Ethics and Business: An Inherent Conflict?

1. Ethics and Business: An Inherent Conflict? Dr. Wayne H. Shaw Helmut Sohmen Distinguished Professor of Corporate Governance

2. Corporate “Bobbleheads”

3. 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

4. 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

5. 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

6. 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

7. What went wrong Corporate Governance • Executive compensation increased exponentially • Decisions on compensation often accepted based solely on recommendations by compensation consultants

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. Structure set up to assure the system works • 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

15. What was the result? • 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

16. On Duties • 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.

17. Basis for judging the decisions made in business • Rules • or • The rightness or wrongness of the act • or • The quality of the outcome

18. Why ethical issues may crop up in business decisions • 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

19. Who might be at blame for failure to address ethical issues? • The Board of Directors • Management • The Auditor • Legal and other advisors

20. Role of the Board and the CEO • 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.

21. Established Duties of Boards of Directors and Members of Management • 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.

22. So what is the difficulty in meeting the Duty of Loyalty? • 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.

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

24. So what actions should be taken in facing 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.

25. Application to business situations • 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

26. How should the process be judged? • Based on internal knowledge of the issues • or • Based on an outsider’s perceptions