxon’s HR policies and oversight; in Alyeska, the oil spill recovery consortium; by the Coast Guard; and by the government decision makers. If any one of these had been up to their intended task, the disaster could have been avoided or its impact minimized. The case allows examination of the costs of the disaster relative to its prevention or early remediation. The tragedy led to the creation of the Valdez Principles. Originated by activist environmental groups, they later became the CERES Principles, while the CERES group went on to do well on a broader activist mandate. Codes and their effectiveness are also reviewed in relation to the prevention and resolution of crises. In addition, whether drunkenness (or drugs) on personal time should be allowed to be cause for keeping an employee from his/her work or instituting substance-abuse testing can be discussed. Teaching suggestions/Discussion of ethical issues I would suggest giving a brief introduction to the class discussion that covers the material in the paragraph above. 1. Who was responsible for the accident? 2. What were the responsibilities of the company, the government authorities, and the employees of the company, that were not properly discharged?

Question 1 is intended to provoke debate on the relative responsibilities involved in the tragedy and to tease out the responsibilities not properly discharged that are called for in question 2. I try to ensure that the class comes to the view that the Captain (for his lack of supervision) and particularly Exxon (for its lack of action and oversight) were primarily at fault. In particular, the aspects of negligence that should be brought forward are: •

Captain—failure to provide adequate supervision on shipboard

•

Exxon failed to: o

act on knowledge of captain’s loss of drivers license for drunkenness

keep Alyeska in a sufficient state of readiness

have pre-approval for use of dispersant

assess the full risk in the tanker routes chosen

double hull their tankers

•

Alyeska failed to maintain sufficient readiness and effectiveness

•

Coast Guard failed to:

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•

staff fully (radar and pilots)

monitor traffic routes

U.S. government failed to: o

supervise Coast Guard

invest in workable effective radar

make decisions on dispersant quickly enough

3. Should Exxon abide by the Valdez Principles? Answers will vary for question 3. Initially the reactions by companies asked to sign off on the Principles, and commit to observing them, were based on caution, because many feared: •

commitment to public release of environmental information prior to an inventory and understanding of the company’s record and exposures

•

uncertainty about what was meant by sustainable use of natural resources and concern over whether it could be attained

•

commitment to disclose harm caused, thus leading to more, and higher, damage claims

•

intrusion into the Board of Directors of someone not in the “club”

•

annual assessment and audit, and a public report, all of which would cost money and possibly create liability

Exxon was no exception, and they refused to sign. It should be noted that observance of the Principles without signing off and public disclosure is an option that many companies have followed because the Principles provide a great framework for managing a company’s environmental interface. Others have signed on when they made a risk assessment and got their house in order. 4. Could a better code of conduct have prevented this accident? No, not without an effective ethics program involving awareness, training, reinforcement including top management support, sanctions, integration in strategic planning and operating decisions, and other means to ensure observance of the code. 5. If Exxon had known, before the accident, about the captain’s alcohol problem, what actions should have been taken, if any? In fact, Exxon did know and did nothing. Some students will argue that what the captain did on his own time was his business. However, given the serious harm caused to the environment, a stronger argument is that Exxon should have acted to ensure that the public interest was protected even if the captain’s personal rights would have been tampered with.

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P a g e | 502 It is interesting to note that Exxon instituted a worldwide policy as a result of the Exxon Valdez disaster whereby staff are randomly but periodically tested for substance abuse. If they fail the test, they are suspended from their job and are assigned to a lessexposed position, and must take a remedial program. If they complete the program successfully, they may resume their job in seven years. Exxon has retained this policy even though it has been considered unreasonable in some jurisdictions. Exxon should have: •

removed the captain, or had an overseer on hand to check on him, on his crew and practices

•

made sure Alyeska was ready to be deployed

•

had a crisis management plan that included:

•

prior government approval for the use of dispersant and other possible contingent activities

risk assessment and pre-planning for problems

considered double hulls for its high-risk oil tankers

Another issue that should be considered is the high cost of cleaning up. The fines and clean-up are only part of the total cost that should include lost gross margin on sales that could not be made to angry consumers. In addition, it should be noted that the CEO of Exxon committed a big public relations gaff when he publicly announced the company’s estimate of the total cost, but then declared that it, of course, would be deductible for tax purposes. He did not realize that this implied that the public were going to pay for the Exxon disaster in the amount of the reduced taxes. This did not sit well with many who were already angry. Update/Subsequent events June 1, 2006

From “Exxon asked to pay more to clean spill.” (June 2, 2006). CNNMoney.com, http://edition.cnn.com/2006/US/06/01/exxon.valdez/index.html The Justice Department and the state of Alaska “…asked [ExxonMobil] to pay another $92 million to further clean up shorelines … which still contain oil from the 1989 Exxon Valdez oil spill”: “The action was taken under a provision in a $900 million damage settlement in 1991 allowing the government to reopen the agreement in 2006 to consider issues unforeseen at the time.”

Dec. 22, 2006 Appeals Court reduces damages to $2.5 billion June 25, 2008 Supreme Court vacated the $2.5 billion damages and sent the case back to a lower court for re-determination, and limited punitive damages to the compensatory damages of $507.5 million. Useful Articles, Links, and Videos

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P a g e | 503 “1999: Exxon Valdez, 10 Years Later.” (May 25, 2010). CBC 60 Minutes, https://www.cbsnews.com/video/1999-exxon-valdez-10-years-later/ Stephens, Joe (July 14, 2010) “Lessons from Exxon Valdez spill have gone unheeded” Washington Post, http://www.washingtonpost.com/wpdyn/content/article/2010/07/13/AR2010071306291.html?wprss=rss_print/asection Vicini, James (June 26, 2008). “Exxon Valdez $2.5 billion oil spill ruling overturned.” Reuters, http://in.reuters.com/article/idINWBT00926720080625 Church, George (April 10, 1989) “Exxon Valdez: The Big Spill.” Time, http://content.time.com/time/magazine/article/0,9171,957429,00.html Exxon Valdez Oil Spill Trustee Council [website providing updates]: http://www.evostc.state.ak.us/ “Exxon Valdez Oil Spill.” (2017). Wikipedia, http://en.wikipedia.org/wiki/Exxon_Valdez_oil_spill

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19. The Brent Spar Decommissioning Disaster (Chapter 7, pages 630632) What this case has to offer The Brent Spar oil storage vessel decommissioning story is one that shows how a company can get into a crisis without expecting it, and can make it worse in a hurry because it doesn’t understand what it’s up against, and how to manage a crisis. Shell UK was dealing with public outrage caused by a very adept Greenpeace team that used the TV to turn public sentiment to its advantage. The outrage spilled over to incite the Germans and French (not the Brits) to riot, damaging Shell stations and causing a boycott that lost at least 50% of one month’s sales. Shell UK was handling a problem that took on global proportions, apparently without input from Shell’s head office in the Netherlands, or from Shell executives in Europe. They forgot that they were in a global marketplace, with stakeholders outside the UK whose support Shell needed. Shell found that it wasn’t able to combat Greenpeace’s hold on the media and the public until it created a website on which it put its research for all to read— unvarnished and uninterpreted. Also, the solution Shell finally came up with showed moral imagination, but it came too late: it should have come earlier. In the end the Brent Spar became a support for a new pier in a fiord, a use for which it was admirably suited. In the end, as well, Greenpeace admitted it had misled the public with erroneous reports. The case holds many revelations for the class, and we have a good time with it. Teaching suggestions/ Discussion of ethical issues 1. What would you have done if you were calling the shots at Shell UK? When? Actions of Shell UK With regard to question 1, I use the case on a surprise basis (no prior reading) if I can, and, using an overhead version of the case, only let the class read up to the date at which I want them to react. Then I get their reactions, and we read on, up to the next date that I want their reactions. This step-wise progress shows the students what foolish choices were made, how Greenpeace used the media, and how Shell really didn’t try to combat this influence. I have the class read only up to May 5, then to May 19, and finally to June 14th and ask them what they would do next (after each date) if they were the executives in charge of Shell UK. We then read to the next date and assess why their conclusions were wrong or right before asking what their next action would be. If I cannot use surprise, then I ask the class to comment on Shell UK’s actions after May 5, May 29, and June 14th as to what went wrong. They raise the issues I note in the opening section, or I tease them out.

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2. What would you have done if you were calling the shots at the parent Shell head office? Actions of Shell Head Office For a discussion of question 2, I ask the class what they think. Usually they suggest that Head Office insist that Shell UK take advice to consider a worldwide stakeholder view, or transfer the decision making to Head Office. This was, however, counter to the autonomous regional culture that Shell operated under and which resulted in a reluctance to interfere with Shell UK until the full impact of this tragedy was analyzed, well after the crisis had passed. Subsequent analysis led to a revision of the Shell approach to handling crises worldwide, to build in broader consideration of stakeholders, the lessons learned in this crisis, as well as Shell’s crisis in Nigeria. Further Discussion of ethical issues Greenpeace created outrage This is a favorite tactic of special interest groups, some of which have been known to bend the truth, only to admit it later after the company has responded or the crisis has passed. The public should react with skepticism at all times, but it does not, particularly when the special interest group is controlling the TV video news and the company is unable or not ready to respond. Lesson: A company must be able to respond very quickly with a credible explanation/facts to refute unwarranted claims. Once it loses the trust of the marketplace reclaiming it is very difficult. The degree to which the company and its spokespersons have developed credibility with the media and public will provide a window of time or tolerance for the company to react. But the record must be set straight quickly, or the company is going to have to deal with outrage on the part of the public. Some students suggest that the company should meet with Greenpeace. Others will indicate that if Greenpeace needs a high-profile case to stimulate financial support, then it may not agree to meet, or the meeting will not produce any positive effect. Shell needed a website Only when Shell put its scientific research on a website for all to read—uninterpreted by the press–did the controversy begin to subside. For effective crisis management, it would be wise to have such a mechanism in operation in advance. Moral imagination This is an important issue that the class should be sensitized to. Management should push and probe very hard to make sure they understand the best options that moral imagination can develop before the crisis develops, not after. Using moral imagination should be an important part of the decision process. Crisis management

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P a g e | 506 This is an excellent case for showing how a company could have vastly reduced the impact of the crisis by early recognition, pre-planning, recognition of the need for wide stakeholder consultation and support, and effective information mechanism to greatly reduce the negative impact to the company. Did top Shell UK management really think that they could quickly dispose of the Brent Spar without anyone noticing? Did they have any sense of what the reaction would be in Europe? Why not? Perhaps theirs was not a full stakeholder model of management. Useful Articles, Links, and Videos “Brent Star Dossier” Shell UK, http://wwwstatic.shell.com/static/gbr/downloads/e_and_p/brent_spar_dossier.pdf [See comment below.] In recognition of the need to change Shell UK’s approach in its operations, the company created a dossier which provides historical archives of the decommissioning of the Brent Star, press releases and articles published during the disaster. [In 2017, information on this website became difficult to find.] “1995: Shell makes dramatic U-turn.” (June 20, 1995). BBC News, http://news.bbc.co.uk/onthisday/hi/dates/stories/june/20/newsid_4509000/4509527.st m Rohrer, Finlo (Aptil 24, 2008). “The right way to do a U-turn.” BBC News, http://news.bbc.co.uk/2/hi/uk_news/magazine/7364532.stm

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20.

Crisis at Wind River Energy Inc. (Chapter 7, pages 632-634) What this case has to offer

This case involves the relatively frequent occurrence of multiple crises happening at more or less the same time. This forces the decision makers to sort out which are the more important and solve those first, and/or get out of the way smaller easier to solve and concentrate on the worst dilemmas. Some of the details are real, and particularly crawling around in a tight pipe on the other side of a door from a watery death is sure to raise emotions in the class as they read and solve the case. In addition, the class will realize the high value of prepreparation and the development of contingency plans. Teaching suggestions/ Discussion of ethical issues Although role-playing could be effective, I would ask the class to recap the case, and then to consider the following questions, in sequence: a) What are the crises that Lynn faces? b) What order should the crises be considered in? (i.e., which are the most serious?) Why? c) What solutions can they offer? d) How would they guard against and prevent such crises in the future? After discussing these questions, question 1 in the Text (1. What would you do if you were Lynn?) can be posed. a) What are the crises that Lynn faces? Lynn faces the following crises by Thursday: •

Toronto - An IPO is being prepared for launch one week away, but representations are needed by next Tuesday on the excellent status of the company of the IPO may be deferred or cancelled.

•

Freeman, Alberta—is facing a lack of electricity: o

A hydro generating station intake pipe was closed for clearance of a blockage but, although the blockage was now clear, one of the hinge pins for the water intake door was jammed, so the door would not open, thereby rendering the station inoperative.

Lightening struck the windmill energy transformer station, resulting in intermittent power flow.

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P a g e | 508 •

Ontario hydro station: o

The input pond was judged to be stagnant and a possible breeding ground for mosquitoes that could spread West Nile virus. The plant was to be closed.

West Fork, Alberta: a contract had just been signed to provide power, and the mayor was calling to check rumors that Wind River’s fine reputation for reliability was in doubt. The whole deal might be jeopardized if the truth reaches the mayor.

b) What order should the crises be considered in? (i.e., Which are the most serious?). Why? Generally, the crises that should be ranked as worst are those that can negatively impact life and health, followed by other impacts, including financial. This approach to ranking is likely to match what the media and public prefers, and what will minimize impact on reputation and future lawsuits. This approach suggests that the West Nile virus problem should be ranked first, followed by the need for power in Freeman. The IPO and West Fork crises will require the other problems to be solved first, as well. c) What solutions can they offer? Here the class will demonstrate their ingenuity. Here are some suggestions: •

West Nile virus issue: Many communities have been spraying a substance, deadly only to the virus-carrying mosquitoes, into storm drains and stagnant water sources. Why not arrange for the local municipality or the government to spray some of this into the intake pond until your chief engineer could arrange for a pump to circulate the water?

•

Freeman’s electricity o

Ask your manager to check if the local mines could cut back their power usage or turn on their emergency generators. Also, could Freeman’s old generators be turned on, or could Freeman be connected and draw power from to Alberta’s electric grid? Any of these will buy time until repairs are made.

Ask for someone thin to take a camera back into the pipe to take digital pictures of the stuck hinge pin and email them to you in Toronto, and to an engineering consulting firm you will name. They and your hydro managers will determine if there are tools that the small person could use to fix the hinge pin situation. A video hook-up could also be used for getting live pictures to consultants on the surface.

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P a g e | 509 •

Relations with the Mayors and the IPO team It is best to advise these folk of your problems before they find out from another source. You will retain your reputation for honesty and truthfulness, and you may gain reputation with regard to dealing with problems effectively.

d) How would they guard against and prevent such crises in the future? •

•

Pre-planning o

Back-up engineers, consultants, plans for disasters

Emergency phone arrangements

Other suggestions

Chapter 8—Subprime Lending Fiasco—Ethics Issues Chapter Questions and Case Solutions richard@qwconsultancy.com

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Chapter Questions..................................................................2 Case Solutions.........................................................................7

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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: it 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 over-leveraged, whereas 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 constrain unbridled self-interest by broadening the decision maker’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

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P a g e | 512 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 to 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 Mae 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 International Group (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 the ethics case, Mark-to-Market (M2M) Accounting and the Demise of AIG, in Chapter 8 of the Text.) 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? richard@qwconsultancy.com

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P a g e | 513 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, and Disaster, in Chapter 8 of the Text.) The problem with executive bonuses is that the link between managerial effort and the firm’s success or failure is often difficult to see and measure. There are many exogenous factors that influence firm performance, and which of these factors were and were not within the control of management is not always clear. 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 you 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 mortgage-backed 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 based on false, misleading or deceptive information. 10. Are the criticisms that mark-to-market (M2M) accounting rules contributed to the economic crisis valid? See the discussion of the ethics case, Mark-to-Market (M2M) Accounting and the Demise of AIG, in Chapter 8 of the Text, for a full analysis of the link between mark-tomarket accounting and the economic crisis.

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P a g e | 514 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 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? Should enforcement be global or by 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. Therefore, Enforcement could be by country, with global cooperation. 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: richard@qwconsultancy.com

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Bator, Paul (July 21, 2010). “Does FinReg Address the Material Issues Surrounding our Nation’s Financial Crisis?” The Raddon Report, http://www.theraddonreport.com/?p=3560

•

Acharya, Viral V. (n.d.) “The Dodd-Frank Act and Basel III Intentions, Unintended Consequences, Transition Risks, and Lessons for India.” New York University Stern School of Business [research note], http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/Dodd-Frank-Basel-andIndia-by-Viral-Acharya.pdf

•

Thoma, Mark (July 15, 2010). “The Dodd-Frank Financial Reform Bill.” CBS Moneywatch, , 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 several possibilities include: •

Passing extraordinarily risky securities onto unsuspecting investors without proper, clear disclosure of those investment risks in the investment documents

•

Many people in the chain knowing of the extraordinary risk but carried on without blowing the whistle

•

Rating agencies giving very risk securities higher than warranted ratings thereby not protecting investors, which was the agencies’ function

•

Investment houses that knowingly over-leveraged 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

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Case Solutions 1. Questionable Values Produce Resignation at Goldman Sachs (Chapter 8, pages 671-672) What this case has to offer This case provides a look at: (1) the values system that pervaded Goldman Sachs during what could be called their “greedy or exploitive era” that followed what could be called their “professional or fiduciary era”, and (2) the consequences that resulted from an unethical corporate culture. Goldman Sachs was not the only investment or brokerage company that made this transition to serving themselves from serving their clients. In fact, the switch was evident in the accounting field when Arthur Andersen imploded, in the ratings agencies and investment houses involved in the financial crisis of 2008, and in the banks that manipulated the LIBOR rates to maximize their own profit. The case affords an excellent opportunity to discuss appropriate values, who should encourage them, and how to keep an appropriate balance between self-interest and service to clients. In addition, readers can assess the potential of a culture that is open to challenge, the mechanisms for doing so, as well as the role of the executives and board of directors in creating and maintaining an ethical corporate culture. It is also interesting for readers to see how cultural red flags can permeate the speech and actions of employees and to consider how improvement might be stimulated by concerned employees using whistleblowing or other techniques. The discussion in the Text (Section Whistleblower Programs & Ethics Inquiry Services, Chapter 7, pages 566-568) on being aware of and identifying ethics risks should be quite helpful in bolstering this discussion. The fact that disenchantment with corporate values led to the resignation of a worthy employee should also be stressed. Research reveals that this happens frequently, and that many of the individuals who start up their own companies (particularly women) do so because they are not comfortable with the culture of their employer. Teaching suggestions I would begin the case by asking the class what they thought the consequences were for Goldman Sachs, which arose from their unethical corporate culture, such as: losing good employees and executives; inability to recruit ethically minded new staff who do not want to soil their reputations; damage to corporate reputation so that trust is undermined, thus affecting future business; and legal expenses and penalties. Then I would ask why GS culture could be considered unethical, and this would lead to a discussion of culture and values, and their role in the company’s purpose, services, and success. After this, I would ask for the answers to the questions posed at the end of the case, as noted below. Discussion of ethical issues According to Greg Smith, the culture he describes existed in 2012, long after the 2008 financial crisis and subsequent fall out, suggesting that the lessons have not been learned and the problems are at least as bad as they were before the crisis. richard@qwconsultancy.com

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P a g e | 517 1. How could the culture described be changed? Changing the corporate culture described will require ethical leadership to steer and incent the process, determined continuous evaluation and feedback involving the identification and reporting of ethics risks and opportunities for improvement, training for old and new staff on the new expectations and guidelines, and continued exhortations from the leaders at GS. Those who do not have matching expectations should be dealt with quickly, publicly and decisively. Promotion and merit pay should be based, in part, on meeting or exceeding ethical performance objectives. The company should identify a senior person (the designated program champion) in addition to the CEO who is responsible for the program to change and maintain the ethical culture, and put in place a strong support mechanism involving trainers, whistleblowers, and so on. 2. Who will need to cause this culture to change? The top company leaders must actively speak in favor of a new culture, stating why and its importance, and they must be supported by other managers all the way down the line. The CEO and the ethical culture champion need to recruit as followers the rest of the key managers, who should be convinced of the logic of operating with an ethical culture. The Board of Directors is ultimately responsible for the company’s culture and should appoint a CEO with the right “tone at the top” and monitor the performance of other managers to ensure that they also demonstrate the type of leadership expected. The Board should also ensure that the appropriate systems are in place to create and monitor the desired culture with periodic reports to the Board. This exercise cannot be left to management without any follow-up. One of the follow-up mechanisms could be to schedule the internal audit personnel to verify adherence to company policies and complete a values audit or hire an outside expert to do so. 3. What will have to happen to cause this change? Management at all levels must buy into the rationale for, and specific values specified in, company policy. They will have to convince the rest of the employees that the rationale is sound, the values are worthy, that management are serious, and that they really do expect employees to fall in line. Managers, employees and prospective hires should be screened to assess their willingness to be fiduciaries rather than selfinterested corporate psychopaths.

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P a g e | 518 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? According to research done on U.S. Ivey League students, students are unwilling to take interviews with firms whose reputation could lead to their embarrassment. Consequently, there is a reduced chance that the best and the brightest will end up working for unethical corporations. The class should be asked if they would be willing to work for a company that has recently suffered an ethical fiasco such as Wal-Mart, GS, and GM. 5. Corporate psychopaths would likely be attracted to a firm with Goldman’s modern culture. How would Goldman ensure that they are not hired? Goldman should work with industrial psychologists to develop screening tests intended to reveal information about an employee’s or recruit’s sense of right and wrong, so that corporate psychopaths can be identified and dealt with before they become serious problems. In addition, as the Text suggests (see sections on Corporate Psychopaths in Chapters 5 and 8 and discussions of motivation in Chapters 3, 4, 7), managers should be aware of unsound motivations that employees might use or speak of, be ready to persuade them not to do so, report them for others to counsel and/or deal with directly. Useful Articles, Links, and Videos William Cohan Interview on Goldman Sachs: Video – Bloomberg Television [June 13, 2011(?)], accessed at http://www.bloomberg.com/video/70812232-william-cohan-interview-ongoldman-sachs.html on September 22, 2014. [Link no longer valid in 2020.] In this interview of Bill Cohen (author of Money and Power: How Goldman Sachs Came to Rule the World (see References, below) by Erik Schatzker and Deirdre Bolton on Bloomberg Television's "InsideTrack," Cohen is questioned about his maintaining that Goldman Sachs profited over its short position on mortgage-based securities, even though the corporation maintains it did not sell short and will not likely be charged for doing so. Cohan on Psychopaths and the Financial Crisis: Video – Bloomberg Television [January 3, 2012], accessed at http://www.bloomberg.com/video/83609304-cohan-on-psychopaths-andthe-financial-crisis.html on September 22, 2014. [Link no longer valid in 2020.] In this interview of Bill Cohen (author of Money and Power: How Goldman Sachs Came to Rule the World (see References, below) by Erik Schatzker on Bloomberg Television's "InsideTrack," Cohen is questioned about Clive Boddy’s Journal of Business Ethics article (see References, below) that contends that psychopaths in large corporations played a major role in the financial crisis. Cohen, William D. (2012). Money and Power: How Goldman Sachs Came to Rule the World. Anchor Books, New York. The author—a frequent contributor to Bloomberg news and television–provides a history of Goldman Sachs.

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P a g e | 519 Boddy, Clive R. (2011). “The Corporate Psychopaths Theory of the Global Financial Crisis.” Journal of Business Ethics, 102, 255–259. In the paper’s abstract, the author writes, “The paper presents a theory of the Global Financial Crisis which argues that psychopaths working in corporations and in financial corporations, in particular, have had a major part in causing the crisis.”

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2. Naked Short Selling—Overstock.com Lawsuit against Goodman Sachs & Merrill Lynch (Chapter 8, pages 672-673) What this case has to offer This is an interesting case in which profit-oriented organizational cultures encouraged employees to engage in unethical behavior that, in this case, caused an abnormal decrease in a company’s stock because of naked short selling. Teaching suggestions Have the class discuss organization cultures. In particular, have the students think about the differences between a profit-oriented culture and a responsible, business-oriented culture. •

A profit-oriented culture focuses on earning profits and does not focus on how those profits are generated.

•

A responsible business-oriented culture strives to provide services in an efficient and effective manner; profits are the consequence of being efficient, effective, and responsible.

Which of these two cultures do they think is more prevalent among stock brokerage houses? Which of these do they think might encourage unethical behavior by employees? Next, have the students discuss the purpose of stock markets: •

Are stock markets forums for raising capital or are they gambling casinos?

•

Are they both? Discussion of ethical issues

1. Should short selling be outlawed? One of the purposes of the stock market is to be a forum where firms can raise money. Investors invest in companies with an expectation of earning a reasonable return on their investments. An active, vibrant stock market helps to stimulate the economy. Short selling, on the other hand, is gambling. It is a bet that the price of a stock will fall, and that the seller will be able to buy enough stock later at a lower price to deliver later to complete the short sale. If the stock price falls, then the bet pays off. Many people object to short selling because it turns the stock market into a gambling casino rather than a forum for generating investments in companies. Consequently, short selling is too risky to be allowed. Others argue that the stock market is a forum for investments and that short selling is a mechanism that moves the stock price quickly to its real equilibrium price, which is a service to prospective investors. Therefore, short selling should be encouraged. richard@qwconsultancy.com

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P a g e | 521 2. Should naked short selling be outlawed? A seller can undertake short selling whether s/he owns the stock or not. If the short seller doesn’t own the stock sold, then it is referred to as naked short selling. Naked short selling is even more of a gamble than short selling, since the shorter neither owns nor has borrowed the shares that were shorted. Consequently, if a person/student objects to short selling, then s/he should be even more vehemently opposed to naked short selling. 3. How would you describe the ethical cultures at Goldman Sachs and Merrill Lynch with respect to failed trades? The ethical cultures at these two brokerage houses appear to be profit-oriented rather than responsibly business-oriented. A profit-orientation focuses only on making money and ignores how the money is made. A responsible business-orientation focuses on providing value to its customers: the better the service that is provides, the greater are the profits. In a business-orientation, profits are a consequence of operating in an efficient and effective manner; the more efficient and effective, the greater the profits. 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? Senior management at these two brokerage houses have to change the culture from being profit-oriented to being responsibly business-oriented. One way to change a culture is through compensation. Employees do what they are rewarded for doing. If compensation is geared more towards providing value to clients, then employees will focus on providing value to clients. The Text discusses other approaches such as appropriate screening techniques and on-going alertness in diagnosing cultural deficiencies. Useful Articles, Links, and Videos See also Useful Videos & Films in Chapter 8 (in section Case Insights). “Short sellers not to blame for 2008 financial crisis, study finds,” Matthew Biddle, University at Buffalo (UB) News Center: News Releases, July 29, 2014, accessed at http://www.buffalo.edu/news/releases/2014/07/042.html on September 23, 2014. This news release says that a new study to be published in the Journal of Financial Economics by researchers that include a University at Buffalo School of Management assistant professor, Veljko Fotak, “focused on fails caused by naked short sales…and found these trades were not responsible for falling stock prices.”

3. Lehman Brothers Repo 105 Manipulation (Chapter 8, pages 673685) 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.

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P a g e | 522 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 (page 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.”

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P a g e | 523 However, the most important direct cause of the firm’s collapse was that LB overinvested in sub-prime mortgage securities (MBS). As explained by the Examiner’s Report (page 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 (page 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 (page 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 FINANCIAL INSTRUMENTS (Asset Account)

1,000,000 1,000,000

Pay $1 million in financial liabilities using the proceeds of the sale before quarter-end: richard@qwconsultancy.com

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P a g e | 524 COLLATERALIZED FINANCINGS (Liability Account) CASH

1,000,000 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 (2011) 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 (page. 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.”

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P a g e | 525 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 richard@qwconsultancy.com

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P a g e | 526 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 (page 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 needed 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?

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P a g e | 527 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 (page 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

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P a g e | 528 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 United States, 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. 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 richard@qwconsultancy.com

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P a g e | 529 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 previously, 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 of the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk richard@qwconsultancy.com

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P a g e | 530 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.”

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P a g e | 531 have an active discussion with the board to establish a mutual understanding of the organization’s overall appetite for risks. •

•

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. richard@qwconsultancy.com

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P a g e | 532 According to the Examiner’s Report, the Examiner’s mandate included the following (page 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 (page 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 (page 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 (page 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. richard@qwconsultancy.com

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P a g e | 533 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.

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P a g e | 534 Useful Articles, Links, and Videos American Institute of Certified Public Accountants (AICPA). “AU 316 Consideration of Fraud in a Financial Statement Audit SAS No. 99.” 2002 http://www.aicpa.org/Research/Standards/AuditAttest/Pages/SAS.aspx [Link active in 2020; content is current, not historical.] 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 [Link active in 2020; content is current, not historical.] 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 [Link active in 2020; content is current, not historical.] Committee of Sponsoring Organizations of the Treadway Commission (COSO). “Enterprise Risk Management —Integrated Framework” 2004. http://www.coso.org/guidance.htm [Link active in 2020; content is current, not historical.] 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.htm l “Examiner’s report.” See Report of Anton R. Valukas, Examiner (below). 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 [Link active in 2020; content is current, not historical.] 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 [Link active in 2020; content is current, not historical.] PwC Audit Guide. Materiality. 2011. http://auditguide.0009.ws/PwCAuditGuide/2102.htm) [Link no longer valid in 2020.] Report of Anton R. Valukas, Examiner, Lehman Brothers Holdings Inc., Chapter 11 Case No. 0813555(JMP) (Jointly Administered), United States Bankruptcy Court, Southern District of New York, March 11, 2010. [“Examiner’s report.”] See Digital Resources for the Text at www.cengage.com richard@qwconsultancy.com

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4. Goldman Sachs’ Conflicts: Guilty or Not? (Chapter 8, pages 685692) What this case has to offer This case exposes Goldman Sachs’ roles regarding 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., which 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, homeowners, and the large insurer AIG, Goldman Sachs actually profited from the crisis. This case is related to the Goldman Sachs and the Greek Veil Case (Text, Chapter 1), which explains how the investment banking firm aided the government of Greece to enter 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 through 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 richard@qwconsultancy.com

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P a g e | 537 Goldman Sachs defended the three roles of the company as underwriter, market maker, and trader separately: •

First, as explained in the Text, 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 (section Conflicts of Interest, page 272ff), 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 though 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

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P a g e | 538 transactions were acceptable or ethical because of their highly negative social consequences. 2. How should Goldman Sachs have handled each conflict of interest? The Text, Chapter 2 (also Chapters 5 and 6) provides some guidance about the mechanisms to avoid a conflict of interests. To remedy the concerns over a conflict of interests, three general approaches should be considered: (1) avoidance, (2) disclosure to those stakeholders relying on the decision, and (3) management of the conflict of interests 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 interests 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 cost-benefit 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. richard@qwconsultancy.com

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P a g e | 539 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 regarding 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. richard@qwconsultancy.com

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P a g e | 540 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 offered 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.

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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.

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The firm could have used this opportunity to be seen as an ethical leader to be followed to re-establish 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 must be adequate enough to attract and retain talent, while motivating adequate risk-taking behavior. Often, the level of compensation is determined by the board of directors aided by 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 richard@qwconsultancy.com

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P a g e | 541 ethical actions. Moreover, paying bonuses seems like a definite mistake 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 lost their jobs, 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 Text (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.

Useful Articles, Links, and Videos Martin, Roger (Spring 2009). “Undermining Staying Power: The Role of Unhelpful Management Theories.” Rotman Magazine, http://rogerlmartin.com/docs/defaultsource/Articles/incentives-governance/rotman_spring_09_staying_power

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5. Mark-to-Market (M2M) Accounting and the Demise of AIG (Chapter 8, pages 692-694) 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. Discussion of ethical issues 1. The argument is that M2M accounting caused AIG to record huge unrealized losses. These losses led to a downgrade in the quality of AIG stock. The downgrade and frozen credit markets led to eventual bailout. So, do you agree that the accounting rules contributed to AIG’s demise? 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.

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P a g e | 543 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 is 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 were sold or discharged. This is useful information for making investment and credit decisions and 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 continued 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 un-conservative 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 are not 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 is 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 accountants and auditors who were involved with them. In the final analysis, AIG’s management made mistakes that caused its collapse, not the mark-to-market accounting that provided a clear view of the problem. Some people, however, prefer the ostrich’s head-in-the-sand approach of dealing with their problems. 2. The government said that AIG was “too big to fail.” It was concerned that if AIG declared bankruptcy, then individuals holding personal insurance as well as other investments would have no insurance and would be in danger as the financial and liquidity crisis deepened. But many felt that the federal government should not be investing in publicly traded companies. There is risk in the marketplace, and one such risk is that occasionally businesses go richard@qwconsultancy.com

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P a g e | 544 bankrupt. 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 bail out 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 bail out some industries and firms and not others. This would be treating equals unequally, which is a violation of the Kantian principle. In 2009, for example, GM and Chrysler were 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.

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P a g e | 545 Useful Articles, Links, and Videos Smalera, Paul (July 16, 2010) “AIG settles longstanding fraud cases for $1 billion.” CNN Money, http://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. 6, 2009, http://www.sec.gov/news/press/2009/2009-180.htm Satow, Julie (April 24, 2009) “AIG’s Six Year Saga of Alleged Fraud.” Huffington Post, http://www.huffingtonpost.com/2009/03/24/aig-fraudhistory_n_178545.html?show_comment_id=22288349 “AIG Accused of Fraud.” (June 12th 2009). CBS News, http://www.cbsnews.com/video/watch/?id=5085130n [Video no longer available in 2020.] “AIG Exec. Avoids Criminal Charges.” (April 6, 2010). CBS News, http://www.cbsnews.com/video/watch/?id=6369592n [Video no longer available in 2020.]

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6. Subprime Lending—Greed, Faith, and Disaster (Chapter 8, pages 694-695) 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, Text, Chapter 8.) •

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. Subprime mortgages targeted lower-income Americans, new immigrants, and people who had a poor credit history. The customers were told that because house prices had been rising, the borrower would be able to refinance the loan at a later date with the increased equity in the house. Was this an ethically correct sales pitch? Were the lenders taking advantage of financially naïve 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, such as those with a physical ailment or disability, may be more susceptible to buying products that they think may help them to overcome their limitation.

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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.

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The intellectually vulnerable, e.g., among the young and the senile, lack the cognitive capability to understand the true meaning of the advertising claims.

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The socially vulnerable, including the poor, 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 mortgage-backed investments were not properly and fairly disclosed. 2. O’Neal transformed Merrill Lynch from a conservative bank into an aggressive risk-taking institution. Risk taking means that there is the potential for high rewards as well as large losses. From 2002, when O’Neal became CEO, Merrill’s share rose 53%. Should the investors now be upset that, as a result of the subprime mortgage meltdown, Merrill’s stock price fell by about 30% 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 of-pocket any money. They have incurred an opportunity cost. But there is no cash flow associated with an opportunity cost, 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.

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P a g e | 548 3. As a result of the subprime mortgage debacle, the CEOs at Merrill Lynch, Citigroup, Bear Stearns, and Morgan Stanley all resigned or were fired. Their departure packages were $161 million, $68 million, $40 million, and $18 million, respectively. Are these executive settlements unreasonably high, given the huge financial losses and write-downs 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 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 given 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.

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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.

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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.

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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? Useful Articles, Links, and Videos richard@qwconsultancy.com

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P a g e | 549 Brenkert, G.G. (1998). Marketing and the vulnerable. Business Ethics Quarterly, Ruffin Series 1, 7-21. McLean, Bethany & Joe Nocera (November 2010). “Excerpt: The Blundering Herd.” Vanity Fair, http://www.vanityfair.com/business/features/2010/11/financial-crisis-excerpt-201011 Comstock, Courtney (November 12, 2010). “Why the Fall of Merrill Lynch Hurt Stan O’Neal More than John Thain.” Business Insider, http://www.businessinsider.com/greg-farrell-johnthain-stan-oneal-2010-11 “E. Stanley O’Neal” (December 8, 2010). Times Topics, New York Times, http://topics.nytimes.com/top/reference/timestopics/people/o/e_stanley_oneal/index. html This website provides access to many news articles O’Neal.

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7. Moral Courage: Toronto-Dominion Bank CEO Refuses to Invest in HighRisk Asset-Based Commercial Paper (Chapter 8, pages 696-697) 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. Because the TD was neither a manufacturer nor a distributor of ABCP products, 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.

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A legal responsibility to operate within the laws of the society in which they conduct their business.

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An ethical responsibility to respect and adhere to the social norms and values of the society in which they operate.

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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 the financial industry, in which the bank operates, in particular. 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. If you were Edmund Clark, how would you explain to the Board of Directors that you were having the bank exit a market in which your competitors were making a lot of money?

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P a g e | 551 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 longer-term. 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. The banks in Canada are highly regulated by the federal government. If the banks could not come to a voluntary agreement, should the federal government have forced the banks through legislation to provide $950 million in 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. Useful Articles, Links, and Videos Carroll, A. 1991. “The pyramid of corporate social responsibility: Toward the moral management of organizational stakeholders,” Business Horizons 34, 39-48.

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8. The Ethics of AIG’s Commission Sales (Chapter 8, pages 697-698) 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 and Disaster, in Chapter 8 of the Text.) •

•

1. Commission salespeople are paid their commission after they write successful insurance policies or consummate the sale of financial products. Should their commissions be recovered if the company subsequently suffers a loss as a result of the business written by the sales staff? Should there be an upper limit placed on commissions so that no one employee receives $280 million in commissions over an eight-year period? How could such an upper limit be selected if a company wished to establish one? 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.

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P a g e | 553 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 receiving taxes on the net income of the firm, and the agent receiving the sales commission. Several arguments can be made in favor of placing 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.

•

The agent will only work until the agent receives the cap and then will stop working.

Capping commissions would not be to the benefit of the firm since the value of sales to be derived from commissions would essentially 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, and also: •

the impact the incentive schemes will have on the achievement or not of the company’s values

•

the impact they will have on the corporation’s reputation in the eyes of the public

2. Is it right that perks such as holidays at luxury resorts are provided only to senior executives and the sales staff but not to the other employees of the firm? 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 taking away a benefit previously 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 change the employment contract later and arbitrarily, 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. Should senior officers who have extensive firm-specific knowledge be hired back as consultants to help rectify their mistakes? richard@qwconsultancy.com

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P a g e | 554 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 learning and mastering the firm-specific skills required by the new employer may take a period of time. The argument for re-hiring managers who caused problems is that those managers have firm-specific knowledge of the problems since they are the people who caused them. Because of their unique knowledge, they may be in the best position to solve the problems. If new managers are hired, gaining the firm-specific skills necessary to solve these problems may take some time. Investing time, trouble and effort in training those new managers may be costly for the firm. On the other hand, rehiring the old managers and having them fix the problems they created may be less costly. 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. Rewarding poor performance sends out the negative signal to other employees that there is no reason to work hard at doing a good job, since both good and poor performance are 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 cleanup. Useful Articles, Links, and Videos “AIG set to repay $37 billion in bailout money.” (November 1, 2010). The Wall Street Journal, http://online.wsj.com/article/AP8988d983d6d646109cffb4cacfc762a7.html?KEYWORD S=aig+bailout “News Hub: AIG, US Agree on Exit Plan [Video].” (September 30, 2010). The Wall Street Journal, https://www.wsj.com/video/news-hub-aig-us-agree-on-exit-plan/6A15A1AD-F84044DC-AFE4-F206C70084AC.html?KEYWORDS=aig+bailout Champ, Henry (October 8, 2008) “Lawmakers fume at excess of failed firm’s execs.” CBC News: Washington File, http://www.cbc.ca/news2/reportsfromabroad/champblog/2008/10/eyebrowraising_exc ess_at_the_t.html [Video no longer available in 2020.]

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