Ethics and Business: An Inherent Conflict?

Dr. Wayne H. ShawHelmut Sohmen Distinguished Professor of

Corporate Governance

Corporate “Bobbleheads”

What went wrong in early 2002 Wall Street

Firms managing earnings short-term because analysts glorified and overvalued steady earnings

Any level of compensation was viewed acceptable

What went wrong Wall Street

Special purpose entities marketed to create revenue of remove debt from balance sheet

Analysts accepted pro forma earnings Hot IPOs became a currency for courting

favor Media extolled the “new era” SEC and Congress ignored problems Collapse of large corporations

What went wrong Corporate Governance

Boards of directors independent in name only

CEOs dominated boards Ethics codes were waived by directors Board meetings were short and unfocused Audit committees did not understand

accounting and failed to insist on adequate explanations

What went wrong Corporate Governance

Whistleblowers were silenced Non-management directors had no leader or

forum Companies made unsecured loans to

officers Large stock profits realized by managers

shortly before stock price declines

What went wrong Corporate Governance

Executive compensation increased exponentially

Decisions on compensation often accepted based solely on recommendations by compensation consultants

What went wrongAccountants

Accountants failed to demand true transparency

Auditors routinely went to work for client after leaving CPA firm

Auditor also did internal audit Could use rules-based GAAP rules to

present a misleading picture

What went wrongAccountants

Auditor’s basic relationship with management not board

Auditors were paid more and better for consulting rather than auditing◦ Might “low ball” audit fee to get engagement

What went wrongGatekeepers

CEO’s and CFO’s used creative accounting◦ Blamed subordinates and accountants for failure

Board of directors blamed management and accountants

Accountants blamed management

What went wrongGatekeepers

Lawyers approved questionable transactions and did not force recognition of disclosure violations

Investment bankers assisted accountants and management by developing more sophisticated financing vehicles◦ Sometimes “suggested” alternatives

What did we do? Enacted the Sarbanes-Oxley Act of 2002 Shifted power to board Made majority of board independent Limited board interlocks Excluded CEO from some board meetings Enhanced shareholder powers

What happened? Board meetings became longer and more

meaningful Dissent began to be viewed as an obligation Board now made strategic reviews

customary Only independent directors were permitted

on key board committees Executive compensation receive more

scrutiny Accounting became more transparent

A Board of Directors consisting primarily of “independent” persons

Independent members on the important board committees◦ Such as the audit, compensation and nominations

committees A whistle blower structure An establishment of a company wide code

of ethics

Structure set up to assure the system works

Collapse of our financial markets Failure of many large, well-known firms Development of large Ponsi schemes Spiraling CEO salaries and buy-out

packages Continued difficulty in determining any tie

between pay and performance Raises given to management as employees

are laid off or required to take pay-cuts Warnings again ignored by Congress and

the SEC

What was the result?

A letter from Cicero to his son Marcus

Conclusion: Consider the deliberations and soul

searching of the sort of man who would keep the Rhodians in ignorance

If he thought this would be dishonest but was not certain that dishonesty would

be involved.

On Duties

Rules or The rightness or wrongness of the act or The quality of the outcome

Basis for judging the decisions made in business

We have an agent, management, whose behavior can affect the system

We have a principal, the company’s shareholders, whose grander purposes and values are to be served

Resources are consumed in taking action A variety of courses of action are available

to management Many of the actions taken are unobservable

by the shareholders

Why ethical issues may crop up in business decisions

The Board of Directors Management The Auditor Legal and other advisors

Who might be at blame for failure to address ethical issues?

The Board of Directors, including the CEO, have a fiduciary obligation to the shareholders

Because of this obligation, they have a duty of care and duty of loyalty they must fulfill.

Role of the Board and the CEO

Duty of Care The duty of care describes the level of competence that is

expected of a board member and members of management◦ is commonly expressed as the duty of "care that an ordinarily

prudent person would exercise in a like position and under similar circumstances.”

Duty of Loyalty The duty of loyalty is a standard of faithfulness.

◦ Board members and members of management must give undivided allegiance when making decisions affecting the organization.

◦ This means that they can never use information obtained as a member for personal gain at a “cost” to the stakeholders, but must instead act in the best interests of the organization.

Established Duties of Boards of Directors and Members of

Management

One author suggests the following common pitfalls:

◦ Focusing on short-term profit and shareholder only impacts,

◦ Focusing only on legalities,◦ Conflicts of interest,◦ Interconnectedness of stakeholders,◦ Failure to identify all stakeholders, and◦ Failure to rank the specific interests of

stakeholders.  Brooks, Leonard J., Business & Professional Ethics for Directors, Executives & Accountants, Mason, OH, Thomson South-Western,

2007, citing Pastin, M., The Hard Problems of Management: Gaining the Ethics Edge, San Francisco, Jossey-Bass Inc., Publishers, 1986.

So what is the difficulty in meeting the Duty of Loyalty?

Brook’s (2007) definition A conflict of interest 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.

A director or employee is expected to make judgments in the best interest of the company.

A director is legally expected to make judgments in the best interest of company and its shareholders, and to do so strategically so that no harm and perhaps some benefit will come to other stakeholders and the public interest.

My focus is on the issues relating to a conflict of interest

(1) avoidance, (2) disclosure to those stakeholders relying

on the decision, or (3) management of the conflict of interest

so that the benefits of the judgment outweigh the costs.

So what actions should be taken in facing a conflict of interest

Reporting of earnings by a corporation Selling a firm Taking a firm private A corporate acquisition Setting CEO compensation Meeting a CEO’s desires to expand her

horizons or give to charitable organizations Use of company assets by a CEO for

personal reasons

Application to business situations

Based on internal knowledge of the issues or Based on an outsider’s perceptions

How should the process be judged?