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Reading and writingReading and writingReading and writingReading and writingReading and writing .png .png ethics_in_finance.pdf Unformatted Attachment Preview UV0472 Version 4.0 ETHICS IN FINANCE The first thing is character, before money or anything else. —J. P. Morgan (in testimony before the U.S. Congress) The professional concerns himself with doing the right thing rather than making money, knowing that the profit takes care of itself if the other things are attended to. —Edwin LeFevre, Reminiscences of a Stock Operator Integrity is paramount for a successful career in finance and business, as practitioners remind us. One learns, rather than inherits, integrity. And the lessons are everywhere, even in case studies about finance. To some people, the world of finance is purely mechanical, devoid of ethical considerations. The reality is that ethical issues are pervasive in finance. Exhibit 1 gives a list of prominent business scandals around the turn of the twenty-first century. One is struck by the wide variety of industrial settings and especially by the recurrent issues rooted in finance and accounting. Still, the disbelief that ethics matter in finance can take many forms. “It’s not my job,” says one person, thinking that a concern for ethics belongs to a CEO, an ombudsperson, or a lawyer. But if you passively let someone else do your thinking, you expose yourself to complicity in the unethical decisions of others. Even worse is the possibility that if everyone assumes that someone else owns the job of ethical practice, then perhaps no one owns it and that therefore the enterprise has no moral compass at all. Another person says, “When in Rome, do as the Romans do. It’s a dog-eat-dog world. We have to play the game their way if we mean to do business there.” Under that view, it is assumed that everybody acts ethically relative to his local environment so that it is inappropriate to challenge unethical behavior. This is moral relativism. The problem with this view is that it presupposes that you have no identity, that, like a chameleon, you are defined by the This technical note was prepared by Robert F. Bruner and draws segments from two of his books, Applied Mergers and Acquisitions (John Wiley & Sons, copyright © 2004 by Robert F. Bruner) and Deals from Hell: Lessons That Rise Above the Ashes (John Wiley & Sons, copyright © 2005 by Robert F. Bruner). These segments are used here with his permission. Copyright © 2006 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. -2- UV0472 environment around you. Relativism is the enemy of personal identity and character. You must have a view, if you are rooted in any cultural system. Prepare to take a stand. A third person says, “It’s too complicated. Civilization has been arguing about ethics for 3,000 years. You expect me to master it in my lifetime?” The response must be that we use complicated systems dozens of times each day without a full mastery of their details. Perhaps the alternative would be to live in a cave, which is a simpler life but much less rewarding. Moreover, as courts have been telling the business world for centuries, ignorance of the law is no defense. If you want to succeed in the field of finance, you must grasp the norms of ethical behavior. There is no escaping the fact that ethical reasoning is vital to the practice of business and finance. Tools and concepts of ethical reasoning belong in the financial toolkit alongside other valuable instruments of financial practice. Ethics and economics were once tightly interwoven. The patriarch of economics, Adam Smith, was actually a scholar of moral philosophy. Although the two fields may have diverged in the last century, they remain strong complements.1 Morality concerns norms and teachings. Ethics concerns the process of making morally good decisions or, as Andrew Wicks wrote, “Ethics has to do with pursuing—and achieving—laudable ends.”2 The Oxford English Dictionary defines moral as follows: “Of knowledge, opinions, judgments, etc.; relating to the nature and application of the distinction between right and wrong.”3 Ethics, however, is defined as the “science of morals.”4 To see how the decision-making processes in finance have ethical implications, consider the following case study. Minicase: WorldCom Inc.5 The largest corporate fraud in history entailed the falsification of $11 billion in operating profits at WorldCom Inc. WorldCom was among the three largest long-distance telecommunications providers in the United States, the creation of a rollup acquisition strategy by its CEO, Bernard Ebbers. WorldCom’s largest acquisition, MCI Communications in 1998, capped the momentum-growth story. This, combined with the buoyant stock market of the late 1990s, increased the firm’s share price dramatically. By early 2001, it dawned on analysts and investors that the United States was greatly oversupplied with long-distance telecommunications capacity. Much of that capacity had been 1 Sen (1987) and Werhane (1999) have argued that Smith’s masterpiece, Wealth of Nations, is incorrectly construed as a justification for self-interest and that it speaks more broadly about virtues such as prudence, fairness, and cooperation. 2 Wicks (2003), 5. 3 Oxford English Dictionary (1989), vol. IX, 1068. 4 Oxford English Dictionary (1989), vol. V, 421. 5 This case is based on facts drawn from Pulliam (2003), Blumenstein and Pulliam (2003), Blumenstein and Solomon (2003), and Solomon (2003). -3- UV0472 put in place with unrealistic expectations of growth in Internet use. With the collapse of the Internet bubble, the future of telecom providers was suddenly in doubt. WorldCom had leased a significant portion of its capacity to both Internet service providers and telecom service providers. Many of those lessees declined and, starting in 2000, entered bankruptcy. In mid-2000, Ebbers and WorldCom’s chief financial officer (CFO), Scott Sullivan, advised Wall Street that earnings would fall below expectations. WorldCom’s costs were largely fixed—the firm had high operating leverage. With relatively small declines in revenue, earnings would decline sharply. In the third quarter of 2000, WorldCom was hit with $685 million in write-offs as its customers defaulted on capacity-lease commitments. In October 2000, Sullivan pressured three midlevel accounting managers at WorldCom to draw on reserve accounts set aside for other purposes to cover operating expenses, which reduced the reported operating expenses and increased profits. The transfer violated rules regarding the independence and purpose of reserve accounts. The three accounting managers acquiesced, but later regretted their action. They considered resigning, but were persuaded to remain with the firm through its earnings crisis. They hoped or believed that a turnaround in the firm’s business would make their action an exception. Conditions worsened in the first quarter of 2001. Revenue fell further, producing a profit shortfall of $771 million. Again, Sullivan prevailed on the three accounting managers to shift operating costs—this time, to capital-expenditure accounts. Again, the managers complied. This time, they backdated entries in the process. In the second, third, and fourth quarters of 2001, they transferred $560 million, $743 million, and $941 million, respectively. In the first quarter of 2002, they transferred $818 million. The three accounting managers experienced deep emotional distress over their actions. In April 2002, when they discovered that WorldCom’s financial plan for 2002 implied that the transfers would continue until the end of the year, the three managers vowed to cease making transfers and to look for new jobs. But inquiries by the U.S. Securities and Exchange Commission (SEC) into the firm’s suspiciously positive financial performance triggered an investigation by the firm’s head of internal auditing. Feeling the heat of the investigation, the three managers met with representatives from the SEC, the U.S. Federal Bureau of Investigation (FBI), and the U.S. attorney’s office on June 24, 2002. The next day, WorldCom’s internal auditor disclosed to the SEC the discovery of $3.8 billion in fraudulent accounting. On June 26, the SEC charged WorldCom with fraud. But the scope of the fraud grew. In addition to the $3.8-billion reallocation of operating expenses to reserves and capital expenditures, WorldCom had shifted another $7.2 billion to its MCI subsidiary, which affected the tracking stock on that entity. As news of the size of the fraud spread, WorldCom’s stock price sank. From its peak in late 2000 until it filed for bankruptcy in July 2002, about $180 billion of WorldCom’s equitymarket value evaporated. In March 2003, WorldCom announced that it would write off $79.8 -4- UV0472 billion in assets following an impairment analysis: $45 billion of the write-off arose from the impairment of goodwill. The three accounting managers had hoped that they would be viewed simply as witnesses. On August 1, they were named by the U.S. attorney’s office as unindicted coconspirators in the fraud. WorldCom fired them immediately. Unable to cope with the prospect of large legal bills for their defense, they pleaded guilty to securities fraud and conspiracy to commit fraud. The charges carried a maximum of 15 years in prison. Bernard Ebbers and Scott Sullivan were charged with fraud. A study conducted by the bankruptcy examiner concluded that Ebbers had played a role in inflating the firm’s revenues. One example cited in the report was the firm’s announcement of the acquisition of Intermedia Communications Inc. in February 2001. Even before WorldCom’s board had approved the deal, the firm’s lawyers made it look as if the board had approved the deal by creating false minutes. WorldCom emerged from bankruptcy in 2004 with a new name, MCI Communications. On March 2, 2004, Sullivan pleaded guilty to fraud. Ebbers continued to protest his innocence, arguing that the fraud was masterminded by Sullivan without Ebbers’s knowledge. A jury found Ebbers guilty on March 15, 2005. In the summer of 2005, MCI agreed to be acquired by Verizon, a large regional telephone company in the United States. This case illustrates how unethical behavior escalates over time. Such behavior is costly to companies, investors, and employees. It damages investor confidence and trust—and it is invariably uncovered. Fraud and earnings management share a common soil: a culture of aggressive growth. Although growth is one of the foremost aims in business, the mentality of growth at any price can warp the thinking of otherwise honorable people. The shields against fraud are a culture of integrity, strong governance, and strong financial monitoring. Yet in some circumstances, such shields fail to forestall unethical behavior. Michael Jensen (2005) explored an important circumstance associated with managerial actions: when the stock price of a firm is inflated beyond its intrinsic (or true) value. Jensen pointed to the scandals that surfaced during and after a period of overvaluation in share prices between 1998 and 2001. He argued that “society seems to overvalue what is new.” When a firm’s equity becomes overvalued, it motivates behavior that poorly serves the interests of those investors on whose behalf the firm is managed. Managers whose compensation is tied to increases in share price are motivated to “game the system” by setting targets and managing earnings in ways that yield large bonuses. This behavior is a subset of problems originating from target-based corporate-budgeting systems. Jensen argues that the market for corporate control solves the problem of undervalued equity (i.e., firms operating at low rates of efficiency) with the instruments of hostile takeovers, proxy fights, leveraged buyouts, and so on. But he points out that there is little remedy for the opposite case, overvalued equity. Equity-based compensation—in the form of stock options, shares of stock, stock-appreciation rights, and so on—merely adds fuel to the fire. -5- UV0472 Paradoxically, a high stock price would seem to be desirable. But occasionally, stock prices become detached from the fundamental basis for their valuation—that is, when the price exceeds the intrinsic value of the shares. Jensen defines overvalued stock as occurring when the performance necessary to produce that price cannot be attained except by good fortune. The problem is that managers fail to face the facts and explain to investors the overvaluation of shares. Instead, they take actions that prolong, or even worsen, the overvaluation. Those actions destroy value in the long run, even though they may appear to create or preserve value in the short run—as was the case with WorldCom. A little of this behavior begins to stimulate more; soon, a sense of proportion is lost and the organization eventually turns to fraud. The hope is to postpone the inevitable correction in price until after the executive has moved on to another firm or retired. Telling the truth to investors about overvaluation is extremely painful. The firm’s stock price falls, executive bonuses dwindle, and the directors listen to outraged investors. What the tragedies of WorldCom and the other firms cited in Exhibit 1 share is that, like Peter Pan, those companies refused to grow up. They refused to admit frankly to their shareholders and to themselves that their very high rates of growth were unsustainable. Why One Should Care about Ethics in Finance Managing in ethical ways is not merely about avoiding bad outcomes. There are at least five positive arguments for bringing ethics to bear on financial decision making. Sustainability. Unethical practices are not a foundation for enduring, sustainable enterprise. This first consideration focuses on the legacy one creates through one’s financial transactions. What legacy do you want to leave? To incorporate ethics into our finance mind-set is to think about the kind of world that we would like to live in and that our children will inherit. One might object that, in a totally anarchic world, unethical behavior might be the only path in life. But this view only begs the point: we don’t live in such a world. Instead, our world of norms and laws ensures a corrective process against unethical behavior. Ethical behavior builds trust. Trust rewards. The branding of products seeks to create a bond between producer and consumer: a signal of purity, performance, or other attributes of quality. This bond is built by trustworthy behavior. As markets reveal, successfully branded products command a premium price. Bonds of trust tend to pay. If the field of finance were purely a world of one-off transactions, it would seem ripe for opportunistic behavior. But in the case of repeated entry into financial markets and transactions by, for example, active buyers, intermediaries, and advisers, reputation can count for a great deal in shaping the expectations of counterparties. This implicit bond, trust, or reputation can translate into more effective and economically attractive financial transactions and policies. Surely, ethical behavior should be an end in itself. If you are behaving ethically only to get rich, then you are hardly committed to that behavior. But it is a useful encouragement that -6- UV0472 ethical behavior need not entail pure sacrifice. Some might even see ethical behavior as an imperfect means by which justice expresses itself. Ethical behavior builds teams and leadership, which underpin process excellence. Standards of global best-practice emphasize that good business processes drive good outcomes. Stronger teams and leaders result in more agile and creative responses to problems. Ethical behavior contributes to the strength of teams and leadership by aligning employees around shared values and by building confidence and loyalty. An objection to this argument is that, in some settings, promoting ethical behavior is no guarantee of team building. Indeed, teams might blow apart over disagreements about what is ethical or what action is appropriate to take. But typically, this is not the fault of ethics, but rather that of the teams’ processes for handling disagreements. Ethics sets a higher standard than laws and regulations. To a large extent, the law is a crude instrument. It tends to trail rather than anticipate behavior. It contains gaps that become recreational exploitation for the aggressive businessperson. Justice may be neither swift nor proportional to the crime; as Andrew Wicks said, it “puts you in an adversarial posture with respect to others, which may be counterproductive to other objectives in facing a crisis.”6 To use only the law as a basis for ethical thinking is to settle for the lowest common denominator of social norms. As Richard Breeden, the former SEC chair, said, “It is not an adequate ethical standard to want to get through the day without being indicted.”7 Some might object to that line of thinking by claiming that, in a pluralistic society, the law is the only baseline of norms on which society can agree. Therefore, isn’t the law a “goodenough” guide to ethical behavior? Lynn Paine argued that this view leads to a “compliance” mentality and that ethics takes one further. She wrote, “Attention to law, as an important source of managers’ rights and responsibilities, is integral to, but not a substitute for, the ethical point of view—a point of view that is attentive to rights, responsibilities, relationships, opportunities to improve and enhance human well-being, and virtue and moral excellence.”8 Reputation and conscience. Motivating ethical behavior only by trumpeting its financial benefits without discussing its costs is inappropriate. By some estimates, the average annual income for a lifetime of crime (even counting years spent in prison) is large—it seems that crime does pay. If income were all that mattered, most of us would switch to this lucrative field. The business world features enough cheats and scoundrels who illustrate that there are myriad opportunities for any professional to break promises—or worse—for money. Ethical professionals decline those opportunities for reasons having to do with the kind of people they want to be. Amar Bhide and Howard Stevenson wrote: 6 Wicks (2003), 11. K. V. Salwen, “SEC Chief’s Criticism of Ex-Managers of Salomon Suggests Civil Action is Likely,” Wall Street Journal, 20 November 1991, A10. 8 Paine (1999), 194–195. 7 -7- UV0472 The businesspeople we interviewed set great store on the regard of their family, friends, and the community at large. They valued their reputations, not for some nebulous financial gain but because they took pride in their good names. Even more important, since outsiders cannot easily judge trustworthiness, businesspeople seem guided by their inner voices, by their consciences…. We keep promises because it is right to do so, not because it is good business.9 For Whose Interests Are You Working? Generally, the financial executive or deal designer is an agent acting on behalf of others. For whom are you the agent? Two classic schools of thought emerge. • Stockholders. Some national legal frameworks require directors and managers to operate a company in the interests of its shareholders. This shareholder focus affords a clear objective: do what creates shareholder wealth. This approach would seem to limit charitable giving, “living-wage” programs, voluntary reduction of pollution, and enlargement of pension benefits for retirees, all of which can be ... Purchase answer to see full attachment