BBA 4751, Business Ethics 1
Course Learning Outcomes for Unit VII
Upon completion of this unit, students should be able to:
5. Summarize ethics in financial responsibilities affecting and controlling public and private companies,
including those required by Sarbanes-Oxley.
6. Evaluate ethical considerations of executive compensation and insider trading.
Reading Assignment
In order to access the following resource(s), click the link(s) below:
Jennings, M. M. (2015). What accounting fraud looks like at its inception: Could you see it in your own
company? Corporate Finance Review, 20(1), 28-33. Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.proquest.com.libraryresources.c
olumbiasouthern.edu/docview/1700703091?accountid=33337
Carney, T. P. (2006). Feds were accomplices to Enron crooks. Human Events, 62(20), 1-6. Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc
t=true&db=a9h&AN=21198363&site=ehost-live&scope=site
Cohan, W. D. (2015). Can bankers behave? Atlantic, 315(4), 74-80. Retrieved from
https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc
t=true&db=a9h&AN=101988454&site=ehost-live&scope=site
Jones, R. M. (2003). The Sarbanes-Oxley Act of 2002: A primer. Business Torts Journal, 10(3), 18-21.
Retrieved from
http://link.galegroup.com.libraryresources.columbiasouthern.edu/apps/doc/A198548260/GPS?u=oran
95108&sid=GPS&xid=6514f54f
Leite, J. (2012). What Martha Stewart did wrong. Retrieved from
http://coveringbusiness.com/2012/05/15/what-martha-stewart-did-wrong/
Luttrell, D., Rosenblum, H., & Thies, J. (2012). Understanding the risk inherent in shadow banking: A primer
and practical lessons learned. Staff Papers, (18). Retrieved from
http://dallasfed.org/assets/documents/research/staff/staff1203.pdf
Yang, S. (2014). 5 years ago Bernie Madoff was sentenced to 150 years in prison – Here’s how his scheme
worked. Retrieved from http://www.businessinsider.com/how-bernie-madoffs-ponzi-scheme-worked-
2014-7
UNIT VII STUDY GUIDE
Ethics in Financial Matters
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Unit Lesson
Click here to access an introduction video.
Click here to access the introduction video transcript.
Click here to access a video that briefly introduces topics in this unit.
Click here to access the video transcript.
In the movie The Godfather, Tom Hagen is the chief—and only—attorney working for Godfather Vito Corleone (Evans & Coppola, 1972). He is groomed from a young age and later informally adopted by the Godfather as his son. Hagen’s relationship with the Godfather is compromised as he is part-family, part-employee. He both handles the crime family’s legal business in three states as well as gives advice to the Godfather on how he can evade the law’s intent and scrutiny by the police. Hagen follows the letter of the law when it serves him well; however, he is willing to perform illegal actions if they are needed to meet his selfish goals. When necessary, Hagen justifies his actions to keep his client, the Godfather, out of jail for his illegal activities. Sometimes, Hagen is sent to negotiate with those who take positions against the “family” business, such as when he secured a Senator’s forced cooperation. Once, he was famously dispatched to Hollywood to persuade an influential movie director to cast the Godfather’s friend in a movie. When the director refused, he later awakes in bed to find the severed head of his prize racehorse; he is persuaded and acquiesces to Hagen’s request.
Many of the wrongdoers in today’s recent ethical failures are quite similar to Hagen—lawyers, accountants, and business leaders unethically “pushing the envelope” of legality to keep their company’s/client’s actions safe, hidden, and ongoing. As we will see, in most instances, the wrongdoers have strong short-term profit goals in organizations with weak ethical cultures, which contribute to obscuring the line between what is right and wrong.
In this unit, we will learn about the nuances of Enron’s business practices that caused the country’s seventh largest corporation, posting a 57% increase in sales between 1996 to 2000, to go bankrupt in 2001 (Kitsock, 2011). Its stock price plummeted, causing huge loses to shareholders and, in turn, laying off thousands of employees, who lost not only their jobs and benefits but their stock and pension plans. Essentially, after deregulation of the energy markets in the 1990s, the door opened for Enron to manipulate its balance sheets by recognizing various kinds of revenue in creative, confusing, and suspicious ways, in which even industry analysts did not quite understand. In the middle of the chaos, before the irregularities were made public and the Department of Justice launched a criminal investigation, the President and Chief Operating Officer abruptly resigned, citing only personal reasons. The new Chief Executive Officer (CEO) received a detailed memorandum by a whistleblower apprising him of the key areas of purported malfeasance by the company’s accountants and leaders. The whistleblower’s concerns were largely ignored, as the CEO directed the very accountants and attorneys alleged to have acted unethically and illegally. As we learned in Unit III, with Walmart in Mexico, a proper internal investigation or inquiry must be undertaken by an independent third party. As the whistleblower was ignored, and her suggestions of remedying the harm to the company by,
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among other things, taking a write-off and unwinding a transaction were also ignored, the company imploded in late 2001.
In 2008, as we will read, the largest Ponzi scheme in U.S. history was discovered, having been perpetrated by well-regarded financier Bernie Madoff. He was sentenced to 150 years in prison for bilking investors out of $65 billion on paper. As we shall see, a Ponzi scheme is actually a simple strategy but one difficult to sustain. It involves luring in new investors whose incoming money is used to pay promised returns to the prior investors. The strategy is successful, though usually short-lived, as long as new investors are continually recruited, but as soon as new money ceases coming in, and/or too many investors seek to get their money out of the investment, the scheme folds. Madoff was so successful for so long partly because he was esteemed in the industry, having helped launch the NASDAQ stock market and as an advisor to the Securities and Exchange Commission. In addition, the man who was Madoff’s accountant and lawyer is facing up to 30 years in prison for his part in the scheme, which involved manipulating and falsifying financial documentation.
In the subprime lending fiasco wherein the U.S. government bailed out key banks in the wake of the 2008-2009 financial crisis, we will again see this theme in practice of a faulty ethical foundation further eroding in the wake to capture short-term profits. Several key things, among others, converged to cause the collapse: (a) banks were deregulated, which allowed them to engage in high-risk practices; (b) low interest rates (the Federal Reserve dropped rates to 1% for an extended period of time) fueled a housing boom; and (c) asset managers sought to find new and creative ways to make money (enter high-yield mortgage backed securities) since the typical investments had low yields due to the Federal Reserve rate drop. Banks began relaxing mortgage rules and lending money to borrowers who would not have ordinarily qualified for lack of income, credit rating, and down payment. Banks were heavily invested in unsuitable borrowers who later defaulted. More than 80% of the subprime mortgages were issued by private banks (Goldstein & Hall, 2008). Therefore, the crucible was private banks’ unscrupulous lending to unsuitable borrowers in order to make their balance sheet look profitable, when the likelihood of long-term profitability was actually low. There were many whistleblowers in the industry in the last couple of years before the crisis, but banks were making money hand over fist, without regard for tomorrow’s problems with their highly leveraged borrowers (i.e., investments) derivatives, and they were repeatedly ignored and discredited. Once the Federal Reserve dropped interest rates after the dot com bust of 2000-2001, business leaders in the banking and financial services industries came up with new ways to flout the system though legal at the time. Was it ethical to lend money to those who had diminished ability to pay it back and to encourage hundreds of thousands to live beyond their means? Was it right to prioritize short-term profits associated with a raft of lending over the long-term likelihood the money would be repaid? Who was to be penalized for these shaky investments: the home-borrowers who were evicted, the employees of the banks who went under, the taxpayers when five banks were bailed out?
As a postscript to the financial crisis, 49 financial institutions paid the government and private plaintiffs nearly $190 billion in fines and settlements. That may sound significant—and it is, especially when it becomes clear that the money came from shareholders, not individual bankers. Unbelievably, the bank of one banker, having just settled out of court with the government, gave him a 74% raise that brought his salary to $20 million for the year. Only one banker was convicted in the entire financial cries and is currently serving a 30-month sentence (Cohan, 2015).
As a result of the foregoing corporate scandals and in need of a sea-change, President George W. Bush signed the Sarbanes-Oxley Act of 2002 into law. The act was intended to restore investor confidence in the public markets and to rein-in unethical corporations, leaders, attorneys, and accountants, to name a few. The act, as we shall study, is technical but broadly covers three areas: auditor conduct, attorney conduct, and internal corporate governance. There are increased reporting requirements—regulations controlling attorney and accountant relationships and reporting within the company and externally. It severed most of the close ties between auditors and the companies which they counseled, thereby ensuring independence of the two. The act responds to concerns about highly inflated executive compensation, though does not regulate it directly and imposes tighter reporting requirements on insider stock sales (e.g., requiring insiders to report sales of stock within two days of the sale, down from one month and 10 days). Though much outcry was heard from public companies upon its passage, based on the alleged onerous reporting requirements and cost of compliance, the overhaul was viewed positively by investors (Li, Pincus, & Rego, 2004).
We will also review the case of Martha Stewart who was alleged to have engaged in insider trading of 4,000 shares of ImClone stock (Leite, 2012). This is a particularly interesting case study, as she was convicted only
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of perjury since the government did not pursue the insider trading theory in the final analysis. To be convicted of insider trading, one must be (a) in possession of nonpublic, (b) material information in executing the stock trade, and (c) one must have a duty to refrain from trading on the nonpublic information. Stewart received the nonpublic information from her broker that the CEO of ImClone was dumping $5 million of stock that same day. A reasonable investor would have found this information material. The government found they could make a case that she violated the first two principles but not the third: they could not find a duty since she was neither a broker, nor did she work for ImClone. She was merely a private citizen. Instead, the government pursued Stewart for perjury about the trade, and she went to federal prison for five months, was on house arrest for five months, placed on probation for two years, and fined $195,000 (Leite, 2012). But the question remains, especially because she was ironically previously a stock broker before she became famous, should she have known that receiving and acting on such nonpublic material information was illegal, or if not, then highly unethical? In the end, she skirted a penalty of possibly 20 years in jail because she was yet another wealthy, well-connected individual who knew how to work the nuances of the system and may technically not have violated the law.
In the balance between determining what is ethical versus what may be legal in a given organization, we will turn our attention to executive compensation—compensation for senior executives. The issue here is about fairness or the lack thereof. In 1980, executive compensation was 42 times that of the average worker; by 2008, the number ballooned to 319 times (Trottman, 2015). Do CEOs contribute that much value to a company? Ethically, is it just to pay them over 300 times more? To put this in perspective, 20 years ago, the average CEO pay was $750,000; now, it is more than $10 million per year (Trottman, 2015). But here again, we are back to addressing issues of corporate culture, such as short-term profits over long-term ones, investing in high-risk activities, revising financial targets down in mid-stream so that CEOs always succeed but never fail, and weak links between performance and compensation. None of this is illegal, but is it ethical?
Many in the industry maintain that companies must build and sustain a new culture so executive compensation is ethical, does not loot the company and employees, and still attracts high-quality C-Suite talent by, among other things, creating a lasting ethical culture. We will study a number of those recommendations, including claw-backs, which require executives to give back compensation if they are found to have damaged the company; tying executive pay to performance (e.g., not revising down targets so they are easy to meet); paying a larger portion of compensation in restricted stock, which the executive must hold longer thus giving him a vested interest in the long-term success of the company and leveling the playing field with employees by eliminating golden parachutes; large severance packages; and tax gross-ups. Most importantly, there is a call to identify non-financial metrics, such as ethical leadership, for which executives would be compensated.
As we studied in Unit III, tone-at-the-top matters greatly. There is a difference between technically complying with the law and the spirit of the law, and when the intent is violated, the conduct could be seen as unethical. When CEOs make $10 million per year, though their company underperforms and lays off employees, one could argue that the spirit of just compensation in employment is violated.
Each of these case studies and the current state of executive compensation raise serious questions about executive leadership and corporate culture that many argue fails the litmus test of appropriateness, regardless of the possible legality that underlies the issues.
References
Cohan, W. D. (2015). Can bankers behave? Atlantic, 315(4), 74-80.
Evans, R. (Producer), & Coppola F. F. (Director). (1972). The Godfather [Motion picture]. United States: Paramount.
Goldstein, D., & Hall, K. G. (2008, October). Private sector loans, not Fannie or Freddie, triggered crisis. McClatchy DC. Retrieved from http://www.mcclatchydc.com/news/politics-government/article24504598.html
Kitsock, J. (2011). History of Enron to 2001 including their products and services/Kitsock [Prezi presentation]. Retrieved from https://prezi.com/fp7008u-r8gy/history-of-enron-to-2001-including-their-products-and-serviceskitsock/
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Leite, J. (2012). What Martha Stewart did wrong. Retrieved from http://coveringbusiness.com/2012/05/15/what-martha-stewart-did-wrong/
Li, H., Pincus, M., & Rego, S. O. (2004). Market reaction to events surrounding the Sarbanes-Oxley Act of 2002. Retrieved from https://www.sec.gov/news/press/4-497/sorego031505.pdf
Trottman, M. (2015). Top CEOs make 373 times the average U.S. worker. The Wall Street Journal. Retrieved from http://blogs.wsj.com/economics/2015/05/13/top-ceos-now-make-373-times-the-average-rank-and-file-worker/