According to kevin bahr, which of the following is a cause for conflicts in the financial markets?

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10. Ethical Decision Making: Corporate Governance, Accounting, and Finance

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Did you ever expect a corporation to have a conscience, when it has no soul to be damned and no body to be kicked?

Edward Thurlow (1731–1806), Lord Chancellor of England

Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years, it is futile to blame men. It is the institution that malfunctions.

Peter Drucker

Earnings can be as pliable as putty when a charlatan heads the company reporting them.

Warren Buffet

Hartman: Business Ethics: Decision−Making for Personal Integrity and Social Responsibility

10. Ethical Decision Making: Corporate Governance, Accounting, and Finance

Text © The McGraw−Hill Companies, 2008

Chapter Objectives

After reading this chapter, you will be able to:

1. Describe the environment for corporate governance prior and subsequent to the Sarbanes-Oxley Act.

2. Explain the role of accountants and other professionals as “gatekeepers.”

3. Describe how conflicts of interest can arise for business professionals.

4. Outline the requirements of the Sarbanes-Oxley Act.

5. Describe the COSO framework.

6. Define the “control environment” and the means by which ethics and cul- ture can impact it.

7. Discuss the legal obligations of a member of a board of directors.

8. Explore the obligations of an ethical member of a board of directors.

9. Highlight conflicts of interest in financial markets and discuss the ways in which they may be alleviated.

10. Describe conflicts of interest in governance created by excessive executive compensation.

11. Define insider trading and evaluate its potential for unethical behavior.

Opening Decision Point A Piece of Chocolate?

Consider a decision that faced the board of directors of Hershey Foods, headquartered in Hershey, Pennsylvania. Hershey had $4.4 billion in sales in 2004, and had as its majority shareholder the $5.4 billion Milton Hershey Trust.

The Trust in 2002 decided that it wanted to put Hershey up for sale in order to diversify its assets. The residents of Hershey were extremely concerned as they envisioned job loss, reduced support of the community through fewer taxes and other financial impacts, and a weakened tourism industry, especially if the company were sold to a foreign investor. Since the board did not represent the stakeholders who would be impacted by this decision, an ethical decision that considered all stakeholder perspectives was less likely (though not impossible). Contrary to some Western European countries, the United States does not require stakeholder representation, such as employees or local citizenry, on corporate boards.

What do you think the board should have done?

What are the key facts relevant to your decision regarding the sale of Hershey? What is the ethical issue involved in the sale and the decision process? Who are the stakeholders? What alternatives do you have in situations such as the one above? How do the alternatives compare, and how do the alternatives affect the stakeholders?

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Chapter 10 Ethical Decision Making: Corporate Governance, Accounting, and Finance 421

Many of the companies mentioned in the opening pages of this book were involved in financial corruption. Recall those company names—whether from this text or from the headlines of the national press—such as Enron, World- Com, Tyco, Adelphia, Cendant, Rite Aid, Sunbeam, Waste Management, Health- South, Global Crossing, Arthur Andersen, Ernst &Young, ImClone, KPMG, J.P.Morgan, Merrill Lynch, Morgan Stanley, Citigroup Salomon Smith Barney, Marsh & McLennan, Credit Suisse First Boston, and even the New York Stock Exchange itself. In the past few years, each of these companies, organizations, accounting firms, and investment firms has been implicated in some ethically questionable activity that has resulted in fines or criminal convictions. Most of the unethical behavior involved some aspect of finance, from manipulating special purpose entities in order to evidence growth, to cooking the books, to instituting questionable tax dodges, to allowing investment decisions to warp the objectivity of investment research and advice. Ethics in the governance and financial arenas has been perhaps the most visible issue in business ethics during the first years of the new millennium. Accounting and investment firms that were looked upon as the guardians of integrity in financial dealings have now been exposed in violation of the fiduciary responsibilities entrusted to them by their stakeholders. Many analysts contend that this corruption is evidence of a com- plete failure in corporate governance structures; could better governance and oversight have prevented these ethical disgraces?

Consider the following:

The jury is still out on the costs to corporations of Sarbanes-Oxley compliance, but it’s a safe guess that it’s already in the billions of dollars and millions of person-hours. No one doing Sarbanes-Oxley work adds value to any company. They design nothing, make nothing, and sell nothing. They make no improvements to management, marketing, or morale. They meet no demands, satisfy no necessities, create no opportunities. They simply report. 1

If Sarbanes-Oxley has these challenges, are there alternatives to address wrongdoing in corporate governance? Is Sarbanes-Oxley the best alternative? What other suggestions might you offer?

What else might you need to know to determine how to prevent mismanage- ment of this type? What ethical issues are involved? Who are the stakeholders in financial mismanagement? Whose rights are protected by Sarbanes-Oxley’s implementation? What are the consequences of Sarbanes-Oxley’s implementation? Is it the fairest option? Is it regulating companies to act in the way a virtuous company would act? What alternatives have you compiled? How do the alternatives compare; how do the alternatives affect the stakeholders?

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Decision Point But Is Regulation the Answer?

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This chapter will address the cultural elements that led to the Enron Corpora- tion debacle, as well as others during the end of the 20th and beginning of the 21st centuries. Though the Sarbanes-Oxley Act is one response to these corporate governance failures, others exist, such as adherence to the elements of the control environment framework advocated by the Committee of Sponsoring Organizations of the Treadway Commission. (See the Decision Point on the previous page and the above Reality Check to consider other alternatives.) Perhaps, however, many of these challenges could be avoided by having more accountable and responsible boards of directors. The chapter will outline board member roles and responsibili- ties and discuss specifically pervasive issues such as conflicts of interest, insider trading, and leveraged buyouts and mergers. We will explore the impact that cor- porate institutions have on the social fabric and how corporate issues connect with the global environment in the first decades of the 21st century.

Professional Duties and Conflicts of Interest

The watershed event that brought the ethics of finance to prominence at the begin- ning of the 21st century was the collapse of Enron and its accounting firm Arthur Andersen. William Thomas’s essay “The Rise and Fall of Enron” details the steps that led to the downfall of those companies, including using complex special pur- pose entities to access capital or hedge risk. The Enron case “has wreaked more havoc on the accounting industry than any other case in U.S. history,” 2 including the demise of Arthur Andersen. Of course, ethical responsibilities of accountants were not unheard of prior to Enron, but the events that led to Enron’s demise brought into focus the necessity of the independence of auditors and the responsi- bilities of accountants like never before.

Accounting is one of several professions that serve very important functions within the economic system itself. Remember that even Milton Friedman, a staunch defender of free market economics, believes that markets can function only when certain conditions are met. It is universally recognized that markets must function within the law; they must assume full information; and they must be free from fraud and deception. Ensuring that these conditions are met is an impor- tant internal function for market-based economic systems. Several important business professions, for example, attorneys, auditors, accountants, and financial analysts, function in just this way. Just as the game of baseball requires umpires

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According to a report from PricewaterhouseCoopers, more than 1,000 public companies have had to restate their fi nancial statements over the past fi ve years due to accounting irregularities, with the average company losing approximately 6 percent

of its revenue to fraud and abuse. Historically, more than 50 percent of CFOs report that they were pressured by their CEOs to misrepresent accounting or otherwise engage in fraud.

Reality Check What Did They Say, Again?

Hartman: Business Ethics: Decision−Making for Personal Integrity and Social Responsibility

10. Ethical Decision Making: Corporate Governance, Accounting, and Finance

Text © The McGraw−Hill Companies, 2008

who act with integrity and fairness, business and economic markets require these professionals to operate in a similar manner.

Such professions can be thought of as “gatekeepers” or “watchdogs” in that their role is to ensure that those who enter into the marketplace are playing by the rules and conforming to the very conditions that ensure the market functions as it is supposed to function. Recall from Chapter 3 the critical importance of role identities in determining ethical duties of professionals. These roles offer us a source of rules from which we can determine universal values to apply under deontological and Kantian analysis. We accept responsibilities based on our roles. Therefore, in striving to define the rules that we should apply, we see that the ethi- cal obligations of accountants originate in part from their roles as accountants.

These professions can also be understood as intermediaries, acting between the various parties in the market, and they are bound to ethical duties in this role as well. All the participants in the market, especially investors, boards, management, and bankers, rely on these gatekeepers. Auditors verify a company’s financial statements so that investors’ decisions are free from fraud and deception. Analysts evaluate a company’s financial prospects or creditworthiness, so that banks and investors can make informed decisions. Attorneys ensure that decisions and transactions conform to the law. Indeed, even boards of directors can be understood in this way. Boards function as intermediaries between a company’s stockholders and its executives and should guarantee that executives act on behalf of the stockholders’ interests.

The most important ethical issue facing professional gatekeepers and interme- diaries in business contexts involves conflicts of interest. A conflict of interest exists where a person holds a position of trust that requires that she or he exercise judgment on behalf of others, but where her or his personal interests and/or obli- gations conflict with those of others. For instance, a friend knows that you are heading to a flea market and asks if you would keep your eyes open for any beauti- ful quilts you might see. She asks you to purchase one for her if you see a “great buy.” You are going to the flea market for the purpose of buying your mother a birthday present. You happen to see a beautiful quilt at a fabulous price. In fact, your mother would adore the quilt. You find yourself in a conflict of interest—your friend trusted you to search the flea market on her behalf. Your personal interests are now in conflict with the duty you agreed to accept on behalf of your friend.

Conflicts of interest can also arise when a person’s ethical obligations in her or his professional duties clash with personal interests. Thus, for example, in the most egregious case, a financial planner who accepts kickbacks from a brokerage firm to steer clients into certain investments fails in her or his professional responsibility by putting personal financial interests ahead of client interest. Such professionals are said to have fiduciary duties—a professional and ethical obligation—to their clients, duties that override their own personal interests. (For another example of a conflict of interest, see the Decision Point on page 425.)

Unfortunately, and awkwardly, many of these professional intermediaries are paid by the businesses over which they keep watch, and perhaps are also employed by yet another business. For example, David Duncan was the principal accounting professional employed by Arthur Andersen, though he was hired by and assigned to work at Enron. As the Arthur Andersen case so clearly demonstrated, this situation

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424 Chapter 10 Ethical Decision Making: Corporate Governance, Accounting, and Finance

can create real conflicts between a professional’s responsibility and his or her finan- cial interests. Certified public accountants (CPAs) have a professional responsibil- ity to the public. But they work for clients whose financial interests are not always served by full, accurate, and independent disclosure of financial information. Even more dangerously, they work daily with and are hired by a management team that itself might have interests that conflict with the interests of the firm represented by the board of directors. Thus, real and complex conflicts can exist between pro- fessional duties and a professional’s self-interest. We will revisit conflicts in the accounting profession later in the chapter.

In one sense, the ethical issues regarding such professional responsibilities are clear. Because professional gatekeeper duties are necessary conditions for economic legitimacy, they should trump other responsibilities an employee might have. David Duncan’s responsibilities as an auditor should have overridden his

Potential conflicts with management

Pays CPA firm, vested interest in CPA’s report to public

Client’s Management Team

(Hired CPA firm and works daily with it)

CPA firm works for public

CPA firm to Client: Contractual obligation

CPA firm to Public: Fiduciary/Ethical obligation

Public

Client

Client to CPA firm: Financial obligation

CPA Firm

Client’s Board of Directors

FIGURE 10.1 Conflicts of Interest in Public CPA Activity

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Chapter 10 Ethical Decision Making: Corporate Governance, Accounting, and Finance 425

role as an Andersen employee. But knowing one’s duties and fulfilling those duties are two separate issues.

This common situation has many ethical implications. If we recognize that the gatekeeper function is necessary for the very functioning of economic mar- kets, and if we also recognize that it can be difficult for individuals to fulfill their gatekeeper duties, then society has a responsibility to make changes to minimize these conflicts. For example, as long as auditors are paid by the clients on whom they are supposed to report, there will always be an apparent conflict of interest between their duties as auditors and their personal financial interests. This conflict is a good reason to make structural changes in how public accounting operates. Perhaps boards rather than management ought to hire and work with auditors since the auditors are more likely reporting on the management activities rather than those of the board. Perhaps public accounting somehow ought to be paid by public fees. Perhaps legal protection or sanctions ought to be created to shield professionals from conflicts of interests. These changes would remove both the apparent and the actual conflicts of interest created by the multiple roles—and therefore multiple responsibilities—of these professionals. From the perspective of social ethics, certain structural changes would be an appropriate response to the accounting scandals of recent years.

Consider the case of what is referred to as “soft money” within the securities industry. According to critics, a common practice in the securities industry amounts to little more than institutionalized kickbacks. “Soft money” payments occur when financial advisors receive payments from a brokerage firm to pay for research and analyst services that, in theory, should be used to benefit the clients of those advisors. Such payments can benefit clients if the advisor uses them to improve the advice offered to the client. Conflicts of interest can arise when the money is used for the personal benefit of the advisor. In 1998, the Securities and Exchange Commission released a report that showed extensive abuse of soft money. Examples included payments used for office rent and equipment, personal travel and vacations, memberships at private clubs, and automobile expenses. If you learned that your financial advisor received such benefits from a brokerage, could you continue to trust the financial advisor’s integrity or professional judgment?

What facts do you need to know to better judge this situation? What values are at stake in this situation? Who gets harmed if a financial advisor accepts payments from a brokerage? What are the consequences? For whom does a financial advisor work? To whom does she have a professional duty? What are the sources of these obligations? Does accepting these soft money payments violate any individual’s rights? What would be the consequence if this practice were allowed and became commonplace? Can you think of any public policies that might prevent such situations? Is this a matter for legal solutions and punishments

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Decision Point When Does Financial Support Become a Kickback?

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Perhaps the most devastating aspect of the Enron case was the resulting deterio- ration of trust that the public has in the market and in corporate America. Decision makers at Enron ignored their fiduciary duties to shareholders, employees, and the public in favor of personal gain, a direct conflict of interest leading not only to extraordinary personal ruin but also to its own demise: Enron filed for bankruptcy in December 2001. In an effort to prevent these conflicts in the future, Congress enacted legislation to mandate independent directors and a host of other changes discussed below.

However, critics contend that these rules alone will not rid society of the problems that led to this tragedy. Instead, they argue, extraordinary executive compensation and conflicts within the accounting industry itself have created an environment where the watchdogs have little ability to prevent harm. Execu- tive compensation packages based on stock options create huge incentives to artificially inflate stock value. (You might wish to review the reading on execu- tive compensation in Chapter 3 to consider this issue in more detail.) Changes within the accounting industry stemming from the consolidation of major firms and avid “cross-selling” of services such as consulting and auditing within single firms have virtually institutionalized conflicts of interest .

Answers to these inherent challenges are not easy to identify. Imagine that an executive is paid based on how much she or he impacts the share price and will be ousted if that impact is not significantly positive. A large boost in share price—even for the short term—serves as an effective defense to hostile takeovers and boosts a firm’s equity leverage for external expansion. In addition, with stock options as a major component of executive compensation structures, a higher share price is an extremely compelling quest to those in leadership roles. That same executive, however, has a fiduciary duty to do what is best for the stake- holders in the long term, an obligation that is often at odds with that executive’s personal interests. Not the best environment for perfect decision making, or even for basically decent decision making.

The Sarbanes-Oxley Act of 2002

The string of corporate scandals since the beginning of the millennium has taken its toll on investor confidence. The more it is clear that deceit, chicanery, evasive- ness, and cutting corners go on in the markets and in the corporate environment, the less trustworthy those engaged in financial services become. Because reli- ance on corporate boards to police themselves did not seem to be working, Con- gress passed the Public Accounting Reform and Investor Protection Act of 2002, commonly known as the Sarbanes-Oxley Act, which is enforced by the Securities and Exchange Commission (SEC). The act applies to over 15,000 publicly held companies in the United States and some foreign issuers. In addition, a number of states have enacted legislation similar to Sarbanes-Oxley that apply to private firms, and some private for-profits and nonprofits have begun to hold themselves to Sarbanes-Oxley standards even though they are not necessarily subject to its requirements.