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  • 1. Business Ethics: Cases andSelected Readings, 7th Ed.Marianne M. JenningsUnit 4© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 2. 130The New Car and Slippage© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 3. Levels of Moral Development• Morally clueless – aware of no rules (George Costanza ofSeinfeld)• Morally superior/moral egotist – rules are for others who areless gifted (Dot-coms; Computer Associates)• Inherently moral – natural law; will always follow credo(Mother Teresa; Ed Begley, Jr.)• Amoral technician – makes no determination; functions onlywithin the system and the rules; law is law and rules are rulesand they follow both, right down to the line/wire, butpersonal ethics are irrelevant (Fastow)• Moral schizophrenic – one set of ethics at work and anotherin personal life or one set of ethics in personal life andanother at work (NBA referee Tim Donaghey)© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.131
  • 4. Levels of Moral Development• Moral procrastinator/postponer – aware of ethical issues butwill worry about the “ethics stuff” and morality at some timein the future (Carnegie and Gates)• Moral compartmentalizer or rationalizer – “I only do this incertain situations.” “I only do this at work.” “I would neverallow my kids to do this.” (Willy Loman)• Morally desensitized – was once aware of ethical issues, butcopes by no longer being affected by them (Charles Colson)• Morally detached – still acutely aware of ethical issues but thesandbox has worn them down so they go along in a depressedmanner (HP); sometimes called moral disengagement(morally disillusioned)132© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 5. Levels of Moral Development• Moral chameleon – adapts to ethics of thosehe/she is working with at the time; changeswith industry; changes with role being played(Ford truck ad: “Made by the guys we used tocheat off in high school”)• Moral sycophant – adopts the ethics of thosein charge (John Dean)133© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 6. Moral DevelopmentClassificationsPerson• Wi-Fi piggybackers• Speeders• William Wilberforce• Martha Stewart• Pete Bacanovic• Douglas Faneuil• Dr. Sam Waksal• Carly Fiorina• Lloyd Blankfein (Goldman)Category134© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 7. Moral DevelopmentClassificationsPerson• Goldman• Fabrice Tourre• John Paulson• Heather Bresch• Albert Carr• Peter Drucker• Milton Friedman• Edward Freeman• Marjorie Kelly• Michael NovalClassification135© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 8. Moral DevelopmentClassificationsPerson• Marianne Jennings• John Rigas• Franklin Raines• Angelo Mazilo• John Mackey• Ice-T• Dayton-Hudson• Herman MillerClassification136© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 9. Gellerman’s StructuralChanges• Boards of directors• Organizational structure (“Chinese Walls”)• Executive Pay• Auditors137© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 10. Changes in CompensationCurrent Practice• Resisting shareholderactivism• One consultant for systemand certification• Conflicts in consultants• Staid, lock-step programsChanges• Working with and involvingshareholders incompensation policies anddiscussion• Bifurcation of system andcertification functions• System for preventingconflicts• Creativity/innovation138© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 11. Common Traits in Ethical Collapse:Watching for the Signals1. Pressure to maintain numbers2. Fear and silence3. Young ‘uns and a Bigger-Than-Life-Execs4. Weak boards5. Conflicts6. Innovation like no other7. Goodness in some areas atones for evil in others© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.139
  • 12. 140Pressure to Maintain Numbers• Deadlines• Revenue• Budgets• Personal goals• Sunk costs• Rankings/ratings• Loss of _________.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 13. Iconic CEOs• CEO a full generation older than directreports• Lack of depth in direct reports• “I hire them just like me: smart, poor andwants to be rich.”Dennis KozlowskiFormer CEO, Tyco© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.141
  • 14. Weak Boards• Lack of experience• Lack of time commitment• Conflicts: Everywhere• Failure to understand industry issues© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.142
  • 15. Robert Rubin, Former Chair,Citigroup“I tried to help people as they thought theirway through this. Myself, at that point, Ihad no familiarity with CDO’s.”Shawn Tully, “Wall Street’s Money Machine BreaksDown,” Fortune, November 26, 2007, p. 65, at p. 68.143© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 16. Innovation Like No Other“. . . standard accounting rules [are] not thebest way to measure Computer Associate’sresults.”Sanjay Kumar, former CEO, now in prisonDeciding which rules don’t apply to you, whenthey don’t apply, and why© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.144
  • 17. 145HealthSouth and Pressure“We have met earnings to the penny for 47quarters in a row.”HealthSouth Annual Report 2001Last annual report before indictmentsNext annual report would not be until 2005, whennumbers could finally be discerned© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 18. 146Richard Scrushy on JeffreySkilling“The things he did to that company are horrible.I don’t understand the mindset of a man whowould do what he did to that company.”As he sat in on Lay/Skilling trial on March 8, 2006© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 19. 147A Scrushy MeetingAnnouncement“I want each one of the [divisional] presidents toe-mail all of their people who miss their budget.I don’t care whether it’s by a dollar.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 20. 148Scrushy on Performance byEmployeesIn an interview in Fall 2002, Mr. Scrushyexplained his management technique, “Shine alight on someone – it’s funny how numbersimprove.”Reed Abelson and Milt Freudenheim, The Scrushy Mix: Strictand So Lenient, N. Y. TIMES, April 20, 2003, at BU1, 12.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 21. 149HealthSouth and Conflicts• One director had earned $250,000 per year on a consultingcontract with HealthSouth for a 7-year period• Another director had a joint investment venture with Mr.Scrushy on a $395,000 investment property• Another director was awarded a $5.6 million contract forhis company to install glass at a hospital being built byHealthSouth• MedCenterDirect, a hospital supply company run onlineand which did business with HealthSouth was owned byMr. Scrushy, six directors and one of those director’s wives• The audit committee and the compensation committee hadconsisted of the same three directors since 1986• Two of the directors had served on the board for 18 years© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 22. 150Scrushy Conversation with Oneof His Many CFOs• [If you] fixed [financial statements] immediately, you’ll getkilled. But if you fix it over time, if you go quarter toquarter, you can fix it.• Engineer your way out of what you engineered your wayinto.• I don’t know what to say. You need to do what you need todo.• We just need to get those numbers where we want them tobe. You’re my guy. You’ve got the technology and theknow-how.Secret Recording Is Played at a HealthSouth Hearing, N. Y. TIMES, April11, 2003, at C2.Greg Farrell, Tape of ex-HealthSouth CEP revealed, USA TODAY, April11, 2003, at 1B.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 23. 151"Theres a big difference betweenbeing aggressive and beingfraudulent."Bill Schaff, Fund ManagerBerger Information Technology Fund© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 24. 152Options And Their EffectOn Accounting• Ken Lay – $123.4 million realized from exercisingstock options in 2000• At that time not booked as an expense –footnote only; Enron’s options, if booked, wouldhave reduced operating profits by 8%• Increases compensation• Increases income• Only two S&P companies (Boeing and Winn-Dixie) booked options as an expense prior toFASB change© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 25. 153Impact of Backdating“I can say that, to my knowledge, every member ofmanagement in this company believes that, at thetime, we collectively followed appropriate practices forthose option grants which affected all of ouremployees, not simply selected executives, and thatsuch activities were within guidelines and consistentwith our stated program objectives.”William McGuire, CEO UnitedHealth Group, June 2006$1.6 billion in options expenses overlooked© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 26. 154Options and DatesBackdating: The granting of a stock option is datedback to an earlier date, one that had a much lowerprice and allows an immediate return to theexecutive or employee. For example, suppose thatABC Company stock is worth $90 today.However, the stock was at $60 just a few monthsearlier. If the award date is backdated to that lowerstrike price, the option grantee has an immediategain of $30 per share© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 27. 155Options and DatesBackdating with limitations: Microsoft hasadmitted some nuanced backdating in the1990s, but it was only backdating for the past30 days. The options were granted at a strikeprice that was the lowest price of the stockduring the 30-day period prior to the award.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 28. 156Options and DatesSpring-loading: Options are granted just priorto a major announcement by a company thatsees its stock price jump. Once again, there isan immediate gain once the news is public.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 29. 157Options and DatesDownloading: Options are granted justfollowing bad news announcements that drivethe stock price down. Grantees thus have avery low share price and can wait until thestock climbs again and then realize a return onthose options.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 30. 158Option Exposure• Oracle for Larry Ellison – $706 million (OI $933million)• Citigroup – not counting options meantanother $919 million in OI• SOX requires reporting of grant of optionswithin 2 days• Software is now more sophisticated indetecting options grants and dates© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 31. 159Warren Buffett on OptionsAccounting: The Reg Cycle“If options aren’t a form of compensation, whatare they? If compensation isn’t anexpense, what is it? And, if expenses shouldn’tgo into calculations of earnings, where in theworld should they go?”Gregg Hitt and Jacob M. Schlesinger, “Stock Options Come Under Fire inWake of Enron’s Collapse,” Wall Street Journal, March 26, 2002. A1, A8.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 32. 160A Primer on SOX• The Sarbanes-Oxley Act of 2002• The Investor Confidence Act• The Public Accounting and CorporateAccountability Act• The Public Company Accounting Reform andInvestor Protection Act of 2002© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 33. 161SOX Amends Securities Laws• 1933 Securities Act – IPOs• 1934 Securities Exchange Act– Secondary markets– Reporting ($10M or more in assets and 500 ormore shareholder or NSE listing): 10K, 10Q, and8K– Insider trading– Fraud© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 34. 162General Provisions• Quasi-governmental entity called the Public CompanyAccounting Oversight Board (PCAOB, but called “Peek-a-Boo”)• Auditor independence• Corporate Governance– Independent directors on audit committee– Financial expert on audit committee• CEO and CFO certification• EBITDA• Sales of stock disclosures• Section 404 Internal controls certification• Increased penalties and obstruction easier to prove• New Sentencing Guidelines© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 35. 163Sarbanes-Oxley on Structure• The majority of the board must be made up ofoutsiders.• The audit committee of the board must becomprised entirely of independent directors.An independent director is defined as onewho is not employed by the company (or wasemployed), is not related to an officer of thecompany, does not do business with thecompany, and has no personal compensationcontracts with the company.• The audit committee must have at least onedirector who is a financial expert.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 36. 164Sarbanes-Oxley on Structure• The compensation committee must also be made upof independent directors.• The compensation committee must establish anddisclose clear policies for officer compensation andmust approve all compensation packages forofficers.• Boards can no longer make loans to officers.• The board must sign off on the financial statements.• The audit committee must certify the internalcontrols of the company as sufficient for ensuringthe accuracy of the financial report.• Independent of management meetings.• Ethics training.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 37. 165Conflicts and Sarbanes-Oxley:Audit Committee of the Board• No consulting contracts• No advisory contracts• No work with subsidiaries• Must have at least one financial expert on theaudit committee• Direct and independent contact with audit firm• Procedures for notification of internal controlproblems• Process for verification of financial reports© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 38. 166Auditors and SOX• Conflicts on bookkeeping• Conflicts on design of systems and IT systems• Conflicts on appraisal, actuarial services• Conflicts on auditing for internal controladequacy• Conflicts on providing management consulting• Conflicts in serving as broker or dealer• Conflicts on legal and expert services© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 39. 167SOX and Financial Reporting• GAAP must accompany non-GAAP• Changes in accounting rules• Section 404 Internal Controls certificationrequired• CEO and CFO certification© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 40. 168SOX and Criminal Penalties• Increased penalties for obstruction• Increased penalties for false financialstatements• Requirement that bonuses earned on thebasis of false financial information bereturned© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 41. 169SOX and Protection forEmployees• Cannot retaliate against employees whoreport financial issues and legal violationsrelated to financial reporting• Cannot retaliate against employees who helpin investigations of financial fraud• Enforced through the Department of Labor© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 42. 170Corporate SentencingGuidelines• Formula for sentences• Reductions for good behaviors• Ethics training• Carrot and stick requirements• Increases for bad behaviors• CIA agreements© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 43. 171Sarbanes-Oxley• Sections 16 (a) and 16(b) of 1934 Act–Officers, directors and 10% shareholders–Must report transactions in stockelectronically by end of second businessday after they occur© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 44. 172Kozlowski on Boards“Most of us made it to the chief executiveposition because of a particularly high degreeresponsibility . . . We are offended most by theperception that we would waste the resources ofa company that is a major part of our life andlivelihood, and that we would be happy withdirectors who would permit waste. . . So as aCEO I want a strong, competent board.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 45. 173173Dennis Kozlowski Thoughts“We have no perks, not evenparking spaces.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 46. 174174Kozlowski To A Sentencing Judge OnA Tyco Employee Caught Embezzling“Not only did he steal from the stockholders . . .But he breached the fiduciary duty placed inhim. . . Wrongdoing of this nature againstsociety is considered a grave matter. He shouldreceive the maximum sentence.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 47. 175175Kozlwoski And Henry Silverman (CEOOf Cendant) Exchange WhenCendant Had Accounting Fraud"It must really piss you off to hearCendant and Tyco mentioned in thesame sentence.""Henry, it drives me nuts."Dennis Kozlowskiformer CEO of Tyco, circa 2000© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 48. 176E-mails to Tyco Counsel fromOutside CounselWilmer Cutler to Belnick:“We have found issues that will likely interest theSEC . . . creativeness is employed in hitting theforecasts . . . There is also a bad letter from theSigma people just before the acquisition confirmingthat they were asked to hold product shipment justbefore the closing . . .”11Laurie P. Cohen and Mark Maremont, E-Mails Show Tyco’s Lawyers HadConcerns, Dec. 27, 2002, C1. (on Tyco)© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 49. 177E-Mails to Tyco Counsel fromOutside CounselTyco’s financial reports suggest“something funny which is likelyapparent if any decent accountantlooks at this.” 11Id.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 50. 178Bad Judgment is Bad Judgment“There are payments to a woman whomthe folks in finance describe as Dennis’sgirlfriend. I do not know Dennis’ssituation, but this is an embarrassing fact.” 11Laurie P. Cohen and Mark Maremont, E-Mails Show Tycos Lawyers HadConcerns, Wall Street J., Dec. 27, 2002, C1. The payments were made toKaren Mayo (then-girlfriend, then wife during trial, now ex-wife).© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 51. Bausch & Lomb & Krispy KremeCredo Moments• “I would never sign a document that I knowcontains false information.”• “I would never release financial statementsthat do not show the true financial situationof the company.”• “I would never ship product that I know wasnot ordered.”• “I would never backdate a document.”179© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 52. 180Enron’s Labyrinth Finances© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 53. 181CALPERS3%FASB 125New Power-Enron Execs(Fastow)Not a subsidiaryLENDER-loansUp to 97%ENRONAsset: Power PlantMoneyHelp with capitalEnron guarantees loanmoney© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 54. 182Enron –Total return swapGuarantees pshpHawaii 125-0(Raptor III)Enron Execs(Fastow)881/700 Cayman16-bank consortiumCanadian ImperialBankNew PowerWarrantsCash$500 millionloanWarrants pledged as collateralShare price drop risk© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 55. 183LJM2 Co-LPFastow’s pshpPorcupine LLC(hedging vehicle)After NP IPO, FastowTakes out $30 mil +$9.5 mil profitFee for himselfEnron$30 million$30 million24 million New PowerWarrants ($10.75)Hedges $245 millionIf New Power dropsBecause NP IPO is $21© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 56. 184Enron – Mark-to-MarketAccounting• Contract for sales of gas – one gallon at $2.10 for2007• Price to acquire gas at end of 2005 is $2.47• Is there a loss?• Converse – contract to sell one gallon at $2.75 for2007• Price to acquire gas at end of 2005 is $2.47 – is it again?• When can you book revenue?© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 57. 185Enron –Special Purpose Entities• Accounting rules focus on control• 50% rule intended to apply to entities with shareholders andequity interests• SEC implemented the 3% rule; some outsider had to own atleast 3%• Enron would create off-the-book entities with a partner, likeCalpers• Calpers would own 3%, but Enron would often front that 3%• Enron did not disclose its loan guarantee on SPEs – one ofthe missing management disclosures that caused Andersenconcern• Officer ownership and conflicts© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 58. 186Jeffrey Skilling, FormerCEO, Enron“Andy, I have hit a brick wall. I just don’tknow what to do.”Trial testimony March 7, 2006Skilling resigned 2 months later© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 59. 187Andrew Fastow, FormerCFO, Enron“What I did was reprehensible. It is not easy tolook at yourself and to recognize that aboutyourself. It took me a long time to do that. Andsome days it is still hard to do that. I havedestroyed my life. All I can do is ask forforgiveness and be the best person I can be.”Trial testimony, March 8, 2006© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 60. 188Andrew Fastow, FormerCFO, Enron“Within the culture of corruption thatEnron had, that valued financial reportingrather than economic value, I believed Iwas being a hero.”Trial testimony, March 8, 2006© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 61. 189Andrew Fastow, FormerCFO, Enron“We have to open up the kimono and showthem the skeletons in the closet, what ourassets are really worth.”Testimony on what he told Ken Lay(mixed metaphors aside)© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 62. 190Andrew Fastow, FormerCFO, Enron“I feel like I’ve taken a lot of blame for Enronthese past few days. It’s not relevant to mewhether Mr. Skilling’s or Mr. Lay’s names areon that page. . . . I’m ashamed of the past.What they write about the past I can’t affect.I want to focus on the future. Even afterbeing caught, it took me awhile to come togrips with that I’d done. . . I’ve destroyed mylife.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 63. 191Andrew Fastow, FormerCFO, Enron“I believe I was very greedy and that I lostmy moral compass.”Trial testimony, March 8, 2006© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 64. 192Andrew Fastow, FormerCFO, Enron“My actions caused my wife to go toprison.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 65. 193Andrew Fastow, FormerCFO, Enron“I thought I was being a hero for Enron. Atthe time, I thought I was helping myselfand helping Enron to make its numbers.”Trial testimony March 7, 2006© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 66. 194194David W. Delainey, FormerHead of Enron Energy Services“That was the worst conduct I had everbeen a part of and everybody knew exactlywhat was going on at that meeting.”11Alexei Barrionuevo, “Ex-Enron Official Insists Chief Knew HeWas Lying,” New York Times, March 2, 2006, p. C3.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 67. 195David W. Delainey, FormerHead of Enron Energy Services“I wish on my three kids’ lives I wouldhave stepped up and walked away fromthe table that day.”Response to cross-examination by Daniel Petrocellion why he did not walk away when other Enronexecutives proposed transferring $200 million inlosses out of the company when he knew it waswrong.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 68. 196Former Enron Investor Relations OfficerPaula Reiker After She Admitted LyingOn A Conference Call To AnalystsDaniel Petrocelli (lawyer for Jeffrey Skilling):“Why didn’t you just quit?”Ms. Reiker:“I considered it on a number of occasions. Iwas very well compensated. I didn’t havethe nerve to quit.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 69. How does this stuff happen?RoguesBad ApplesBadCulturesIndustryPatternsandPracticesSocietalNorms© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.197
  • 70. What Gets in the Way of Ethics?DRIVERS1. Pressure (results) andshort-term focus2. Lack of core values anddefinitive lines3. Failure to see issues360 degrees4. High comfort level(complacency; labels;rationalizations)5. Failure to see limitations(truth)6. Lack of historical perspectivewith resulting risk errors+ENABLERSCommunicating the WrongMessage1. Failure to make ethicseveryone’s responsibility2. Organizational Behavior:Retaliation, Incentives,Rewards, Signals, andFear3. Lack of enforcement andmixed messages=EthicalandLegalDebacles© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.198
  • 71. Dodd-Frank Changes• Management must include shareholderproposals• New requirements find more managementteams working with shareholders• Shareholders have been more active andmore successful in gaining approvals evenprior to Dodd-Frank changes that make iteasier• Confirmatory say on pay vote every 3 years199© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 72. Shareholder Proposal Topics• Advisory vote on compensation• Right to call a special meeting• Repeal board structure with classification• Review of political spending• Independent board chairman• Require a majority to elect directors200© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 73. Shareholder Proposal Topics(cont’d)• Take action on climate change• End super majority vote requirement• Retention period for stock awards• Report on sustainability• Adopt sexual orientation antibias policy201© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 74. Levels of Ethical Lapses202IndividualEthicalLapses1. Screening2. Internal controls and audits3. Training4. Personal commitmentCompany/OrganizationEthical Lapses1. Alignment of management goals with compensation2. Enforcement3. Leaders’ behaviorsIndustryNorms EthicalLapses1. Strategic reviews and planning2. Political and regulatory activismCultural/SocietalEthical Lapses1. Philanthropy2. Education standards© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 75. 203Arthur Levitt in His “NumbersGame” Speech at NYU“Too many corporate managers, auditors, andanalysts are participants in the game of nodsand winks. In the zeal to satisfy consensusearnings estimates and project a smoothearnings path, wishful thinking may be winningthe day over faithful representation... Managingmay be giving way to manipulation; integritymay be losing out to illusion.”September 28, 1998© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 76. 204"Theres a big difference betweenbeing aggressive and beingfraudulent."Bill Schaff, Fund ManagerBerger Information Technology Fund© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 77. 205Physical Techniques forManaging Earnings• Write down inventory• Write up inventory product development forprofit target• Record supplies or next year’s expenses aheadof schedule• Delay invoices• Sell excess assets• Defer expenditures© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 78. 206Transactional EarningsManagement• Large-charge restructuring• Creative acquisition accounting• Cookie jar reserves• Materiality• Revenue• EBITDA© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 79. 207Creative AcquisitionAccounting• Overstatement of restructuring charges(springloading)– Soft charges– Anticipated costs• Toss extra charges over and above actualcharges into “cookie jar”• Effect is to make post-acquisition year lookphenomenal© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 80. 208Cookie Jar Reserve• High estimates of acquisition costs• High estimates of sale returns• High estimates of loan losses• High estimates of warranty costs• Dipping in when needed to smooth earnings© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 81. 209Materiality• Judging whether to report a transaction by itspercentage relationship toincome, assets, earnings• Fails to take into account qualitative nature ofthe transaction or trends on immaterial(singularly) items© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 82. 210Questions for Materiality• What historically has happened in cases in which thesetypes of items are not disclosed?• What are the financial implications if this item is notdisclosed now?• What are our motivations for not disclosing this item?• What are our motivations for booking this item in this way?• What are our motivations for not booking this item?• How do we expect this issue to be resolved?• Are our expectations consistent with the actions we aretaking vis-à-vis disclosure?• If I were a shareholder on the outside, would this be thekind of information I would want to know?© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 83. 211Revenue Recognition• Channel stuffing• Delaying or accelerating research• Delaying or accelerating maintenance costs• Early retirement of debt• Sales of securities and/or fixed assets• Depreciation methods• Inventory valuation (LIFO v. FIFO)• Reserves© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 84. 212EBITDA• Earnings• Before• Interest• Taxes• Depreciation• Amortization© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 85. 213EBITDA• Earnings• Because• I• Tricked the• Dumb• Auditor© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 86. 214EBITDA• Non-GAAP reporting• Aka Pro Forma earnings• Consider purpose of showing real earnings• Consider different types of companies such ascompanies that have heavy equipment needs;depreciation is a real expense for them© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 87. Total Bankruptcy Filings215© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 88. The Ethical Issues in Mortgages• Would you accept an approved mortgage loan that youknew was stretching your budget?• What are the moral hazards of mortgage bail-outs? Re-default rates are 55% six months after restructuring• What are the risks of bankruptcy court restructuring?• Review the notion of consideration on all of theserestructures.• What is the difference between a refinancing and a loanmodification?• What are the risks in highly leveraged personal finance?• Who are the stakeholders in mortgages?© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.216
  • 89. The Systemic Effects: What About Bob?Bob defaults•Bob’s lender loses payments;may have to change terms orforeclose•Purchaser of bundled mortgageshas a devalued asset on itsbooks, particularly if Bob isjoined by Betty, Bill, Brent, andall through the alphabet•Bob’s neighborhood is affectedby a n ill-maintained, anempty, and/or a foreclosedhome; value of homesdrops, affecting taxes, affectinggovernment revenue, and keepon goingLender•Tightens credit•More homes on the market•Harder to sell properties•Market glutted with homes forsale•Construction slows down•Those employed in theconstruction industry are laid off•Decorators, landscapers, titlecompanies ,and their employeessuffer loss of income and jobs•These employees default onmore mortgages•Lender can’t sell mortgages•Credit freezesPurchaser of bundledmortgages•Forced to revalue the worth ofthe mortgage-based instruments•Their assets are worth less•They are downgraded•They cannot sell mortgageinstruments•Investors begin selling theirinvestments•Market drops•Money pool no longer there•Frozen markets© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied orduplicated, or posted to a publicly accessible website, in whole or in part.217
  • 90. 218Options for Whistle-Blowers© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 91. 219Beech-Nut Chronology1977 Beech-Nut and Interjuice contract for apple concentrate1978 LiCari sends Beech-Nut employees to Interjuice plant; access to tanksdenied1979 Nestlé buys Beech-NutEarly 1981 LiCari goes to plant manager Lavery with suspicions and circumstantialevidence; “Chicken Little” meetingAugust 1981 LiCari takes chemical tests to Lavery; “Team Player” meetingAugust 1981 LiCari takes evidence and tests to Hoyvald; “Naivete and ImpracticalIdeals”Nov. 1981 LiCari leaves Beech-Nut1982 Processed Apples Institute lawsuit against Interjuice; Beech-Nutcancels Interjuice contractsMarch 1983 Bogus juice sales stopped1986 Lavery and Hoyvald trials (conspiracy, fraud, food and drug lawviolations)© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 92. Westland/Hallmark Meat Co.“The video just astounded us. Our jawsdropped… We thought this place was sparklingperfect.”Anthony Magidow, General ManagerDavid Kesmodel and Jane Zhang, “Meatpacker in Cow-Abuse Scandal May Shut asCongress Turns Up Heat,” Wall Street Journal, Feb 25, 2008, pp. A1 and A10.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.220
  • 93. Lehman’s Former Chief RiskOfficer“In the course of performing my duties for theFirm, I have reason to believe that certainconduct on the part of senior management ofthe Firm may be in violation of the Code. Thefollowing is a summary of the conduct Ibelieve may violate the Code and which I feelcompelled, by the terms of the Code, to bringto your attention.”Letter of Matthew Lee, dated May 18, 2008, as included anddiscussed in the Report of the examiner for the bankruptcytrustee in the Lehman bankruptcy© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.221
  • 94. The Lehman Oversight"We are also dealing with a whistleblower letter,that is on its face pretty ugly.“William Schlich, former lead partner on Ernst &Young Lehman team. June 5, 2008. In July, 2008, theE&Y team told Lehmans audit committee that theallegations were unfounded and immaterial. Lehmanwould file for bankruptcy on September 15, 2008.© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.222
  • 95. 223WorldCom• What was behind its market climb?• Who else had to “go along”?• WorldCom culture?© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 96. 224David Myers to Buddy Yates“I might be narrow-minded, but I can’t seea logical path for capitalizing excesscapacity.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 97. 225Buddy Yates to Scott Sullivan“David and I have reviewed and discussed yourlogic of capitalizing excess capacity and can findno support within the current accountingguidelines that would allow for this accountingtreatment.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 98. 226David Myers to SEC“This approach had no basis in accountingprinciples.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 99. 227Betty and Buddy to ScottFormer WorldCom CFO Scott Sullivan met with twoaccountants, Buford Yates and Betty Vinson, who objected tothe schemes, artifices, and frauds for which they were beingasked to serve as accomplices for. They wanted to tender theirresignations. They had been asked to make entries that tookfrom reserves (the cookie jar phenomenon) and applied them toboost results so as to meet the earnings expectations of themarkets. Sullivan explained that the two of them should thinkof the company as an aircraft carrier that has planes still in theair. He told them that they could leave, but only after theplanes had landed.From MARIANNE M. JENNINGS, THE SEVEN SIGNS OF ETHICAL COLLAPSE: HOW TO SPOT MORALMELTDOWNS IN COMPANIES BEFORE IT’S TOO LATE (2006).Susan Pulliam, “A Staffer Ordered to Commit Fraud Balked, Then Caved,” Wall Street Journal, June23, 2003, pp. A1, A6.© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copiedor duplicated, or posted to a publicly accessible website, in whole or in part.
  • 100. 228Scott Sullivan at Sentencing“Everyday I regret what happened at WorldCom.I am sorry for the hurt caused by my cowardlydecisions.”“I chose the wrong road, and in the face ofintense pressure I turned away from the truth. Itwas a misguided attempt to save the company.”© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.
  • 101. 229Common Factors inFinancial Fraud Cases• Numbers Pressure• Meeting numbers at all costs• Fear among employees• Unwillingness internally and externally to raise questionsabout the company• Perception that company was different and more innovativethan others• Weak boards• Conflicts of interest• Tremendous community and philanthropic presences ofcompanies and officers• Always meeting goals to the penny• Unprecedented performance© 2012 Cengage Learning. All Rights Reserved. May not bescanned, copied or duplicated, or posted to a publicly accessiblewebsite, in whole or in part.