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Business & Professional Ethics
for Directors, Execu6ves &
Accountants, 8e
Leonard J. Brooks and Paul Dunn
Cengage Learning, Boston, MA, 2018
Chapter 5 – Corporate Ethical Governance &
Accountability
Chapter Ques:ons and Case Solu:ons
Chapter Ques-ons..................................................................2
Case Solu-ons........................................................................9
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Chapter Ques:ons
1. Must a company be incorporated as a beneBt corporaCon in order to legally consider acCons other
than those in pursuit of proBt?
No.
All publicly traded corporaCons must meet governance requirements. Given the ability of nonshareholder stakeholders to exert pressure on corporaCons, that may include taking
stakeholders’ interests into account, and in some jurisdicCons, this is a legal requirement.
Therefore, corporaCons have legal accountability to shareholders, but strategic accountability
also to stakeholders. Because gaining the support of non-shareholder stakeholders may be in the
best interest of a company, choosing a course of acCon may involve trade-oPs between
shareholders and other stakeholders in order to gain in the long-term, rather than just the shortterm.
Also, a company can apply for designaCon as a CerCBed B CorporaCon (B Corp) aTer
incorporaCon as long as it meets requirements of transparency and social and environmental
performance.
2. If Lynn Stout is correct, that the drive for shareholder value is a myth, why do so many companies
conCnue to use it as a goal?
Stout asserts that U.S corporate law does not require corporaCons to maximize share price,
shareholder wealth, or shareholder value; thus, the myth. But many lawyers, board members
and execuCves have been living in a world where they only needed to be concerned that a
proposed acCon was legal, and was intended to produce a proBt (and that was usually only a
short-term proBt that was needed). They have found those to be a rather easy set of tests to
consider and to meet. Longer term consideraCons usually involve measurement diZculCes that
many of these individuals consider to be problemaCc, so they naturally were reluctant and
therefore slow to embrace them.
In addiCon, historically companies have been classiBed as “for-proBt,” “not-for-proBt,” or “nonproBt,” so the conCnuing rubric for monikers contributes to the myth.
The myth is also perpetuated by common compensaCon schemes that focus only on proBt or
return on investment, not on the contribuCon to stakeholders. For example, when execuCves,
directors, and shareholders stand to gain from short-term, rather than long-term thinking under
the banner of shareholder value (for example, at Valeant PharmaceuCcals), they may see li_le
incenCve to change, because they may be moCvated by greed. Increasingly, however,
enlightened directors and execuCves realize that recognizing stakeholders--other than just
shareholders--and gaining their support, may be in the best long-term interest of the
corporaCon. In some jurisdicCons, corporate statutes are changing so that directors can act in
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the best interest of stakeholders, not just shareholders, especially if that increases long-term
beneBts for a corporaCon, even at the loss of short-term gains.
3. What is the role of a board of directors from an ethical governance standpoint?
The board is responsible for the acCons of the corporaCon, both with regard to the achievement
of the corporaCon’s strategic objecCves to enhance shareholder value and maintain the support
of the company’s stakeholders to achieve those objecCves. This means that the board must
build into the company’s governance framework such objecCves as growth, proBtability in the
short- and long-run, compliance with laws, and respect for the rights of the primary
stakeholders. The board must set or approve policies that will achieve these objecCves, hire
execuCves and monitor their performance in accord with those objecCves, and make correcCons
where required. The directors must oversee the governance system, monitor it and take
responsibility for it as the agents of the shareholders.
4.
Explain why corporaCons are legally responsible to shareholders but are strategically responsible
to other stakeholders as well.
CorporaCons are created under the laws of a parCcular jurisdicCon (Country, state,
province …) and the directors, as agents of the shareholders’, must account to those
shareholders and must follow the laws of the jurisdicCon in which they are incorporated
as well as where they operate. In addiCon, according to stakeholder theory, corporaCons
need the support of their stakeholders to reach their strategic objecCves on a conCnuing
and sustainable basis. This support can best be obtained it the corporaCon take into
account the interests of stakeholders when building and implemenCng its strategy.
Consequently, corporaCons are legally responsible to shareholders and strategically
responsible to a broader set of stakeholders.
5.
What should an employee consider when considering whether to give or receive a giT?
An employee should be aware that giving or receiving a giT may raise congicts of interest
(COI), and should understand the COI discussion in this chapter, including the material to
be considered speciBcally that is in Table 5.6.
6.
When should an employee saCsfy his or her self-interest rather than the interest of his or her
employer?
An employee’s self-interest, should be saCsBed Brst, if saCsfying the employer would be
unlawful or harm society, or harm the employee or other employees or other people
physically or mentally, or in the case of a professional would oPend the professional’s
code of conduct. Use of an ethical decision making approach such as those discussed in
Chapter 5 could be helpful.
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7. Can an apparent congict of interest where there are adequate safeguards to prevent harm be as
important to an execuCve or a company as one where safeguards are not adequate?
Yes, because an apparent congict of interest can be perceived as real and acCons triggered in
response, whether or not safeguards are present, it can be a risk with the potenCal to do
signiBcant harm. An apparent congict of interest can damage reputaCons, so avoiding congicts
of interest is ideal; managing them is second-best.
8. How can a company control and manage congicts of interest?
See the discussion on pages 257-264 of the text. Employees must be constantly made aware of
potenCal COI and their consequences through training and reinforcement. There must be a
mechanism provided for clariBcaCon and guidance including codes and counsellors. Monitoring
and sancCons are essenCal. Table 5.5 provides a list of helpful management techniques and
issues to consider. Table 6.13 provides safeguards that are available in the accounCng Brms and
profession, which may be of some use in corporaCons to manage the risk of COI problems.
9. What is the role of an ethical culture and who is responsible for it?
An ethical culture provides conCnual guidance to execuCves and other employees with regard to
appropriate pa_erns of behavior, standards of conduct, and how decision are to be made. It is a
vital part of the disseminaCon of company policies and of the internal control compliance
mechanism required by SOX of directors, the CEO and CFO. External auditors have long relied
upon an organizaCon’s internal controls for assurance that transacCons, records and reports are
handled properly.
Without an ePecCve ethical corporate culture, directors, execuCves and auditors are very much
at risk. A corporaCon needs an ethical corporate culture to guide employees to do what the
directors and senior oZcers have decided to be appropriate behavior. Codes of conduct are not
always read or understood well, nor comprehensive, so employees usually consider and emulate
what they believe to be appropriate norms or acCons from informally observing their bosses and
colleagues. An ethical culture is one where those informal observaCons are intenConally
integrated with formal ethics program objecCves and guidance. The informal signals given by
senior execuCves are so important to good ethical governance that directors are now expected
to conCnually assess the ethicality of the “tone at the top”, and to hire/Bre/encourage good role
models. Consequently, the corporaCon’s directors are ulCmately responsible for the ethical
culture, and in turn so are the senior execuCves, as are auditors to some extent (for not Bnding
obvious gaws). In turn, execuCves and managers at lower levels are expected to be supporCve.
A corporate ethics oZcer or advisor can be quite helpful.
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10. What is the most important contribuCon of a corporate code of conduct?
Guidance to ensure minimum standards of behavior and protect the reputaCon of the person,
profession or organizaCon, so that no one can later say: "No one ever told me...", or "I though
that's what top management wanted.”
11. Are one or more of the fundamental principles found in codes of conduct more important than the
rest? Why?
I would argue that all of the ethical principles named at the start of Table 5.18 – honesty,
fairness, compassion, integrity, predictability and responsibility – are very important and each is
essenCal in speciBc situaCons. However, integrity is perhaps the over-reaching principle.
12. Why should codes focus on principles rather than speciBc detailed rules?
Principles are suscepCble to interpretaCon to give guidance on complex or newly emerging
issues. They are far easier to remember and therefore understand and use than an exhausCve,
detailed lisCng of rules. Few people would read, or could remember what they have read of
such a list.
13. How could you monitor compliance with a code of conduct in a corporaCon?
The internal auditor should be charged with tesCng to see if employees have complied with the
code. Tests could involve surveys, annual sign-oPs, interviews, whistle-blower comments, review
of HR complaints and lawsuits, and reporCng of disciplinary acCons. The annual sign-oP process
can be broadened to include a statement that each employee has done nothing to contravene
the code in le_er and in spirit, nor do they know of anything they haven't reported that anyone
else has done. An annual report should be made to the Audit Commi_ee in addiCon to more
frequent communicaCon if required.
14. How can a corporaCon integrate ethical behavior into their reward and remuneraCon schemes?
Rewards could be oPered for outstanding performance, such as for assistance in revealing fraud.
The recogniCon could take the form of paper medals (cerCBcates for the oZce /factory wall),
publicity of good deeds, cash payment on a percentage of recovery/cost avoidance basis, or an
increment of base salary. SancCons should be applied for wrongdoing, including disciplinary
interviews, reducCon of raises, Bnes, dismissal etc. Management-by-objecCve (MBO)-type goals
may be employed to provide the appropriate basis for posiCve recogniCon.
15. Other than a code of conduct, what aspects of a corporate culture are most important and why?
See the discussion beginning on Chapter 5, page 264 of the text. Tables 5.10 and 5.11 are
speciBcally instrucCve, as are Tables 5.12, 5.13, and 5.14.
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16. Is the SOX-driven ePort being made to check on the ePecCveness of internal control systems worth
the cost? Why and why not?
The SOX governance reforms, and the ensuing SEC internal control cerCBcaCon by the CEO and
CFO, and audit thereof, have triggered costly SecCon 404 reviews of internal control and
subsequent improvements that were overdue in many cases. Without sound internal control
systems, accurate Bnancial statements are very unlikely. Lynn Turner, former Chief Accountant at
the SEC, has indicated that the aggregate cost of all the SecCon 404 reviews by SEC registrant
companies is well below the amount lost by Enron’s investors, and that is only one such
bankruptcy.
It is also clear that many companies have good systems of internal control and do not need the
moCvaCon and cost of SecCon 404 compliance. Their costs, however, should be less than for the
oPending Brms. See also the answer to quesCon 17.
17. Why should an ePecCve whistle-blower mechanism be considered a “failsafe mechanism” in SOX
SecCon 404 compliance programs?
No ma_er how good a company’s internal controls are, frauds will sCll occur because systems
cannot prevent and/or catch everything – they can only lower the risk of wrongdoing. It is likely;
however, that someone has seen or become concerned about an individual’s behavior or a
transacCon. If that person can be induced to become a whistle-blower, then the whistle-blowing
mechanism could be considered a “fail-safe” mechanism or add-on to normal internal controls
and/or SecCon 404 compliance programs.
18. If you were asked to evaluate the quality of an organizaCon’s ethical leadership, what would the Bve
most important aspects be that you would wish to evaluate, and how would you do so?
Linda Treviño and others, in 1999, idenCBed Bve important aspects of a company’s ethical
leadership. Beside each are some quesCons of many that could be asked to test a corporaCon’s
adherence to each.
•
Ethical leadership by execuCves and supervisors: Do they espouse the values of the
organizaCon? Support and promote ethical decision making? Are decisions made in
stakeholders’ best interests, rather than to beneBt corporate leaders? Are realisCc goals
set that do not exert undue pressure on employees to meet those goals whatever the
cost? Are product problems corrected when they are found or covered up?
•
Reward systems that incorporate ethical consideraCons: Are rewards systems Ced to
values espoused by the corporaCon (for example, to reducing tailings in a mining
company espousing sustainable development or increasing organic content of oPerings
in a health-espousing grocery chain or puwng paCent health Brst at a pharmaceuCcal
company)?
•
Perceived fairness, fair treatment of employees: Does the company oPer living wages?
BeneBts? Reasonable working condiCons? Flexible working hours?
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•
Open discussion of ethics in the organizaCon: Do leaders walk the talk? Do people
consider ethics in decision making? Do employees sign oP on a code of ethics?
•
Authority structure that emphasizes an employee’s accountability and responsibility to
quesCon his or her own acCons and an obligaCon to quesCon authority when something
seems wrong: Are top execuCves willing to be corrected? Can employees disagree with
management without fear of reprisal? Can employees present poor company results
without being pressured to disguise them? Are employees encouraged to provide input
to improve operaCons?
19. Why is it suspected that corporate psychopaths gravitate to certain industries, and what should
corporaCons within those industries do about it?
Among other traits, corporate psychopaths pursue their own objecCves, rather than others’, and
lack empathy and conscience. When working in the Bnance industry, in areas such as investment
and banking, they are thinking about the game or wealth (their own), but are not concerned
with how their acCons might aPect people or their or corporaCons. CorporaCons in those
industries need to conduct personality tests on prospecCve employees and ensure that people
Bwng the proBle, if hired, have limited power and li_le unchecked autonomy in their work. The
corporaCon should constantly be on watch for individuals who display poor moCvaCon or
judgement that regects a negligible respect for what is right based on the projected impacts on
other stakeholders.
20. DescripCve commentary about corporate social performance is someCmes included in annual
reports. Is this indicaCve of good performance, or is it just window dressing? How can the
credibility of such commentary be enhanced?
SomeCmes CSP reporCng indicates good performance, while at other Cmes it is window
dressing. The credibility of such disclosure can be enhanced by:

the inclusion of negaCve performance or results

review and a_estaCon by an independent reviewer/auditor/commi_ee

comparison with benchmarks now available for similar companies

comparison with ethically screened companies or inclusion in ethically screened investor
databases – Domini, EthicScan or FSTE4Good Indices or lists.
21. Should professional accountants push for the development of a comprehensive framework for the
reporCng of corporate social performance? Why?
Yes, such a framework will assist in making directors and execuCves aware of what they should
and can do to develop and ethical culture, manage risks and ensure a sound system of internal
control. All of these will assist greatly in maintaining trust, credibility, and accurate reporCng of
ethical transacCons that external auditors must cerCfy. Professional accountants working within
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corporaCons will Bnd that their professional responsibiliCes will be much easier to discharge if
they are working in an ethical culture.
22. Do professional accountants have the experCse to audit corporate social performance reports?
They have an understanding of audit and reporCng principles. However, they usually lack
speciBc knowledge of the accountability frameworks and key indicators involved. These can be
learned as readily as for any other management control system. From Cme to Cme, expert
engineers or environmentalists may need to consult with professional accountants to ensure
that such frameworks and indicators are appropriate. Students will increasingly be aware of the
developments that are taking place worldwide in regard to such reporCng. For an up-to-date
picture of developments, see the references in Table 5.23, and refer to the discussion of CSR
reporCng and audit in Chapter 7.
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Case Solu:ons
Cases on Ethical Corporate Culture
1. Hospital Governance Challenges (for Chapter 5)
This case is
new to
Chapter 5, and is provided here:
Hospital Governance Challenges
ETHICS CASE
Kelly Brown had been a member of the
Board of Governors of the Wolfson
General Hospital for two years, and had
been asked to consider becoming the
Vice-Chair of the Board. She had been
a nurse before leaving to raise her
family, and now enjoyed participating
on the Board to make the healthcare
provided by Wolfson General (WGH) as
good as possible for her community.
However, she wasn’t sure she wanted to
become the Vice-Chair because that
meant that within a year or so, she
would become the Chair, and would be
responsible for all hospital functions, its
reputation, and the generation of funds
for growth. She realized that her
knowledge of governance matters was
limited, and she asked for your
assistance in helping her consider
several issues, and her final decision to
become the Chair.
Kelly knew that there would be
increasing expectations for maintenance
of WGH’s reputation, and she wasn’t
sure that the existing governance
mechanisms were effective in identifying
and assessing reputational and financial
risks, and she doubted she that was
personally equipped to play a leading role in
improving a hospital governance system.
But no one else on the board who was better
equipped wanted to take the time required.
Kelly realized that she had the
advantage of growing up in the community
and of knowing many of the senior doctors
and nursing staff. But that was a mixed
blessing, because several of her nursing
friends had been confiding in her about
questionable medical practices, and rumors
about strange purchasing deals and other
“close” relationships.
She had also been reading news stories
about scandals at three nearby hospitals that
had destroyed the reputation of the hospitals
and of their governors, including the
following:
 Fraud, embezzlement and kickback
schemes by senior managers of
construction projects, including:
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o
o
Bidrigg
ing
and
man
ipul
atio
n of
bids
to
favo
r
spec
ific
cont
ract
ors
and
sup
plie
rs
Infl
ated
pric
es
in
exc
han
ge
for
kick
bac
ks
o
Wor
k by
cont
ract
ors
on
man
ager
’s
hom
es
o
Pro
visi
on
of
jobs
for manager’s
children, partly
funded by hospital
overpayments
o
Luxury fishing trips

o
Luxury trips to Napa,
California, and on a Baltic
cruise
o
Payment for old invoices
for which no one
remembered the work
happening.
A manager of redevelopment, who
was involved in the contractor
selection process, failed to disclose
conflicts
of
interest
with
contractors, including:
o
Two business ventures
(bottled water and
commercial real estate)
with the bid-winning
contractor
o
A loan over $100,000
from the contractor to the
bottled water company.
A manager arranged for purchases
from companies her husband was
involved with without competing
quotations, purchase orders or
contracts. In fact, the paper trail
for purchases was frequently
created after purchases had been
made. Also, her husband sent
invoices to the hospital through
pre-existing vendors to avoid
procurement policies.
Of course, scandals frequently came to
light on the medical practice side of the
hospitals as well, and here the problem of
doctors not wishing to criticize or “tell” on
colleagues was evident. Doctors who made
mistakes that caused patients a great deal of
pain or dysfunction were rarely identified
and dismissed, so that the hospitals involved
had to incur serious costs, time wastage, and
loss of reputation when the problems came
to light and lawsuits were launched. The
doctor’s “cone of silence” was simply not
serving the best interest of the patients and
hospitals involved, and some nurses were
negatively influenced against identifying
misdeeds, as well. Moreover, the reticence

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to identify problem
professionals was also
evident in that many
of the governors and
senor officers of the
hospital were doctors
or nurses, and many
of them didn’t want to
get
involved
in
disciplinary
or
dismissal processes.
Kelly
realized
that WGH had a
mission statement and
code of conduct that
called for high levels
of
service
and
integrity, but they
hadn’t been updated
for over 15 years and,
although they had
been provided to new
doctors, nurses, or
administrative
staff
when they joined the
hospital, there was no
significant discussion
or training related to
them. When Kelly
considered the Board
and
its
subcommittees, she
realized that most
Board members were
dedicated
to
providing excellent
health
care,
but
lacked
extensive
corporate Board expertise, and preferred
to leave financial matters and
administrative detail to others. In fact,
of the five Board Subcommittees, four
(Executive, Medical Advisory, Nursing
Advisory, Quality Committee, Quality
of Care) concentrated primarily on
health services, and only one focused on
financial matters (Fiscal Advisory), and
that one was chaired by the senior
administrative executive (CEO) at
WGH.
The internal and external
auditors also reported to the Board
through the Fiscal Advisory Committee.
Although the Medical Advisory and
Nursing Advisory Committees reported
on questionable medical practices,
Kelly couldn’t remember any similar
report on questionable personnel or
financial matters. She wondered if this
was because WGH’s personnel and
financial
functions
had
been
“outsourced” to a shared operation with
two other hospitals. Nor could she
remember
any organized review and discussion of the
risks WGH was facing, and of plans to
reduce those risks.
Not surprisingly, her dear friend, the
current Chair of the Board, was pushing
Kelly for her answer on whether she would
accept the nomination as Vice-Chair. He
had just dealt with a serious crisis and
wanted her answer before he could discuss
the details confidentially.
Questions:
Kelly has asked you to give her advice on
the following matters:
1.
What major governance problems does
WGH face? Which problems are the
most important and need to be fixed as
soon as possible?
2.
What are the most important ethical
problems faced by a general hospital?
How could these ethical problems best
be managed?
3.
Should WGH introduce a crisis
management process?
If so, what
should its objective be? How could that
best be achieved?
4.
Why should WGH introduce a protected
whistleblower program? Who should
administer it, what factors would make
it successful, and how should it report?
5.
Are these any other governance issues
that Kelly should consider?
6.
Should Kelly accept the nomination as
Vice-Chair?
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1. Hospital Governance Challenges (Case above)
What this
case has to
oKer
Hospitals can be for-proBt or non-proBt, and they answer to many stakeholders. Where health is
concerned, many ethical issues arise, and good governance and an ethical corporate culture can reduce
ethical risk. This case looks at Wolfson General Hospital (WGH) that has an opportunity to save itself
from the reputaConal damage neighbouring hospitals have suPered because they lacked ethical
corporate culture and good governance. In this case, a former nurse, Kelly, has been asked by the Chair—
a dear friend—to accept the nominaCon as Vice-Chair.
Teaching sugges:ons
This case can be used to examine board structures, director nominaCon, roles and responsibiliCes, in
addiCon to the variety of ethical issues that hospitals face. The hospital context makes tangible a
discussion of risk management, crisis management and ethical risk.
Discussion of ethical issues
Kelly has asked you to give her advice on the following ma_ers:
1. What major governance problems does WGH face? Which problems are the most important and
need to be Bxed as soon as possible?
Major governance problems
Kelly has a board of directors whose members have…

li_le independence on the board: this is one of most important issues and needs to be
addressed
o
inappropriate recruiCng methods (e.g., the current Chair—“her dear friend”-has asked her as a friend to accept a nominaCon for Vice-Chair)  There should
be an imparCal process for recruiCng potenCal board members; otherwise, the
board could be composed of cronies whose independence to think or act could
be compromised by congicts of interest and like-mindedness or group think.
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o


the CEO chairs the Fiscal Advisory Commi_ee (the closest to an audit commi_ee
that Wolfson General Hospital (WGH) has): a non-execuCve member of the
board, an independent lead director should serve in this role
limited knowledge and understanding of board funcCons: this is one of most important
issues and needs to be addressed
o
the directors have medical, but not Bnancial knowledge, and may not have
governance or ethics training
o
the directors have poorly deBned roles, since they “preferred to leave Bnancial
ma_ers and administraCve detail to others.”  When roles are deBned and
understood, directors perform the duCes required of the role, rather than
deciding they don’t like some duCes and passing them oP.
o
the Chair “had just dealt with a serious crisis and wanted [Kelly’s] answer before
he could discuss the details conBdenCally.”  For the Chair to act alone to deal
with a crisis—instead of invoking a well-rounded crisis management response
with feedback from the directors, stakeholder advisors, etc. -- is inappropriate.
o
no internal Bnancial controls and reporCng to the board (equivalent of an audit
commi_ee)
o
no whistleblowing channel and reporCng system (to address accounCng and
medical or personnel issues) to help support a culture of integrity
limited Cme for hospital ma_ers
Kelly would have a hospital with…

Ethical Risk: this is one of most important issues and needs to be addressed, because
of:
o
a moribund mission statement and code of conduct: no review in many years,
no associated training, no commitment from employees to agree with the
mission or abide by the code; likely no mission or values that regect the code
o
unknown culture: want a culture of integrity, but neighbouring hospitals seem to
lack one
o
no whistleblowing mechanism to help support a culture of integrity
o
no stakeholder analysis or risk assessment and management
o
reputaCon risk in the form of associaCon with other area hospitals known for a
lack of integrity
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2. What are the most important ethical problems faced by a general hospital? How could these ethical
problems best be managed?
Ethical Problems
Useful reference: [ CITATION Der15 \l 4105 ]



Fair and safe treatment of stakeholders, for example, paCents and staP. For example:
o
providing care without prejudice or judgement (even to a suspected criminal or
murderer or …)
o
fair treatment of staP (work hours, work shiTs, burden of care; compensaCon).
o
access to drugs and opportuniCes for misuse (may relate to perceived unfair
compensaCon or workplace condiCons or hiring pracCces)
o
end-of-life care; care for the vulnerable
o
errors/malpracCce (may arise when current pracCces are unchallenged and
people fear speaking up and when a corporate culture is one of organizaConal
secrecy/covering up rather than one of organizaConal learning and conCnuous
improvement)
Quality versus EZciency
o
Quality care versus inexpensive care or faster care (the la_er due to staP
shortages, for example)
o
StaP issues that could compromise care, for example:
staZng levels (e.g., shortages);

burnout; post-traumaCc stress disorder

staP compensaCon

violence and harassment in the workplace, especially because of power
hierarchies
Access to health care
o


hospital personnel as gatekeepers (including access to limited resources, which
might be organs or blood or medical procedures)
Access to informaCon (honesty; transparency; privacy)
How to Address Ethical Problems
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Table 5.14 in Chapter 5 outlines how to develop and maintain an ethical corporate culture. By
staCng a set of values and a mission, and developing a supporCve ethical corporate culture that
employees must review, ascribe to, and be trained in, the likelihood increases that clearer,
decisions can be made when staP are faced with ethical dilemmas. With clearer procedures and
reporCng, fewer crises may arise. Understanding stakeholders and their issues and expectaCons
can reduce congict.
3. Should WGH introduce a crisis management process? If so, what should its objecCve be? How could
that best be achieved?
Yes! Its objecCve should be to prevent crises, if possible, by anCcipaCng and planning for risks-internal and external--that could aPect the hospital. Crisis management should stem from risk
analysis and management, and understanding stakeholders--their issues and expectaCons and
how those might impact the hospital and vice versa--is a place to start. Developing and
maintaining an ethical corporate culture can reduce the number of issues that develop into
crises, and management must include an ethical reacCon to the crisis. The source of externally
driven crises—for example, a new pandemic—may not be controllable, but management of the
crisis would include:

AnCcipaCon and planning

Assignment of responsibility

Responsible gow of informaCon to the public and to hospital employees

Ethical reacCon through the ongoing nurturing of an ethical corporate culture

ConsideraCon of ethical risk (this might include human resources policies and
compensaCon, work hours and employee safety)
Because crisis management stems from good risk management, see Table 5.4 in Chapter 5,
which outlines areas of corporate risk management (e.g., governance and objecCves; areas of
impact (e.g., reputaCon; assets, revenues, costs; performance; stakeholders); sources of risk
(e.g., environmental, strategic, operaConal, informaConal); speciBc hazards; degree of control
over the risk; and documentaCon).
4. Why should WGH introduce a protected whistleblower program? Who should administer it, what
factors would make it successful, and how should it report?
A protected whistleblower program is necessary, especially in a hospital sewng, where power
hierarchies—and, therefore, the risk of inCmidaCon—exist. Medical and Bnancial improprieCes
are possible in a hospital sewng (see ethical problems in QuesCon 2). In fact, the “cone of
silence” pracCce of medical staP means that problems may never be reported without a
protected whistleblower program.
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The program should be administered by an ethics oZcer (or more than one) so that medical and
monetary issues can be conSden:ally reported. It would include whistleblower protecCon and
possibly an obligaCon to report and more than one avenue for reporCng (e.g., website, hotline,
etc.). The ethics oZcer would report to a sub-commi_ee of the board, for example, an audit
commi_ee and a medical-oriented commi_ee, neither of which would have management
present. WGH seems to have many (too many?) advisory commi_ees, so the la_er might be a
Quality of Care Commi_ee.
Other key factors—to eventually make whistleblowing a last resort—would include a code of
conduct with associated training and sign-oP; ePecCve internal controls; ePecCve risk and crisis
management programs; and an ethical corporate culture; a fair hearing process so that
whistleblowers do report; a board review of ethical concerns so that remedial acCons can be
taken.
5. Are there any other governance issues that Kelly should consider?
Should the Vice-Chair automaCcally become the Chair in two years’ Cme, or should a chair be
recruited, nominated and voted for by shareholders (for a for-proBt hospital) or stakeholders
(including government funders for a non-proBt hospital)?
Should the commi_ees of the board be restructured so that directors can properly fulBll their
roles? (See Table 5.1 in Chapter 5).
Should the hospital board have some duCes that for-proBt boards would not have? (For
example, community liaison, fundraising?)
Would non-proBt boards have adequate budget to support their compensaCon and roles? (e.g.,
Bnancial oversight; quality of care; developing and maintaining an ethical corporate culture…)
6. Should Kelly accept the nominaCon as Vice-Chair?
Table 5.1 in Chapter 5 outlines the roles of directors, of which the Chair is one.
Independent directors or an independent Chair should not be employees of the hospital. The
Chair (and in this case, the Vice-Chair who succeeds the Chair) needs leadership skills to steer
the corporaCon and guide its building of an ethical corporate culture (and the CEO must play a
conspicuous role here, too). They will lead the rest of the directors and will put together the
subcommi_ees. They will be responsible for independent acCons and must have clear
knowledge of their responsibiliCes. They will have top-level accountability and will need to
manage a budget for the work they do. They must monitor and oversee the corporaCon and the
board must hire the CEO and set her/his compensaCon. They require experience, because good
intenCons will not limit their liability.
Although Kelly no longer works as an employee of the hospital, she has close Ces there.* She
“had been a nurse before leaving to raise her family, and now enjoyed parCcipaCng on the Board
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to make the healthcare provided by Wolfson General (WGH) as good as possible for her
community,” so she seems to be a very good candidate as a director to represent the local
community. She seems to have limited budgetary and governance experience, but she
recognizes that both need improvement at her hospital. With the experience she gains as a
community liaison director, and with increased governance and Bnancial training, she may one
day be eligible to apply to be Vice-Chair or Chair of one of the boards of neighbouring hospitals.
She should not accept the nominaCon as Vice Chair of this hospital at this Cme unless there is no
beBer op-on available.
* Kelly has many friendship Ces that may cloud her judgement even if they may not be
challenged as creaCng potenCal and/or apparent congicts of interest. She will be lonely at the
top, and she needs to get buy-in from everyone to act with integrity and to leave behind
personal biases or favor. If she were eligible to serve as Vice Chair in the future, and if she can
leverage her friendships to generate loyal personnel to help promulgate the code and values and
what they stand for, she may consider the Vice-Chair posiCon. But she needs to “walk the talk”
and to recognize that she can’t do personal favours for those same friends.
Useful Ar:cles, Links, and Videos
American Hospital AssociaCon’s Center for Healthcare Governance.
h_p://www.americangovernance.com/
Der Bedrosian, Jeane_e (Summer 2015). "Nursing is hard. Unaddressed ethical issues make it even
harder." Johns Hopkins Magazine, h_p://hub.jhu.edu/magazine/2015/summer/nursing-ethicsand-burnout/ (accessed November 4, 2016).
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2. Siemens’ Bribery Scandal (Chapter 5, pages 295-297)
What this case has to oKer
This case focuses on the ethical governance implicaCons of bribery to obtain or maintain business
opportuniCes. Several recent worldwide iniCaCves have recently been mounted to change the rampant
regime of bribery that has existed for centuries. In 1998, 34 countries signed the OrganizaCon for
Economic CooperaCon and Development's "ConvenCon on CombaCng Bribery of Foreign Public OZcials
in InternaConal Business TransacCons," requiring the signing countries to implement laws like the U.S.
Foreign Corrupt PracCces Act prohibiCng bribery of foreign oZcials to gain a business advantage. In
2004, more than 140 countries signed the UN's "ConvenCon against CorrupCon," requiring member
states to return assets obtained through corrupCon to the country from which they were obtained.
In the U.S., the Foreign Corrupt PracCces Act (FCPA) enacted in 1977 prohibits directors, oZcers,
employees and agents of U.S. companies, as well as foreign companies with securiCes registered with
the SEC, from making payments to foreign oZcials to obtain or retain business.
Teaching sugges:ons
It would be useful to explore bribery with the class, parCcularly the forms it can take and the history
noted above. The discussion can move on to the governance issues behind the quesCons posed at the
end of the case.
There are several interesCng quesCons related to bribery that help to start the discussion, for example:

What is the purpose of a bribe?

What forms can a bribe take?

What is the diPerence between a bribe and other types of discreConary payments made to
facilitate business in a given country?

How can a company’s internal control system detect bribes?

What should a company do when an employee is discovered bribing other company’s employee
or a government oZcial; and

How can a company react in a Cmely fashion to changes in stakeholders’ expectaCons about
what are acceptable or ethical business pracCces?
Discussion of ethical issues
1.
The senior execuCves at Siemens’ spent most of their working environment that
condoned bribery outside Germany but not inside. However, they failed to take noCce of the
changes that Transparency InternaConal – championed by a German who was embarrassed by the
double standard of his countrymen – was proposing, and that ulCmately resulted in a new
worldwide anC-bribery regime. Why did they ignore the change?
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There are several potenCal reasons why Siemens’ execuCves ignored the changes in public
expectaCons about bribery:

Wrong-headed incenCves, pushing execuCves to obtain more contracts but
disregarding or even encouraging unethical methods required to win contract bids;

Lack of Bnancial reporCng transparency, including secret discreConary spending
accounts or unidenCBed transacCons without proper authorizaCon;




2.
Lack of recogniCon of anC-bribery environmental changes;
Considering bribery ethical just because it was not illegal at the Cme, or because
everyone was doing it;
Lack of ethical corporate values against bribery;
Weak governance/control environment, no sancCons, no encouragement for ethical
behavior and deBcient ethics programs.
If you were Löscher, the new CEO, how would you show the employees and external
stakeholders that you actually have a zero tolerance policy concerning corrupCon?
The new CEO could make a public statement regarding the company’s views on bribery and
should establish policies and procedures aiming to prevent and detect this pracCce. There are a
number of possible controls that may help to detect and prevent bribery, for example:

Board members and senior execuCves should verify that the company has an ePecCve
anC-bribery program that includes idenCBcaCon and training of employees and agents
who interact with foreign oZcials;

The company should have a reporCng mechanism for violaCons, with sancCons, and an
ePecCve whistle-blower program;

Management could require an ethics audit of contract bids by the company’s internal
auditors; and,

The company should keep strict control of discreConary spending accounts.
Useful Ar:cles, Links, and Videos
Schubert, Siri & ChrisCan Miller (February 13, 2009). “At Siemens, Bribery Was Just a Line Item.”
Frontline, h_p://www.pbs.org/frontlineworld/stories/bribe/2009/02/at-siemens-bribery-wasjust-a-line-item.html
Nicholson, Chris (December 2, 2009). “Siemens to Collect Damages from Former Chiefs in Bribery
Scandal.” New York Times,
h_p://www.nyCmes.com/2009/12/03/business/global/03siemens.html
Jameson, Angela (November 16, 2007). “Siemens bribes reached around world.” Sunday Times,
h_p://business.Cmesonline.co.uk/tol/business/industry_sectors/engineering/arCcle2881841.ec
e
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Cases on Ethical Leadership
3. Salary Equity at Gravity Payments (Chapter 5, pages 297-298)
What this case has to oKer
This case explains how the founder and CEO of the company raised the minimum wage for all employees
to $70,000 and the posiCve and negaCve reacCons to his arbitrary decision.
Teaching sugges:ons
I begin by asking the students to idenCfy factors that should inguence salary levels. Normally they
menCon: educaCon and training; work experience; level of responsibility; past performance; number of
people who report to you; and industry (investment bankers are paid more than grade school teachers). I
then ask the students to think about the following three quesCons (taken Nash 1981):
1. What is your intenCon in paying the employee?
2. How does your intenCon compare with the likely results?
3. What is the symbolic potenCal if compensaCon is misunderstood?
As we take up the case, we constantly refer back to these three quesCons.
Stakeholder analysis involves understanding who a corporaCon’s stakeholders are—including employees
and compeCtors and understanding their issues and expectaCons. In this case, the salary announcement
that the CEO expected would be received happily by all gets surprising reacCons because of what looks,
iniCally, like unilateral decision making and a lack of stakeholder analysis.
Discussion of ethical issues
1. Do you think that Dan Price’s decision to raise the minimum salary to $70,000 represented ethical
leadership?
Dan seems to have characterisCcs of an ethical leader, which, from Chapter 5, include integrity,
trustworthiness, honesty, sincerity, and forthrightness. He shows compassion and that a
company's purpose is not solely about proBt. Indeed, in 2016, the company’s mission says, “Our
mission is to change the way business is done by puwng purpose and people above
proBt,”[ CITATION Gra161 \l 4105 ] so Dan seems to be “walking the talk.”
He seems to be "doing the right thing, [have] concern for people, [and have] personal morality."
Another factor for ethical leadership is "being open and approachable for discussion of
concerns," (Ch. 5), and we’re not told if Dan Price is open to discussion, though he seems to have
other characterisCcs of an ethical leader by "holding to desired values; being objecCve and fair;
exhibiCng concern for society; following reasonable ethical decision rules." (Ch. 5)
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One criCcism is that although Dan Price’s moCves were noble, he acted unilaterally without
input from other stakeholders. If we look at hypernorm values—those which are very widely
held—we could say that Price acted with honesty, and he believed he acted with utmost
fairness. And he acted in keeping with his own value set—with integrity. But despite his good
intenCons, some stakeholders, for example, employees and customers may feel that Dan did not
act with respect, because he did not consult with them. Dan may have acted predictably for him,
but given the Bnancial services industry he is in, some stakeholders—compeCtors -- would say
he did not act predictably for the industry. He showed compassion for lower-paid employees,
but might have failed to realize that the moCvaCon to work well and with ePort might be
diPerent for diPerent people and diPerent for diPerent types of jobs, so some people might
actually feel resentment or a lack of fairness in his acCon. Also, the contribuCon made to the
welfare of the company, and/or to society may diPer – so paying equally may not be regarded as
being fair.
IniCally, business criCcs might say that personally secure, wealthy, career-fulBlled, successful Dan
failed to realize that his acCons regect his own security and, perhaps, ego, guilt or boredom, and
that the acCon was a_enCon-grabbing markeCng. In order to overcome cynicism--especially
because he was proposing a disrup-ve ac-on -- one not expected and certainly very diPerent
from the norm—one might expect that he really would want buy-in from his stakeholders—
clients in parCcular, who might wonder if their rates would rise to pay for the salary changes.
However, in this case, Dan was proposing something radically diPerent in the industry, so he may
have wanted to be purposely provocaCve to compeCtors in order to show that corporate
responsibility can sCll be proBtable.
2. Do you think that Price should have arbitrarily increased the minimum salary to $70,000?
IniCally, no. A company survives, thrives, or dies because of its many stakeholders. By acCng
unilaterally, Dan ignored all others and acted as a friendly dictator. Had he idenCBed his
stakeholders and analyzed their expectaCons of the company, he may have acted diPerently. Or
would he?
Employees - People develop beliefs oTen stem from values learned through people at home or
work—for example, by rules or moCvaConal systems at work. Beliefs moCvate people to act. (Ch.
5) So, surprisingly, not all employees may have welcomed the $70,000 minimum salary.
For example, employees in informaCon technology (IT), Bnancial and legal services, as examples,
have industry-based expectaCons that the training required of their jobs, the importance of their
work—for example, in keeping computer systems running or in recruiCng and maintaining clients
or in generaCng revenue for the company, or in contract law--will result in big salaries or
bonuses. Giving lower-paid employees $70K per year might reduce moCvaCon for professional
employees to work hard—or, more likely, increase resentment that employees with lesser
training, responsibility or stress, will have higher-than-average salaries for their job class. The
case tells us that two employees in this group did quit.
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Lower paid employees may iniCally rejoice at receiving $70,000 per year, but might wonder what
is expected of them to receive it. For example, are they expected to work a great deal of
overCme? Will the heretofore casual corporate culture change? (See also QuesCon #4 and
employee moCvaCon.)
From Chapter 5 (p. 252): “The idenCBcaCon, assessment, and ranking of stakeholder interests
should help develop a comprehensive set of values for an organizaCon. In the face of compeCng
value systems for the moCvaCon of personnel, corporaCons should consider which set of values
most aligns with those of their shareholders, and of their most important stakeholders—those
that can most inguence their largest consumer and capital markets, and their ability to achieve
their strategic objecCves.”
So aTer some consideraCon, Dan may have believed that his most important stakeholders were
his employees (“Take care of your team, and they’ll take care of your clients”[ CITATION
Gra163 \l 4105 ]) and the independent business owner clients to whom he provides credit-card
services: something that other companies say but do not demonstrate. He may have also
believed that he would get only negaCve reacCons from other stakeholders—namely
compeCtors. Because his minimum salary concept was so radical—but so good in intenCon—and
because his company is not publicly held, he could do something radical, disrupCve, be an
example to other corporaCons, and gain free markeCng through media a_enCon.
One can infer that Dan was purposely radical from a video[CITATION Gra162 \l 4105 ] posted on
the website in which he says,
“The company operates on one principle: we never want to make ‘screw-you money’ like the
rest of the Bnancial services industry …. Our industry has a culture and a set of rules that
everyone pre_y much plays by…and I think the idea of the industry is: ‘Don’t rock the boat…
We’re all going to get rich.’ And…why would you challenge that?”
Well, Dan Price did, and his company is sCll successfully operaCng in 2016.
3. Should he have increased everyone’s salary, even those who were earning more than $70,000?
Those earning more--who didn't get more -- may, unfortunately, wonder why they need work
hard or take more stress...if they could do a lesser job and make the same. Price's acCons were
noble, but not everyone will think the same way. When people are consulted or included in the
process of decision making, they may feel ownership or involvement with the decision.
From Chapter 5 (p. 252): “People make things happen, so it is essenCal that their moCvaCons are
aligned with stakeholder expectaCons, which can only be reliably accomplished only by ensuring
that the values underlying corporate moCvaConal elements (i.e., elements (i.e., corporate
culture, codes, policies, etc.) are similarly aligned.” For some -- parCcularly higher-paid
employees not seeing raises -- the increase of some salaries may have been demoCvaCng. Dan
Price may have actually expected this, and may have selected for employees with a sense of
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corporate responsibility by allowing them to leave and by a_racCng new employees with the
same beliefs. His acCons may have changed the corporate culture posiCvely, despite some
“cons” idenCBed in QuesCon #4. (See also QuesCon #2.)
4. Do you think that this plan will moCvate the Gravity employees to work harder?
The moCvaCon to work well and with ePort might be diPerent for diPerent people and diPerent
for diPerent types of jobs.
Low-pay employees: Because leaving a clerk’s job at that salary would be diZcult, employees
who would otherwise undertake training for more and more challenging jobs may not do so,
because their Gravity salary would be unrealisCc at other companies. In the short term, these
employees might feel very loyal and work hard in order to feel as though they deserve the high
salary. Or, they might feel no need to work hard when their salaries are so large and, in the long
term, $70,000 might act as golden handcuPs that prevent self-realizaCon. In the long term, the
la_er might be detrimental for the company, because as people lose interest in their work, but
stay with Gravity because of pay, they may focus on pe_y things that lessen the happiness and
eZciency of the workplace. Outside stakeholders who understand behavioural psychology might
also agree, and worry about the long-term and the rates they pay for Gravity’s services. Has Dan
factored in a way of dealing with employees who under-perform?
Professional employees: Employees in informaCon technology (IT), Bnancial and legal services,
as examples, have industry-based expectaCons that the training required of their jobs and the
importance of their work—for example, in keeping computer systems running or in recruiCng
and maintaining clients or in generaCng revenue for the company, or in contract law-- will result
in bigger salaries or bonuses. MoCvaCon for these employees might be compeCCon or status. So
with Price giving everyone $70K per year, they might feel resentment that employees with lesser
training, responsibility or stress, earn too much. We know from the case that two employees in
this group leT the company. If more leave, Dan’s plan may weaken the company’s ability to
compete or deliver on its mandate.
Dan Price: Financially secure, Dan has a driven personality type and will look for challenges that
are not monetary. His behaviour might suggest that he has achieved great success and that he is
looking for other moCvators and ways to “give back.” Customers and employees might worry
that he losing interest in his company and might sell it to move on to other ventures. Others
might believe the move to be pure markeCng; others, socialism at work. [ CITATION New15 \l
4105 ]
5. Should Price have consulted with his customers and his employees before he made the decision to
increase the minimum salary to $70,000?
ConsultaCons lessen surprise--and oTen people like stability, not surprise. ConsultaCon would
help in thinking out all aspects of the plan--like how to reward or reprimand employees; how
employees feel about the change; how customers feel; Bnding out whether the changes will
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result in rate increases, and Bnding out what some unexpected consequences might be and how
to measure expected beneBts. In the future, will the right Bt of people be hired into the
company, or will a diPerent person than expected apply? Will morale be posiCvely or negaCvely
aPected? Will he be able to track and measure changes in producCvity, morale, revenue, etc.?
(For reviews by current or former employees of Gravity Payments, see the Glassdoor
website[CITATION Gra16 \l 4105 ]. Most reviews are very posiCve, with a recurring negaCve
being, ironically, media a_enCon.)
Useful Ar:cles, Links, and Videos
Glassdoor. Gravity Payments Reviews. 2016. , at h_ps://www.glassdoor.ca/Reviews/Gravity-PaymentsReviews-E697633.htm?countryRedirect=true . (accessed November 14, 2016).
Gravity Payments. [About]: Unique & Innova-ve Company Culture. 2016.
h_ps://gravitypayments.com/about/ (accessed November 14, 2016).
—. About. 2016. h_ps://gravitypayments.com/about/ (accessed November 14, 2016).
—. "CEO Dan Price: How Gravity Payments is DiPerent [Video]." Gravity Payments. [n.d.].
h_ps://gravitypayments.com/ (accessed November 14, 2016).
Nash, Laura (November 1981). “Ethics without the sermon.” Harvard Business Review.
Newman, Jonathan (August 12, 2015). "How Did Gravity’s $70K Minimum Wage Work Out?" Four States
News, h_ps://fourstatesnews.us/2015/08/12/how-did-gravitys-70k-minimum-wage-work-out/
(accessed November 17, 2016).
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4. Merck and River Blindness (Chapter 5, pages 298-299)
What this case has to oKer
This case concerns a company that follows its values and provides a life-enhancing drug for free to those
who cannot aPord the drug.
Teaching sugges:ons
I begin the discussion by talking about organizaConal values. For the MBA students, I ask them to think
about the values of the Brms where they’ve been employed. How did they learn these values? Were
they wri_en down anywhere? How important is it for a Brm to have a set of values?
Then we take up the quesCons.
OTen, at the end of the discussion, students comment that they like this case because it is the opposite
of most of the cases we discuss. Almost all the cases involve bad situaCons, i.e., ethical lapses. The
students like this case because it is so posiCve.
This case shows that posiCve results—and goodwill—can result from doing good and acCng in
accordance with stated corporate values. Rather than shelve a drug that otherwise had li_le commercial
value--since those who needed it could not aPord it--Merck entered into a partnership with the World
Bank, many African countries, and non-governmental developmental organisaCons (NGDOs) to cure river
blindness. While Merck may have shrewdly limited its own risk and Bnancial expenditure, it created a
partnership for drug donaCon that beneBts millions of people and is held up as a model for others to
emulate.
Discussion of ethical issues
1. PharmaceuCcal companies have to spend millions of dollars and years of research to Bnd just one
successful drug. Merck spent Cme and money developing and then distribuCng MecCzan for free. Is
it possible for Merck to jusCfy, to its shareholders, making a sizable investment in a product and
incurring ongoing costs in the distribuCon of that product when the product generates no revenue
for the company?
The donaCon generates reputaConal good will for the corporaCon and the price of that good
will, it could be argued, is probably much less than the markeCng campaign for other drugs in
the company’s stable.[CITATION Mar15 \l 4105 ] The company shows ethical leadership, as well
as a strategic acknowledgement of stakeholders other than shareholders in keeping with the
company’s values and George Merck’s 1950 comment that “Medicine is for the people...proBts
follow.”[CITATION Mernd \l 4105 ]
Because of the program, the company has “greatly beneBted from being seen as a 'good
corporate ciCzen’” and has seen “enhanced employee saCsfacCon” and, in addiCon, “The U.S.
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tax beneBts that Merck has received on account of the MecCzan DonaCon Program have
substanCally reduced the net Bnancial cost of the program to the company.” [CITATION Coy02 \p
16 \l 4105 ]
In Merck’s case, the donaCon keeps on giving…back to Merck as conCnued publicity over the
program... From Merck (2016): In 1994, then-President Jimmy Carter and former Merck
Chairman Dr. Roy Vagelos announced a new World Bank grant program to expand the MecCzan
program; in 1995, Merck unveiled a bronze statue of a boy leading a blind old man that
symbolizes the Bght against river blindness, and the World Bank announced a new 12-year
program to Bght river blindness using MecCzan; in 1999, Merck and the Gates FoundaCon each
gave $56.5M and joined with Botswana to form the African Comprehensive HIV/AIDS
Partnerships (ACHAP); in 2012, the MecCzan DonaCon Program was 25 years old; and as the
case states, in 2015, Dr. William Campbell was awarded the Nobel Prize in Medicine for his work
in discovering ivermecCns while working for Merck & Co.
In case anyone is cynical about the MecCzan donaCon program, it has “…become a paradigm for
successful public-private partnership in the internaConal health arena.” [CITATION Coy02 \p 26 \l
4105 ]
And, to prevent unwanted or substandard donaCons, the World Health OrganizaCon, together
with pharmaceuCcal companies, and non-governmental developmental organisaCons (NGDOs),
developed core principles of donaCon that require that product donaCons [ CITATION Coy02 \l
4105 ]:




are of maximum beneBt to the recipient
respect the wishes and authority of the recipient
strictly avoid any double standards in quality
are based on ePecCve communicaCon between the donor and the recipient.”
Even so, there have been criCcisms of the program, for example [CITATION Coy02 \p 20 \l 4105 ]:



whether the US government should have allowed the tax deducCons given to Merck
whether Merck or other drug companies would be pressured to provide similar
donaCons (although this is considered to have a net posiCve beneBt)
whether drug companies would reduce R&D on tropical drugs if they might expect no
revenue from them. Limited R&D may be true, but other sources of funding (e.g., the
Gates FoundaCon) may sCmulate more.
2. Did Merck have an ethical obligaCon to develop and distribute MecCzan for free?
While it may have had no legal obligaCon to distribute the drug for free, the program was in
keeping with Merck’s values, and George Merck’s 1950 comment that “Medicine is for the
people...proBts follow.”[CITATION Mernd \l 4105 ]. If shareholders and other stakeholders (such
as employees) at the Cme also believed in those values, then Merck may not have felt resistance
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from those stakeholders; indeed, good acts may have been expected. Because of its value
statements, Merck would have a self-imposed ethical obligaCon to provide medicine, although
with the strategical intenCon that proBts (not necessarily from that program) would follow. With
tax breaks oPsewng the cost of the program and Merck just providing the drug, but not the
costs or logisCcs of administering it, doing good became very good for the company.
3. Do you think that Roy Vagelos, Merck’s CEO and chairman, demonstrated ethical leadership? What
value did it have/create?
Yes! Ethical leadership was demonstrated and showed that the company’s stated values were
not just words people wanted to hear, but truly had intenCon and impact. Even if the company
never intended the program to last as long as it has, beneBts were likely realized at its start. As
stated in the answer to QuesCon #1, the company “greatly beneBted from being seen as a 'good
corporate ciCzen’” and has seen “enhanced employee saCsfacCon” and, in addiCon, “The U.S.
tax beneBts that Merck has received on account of the MecCzan DonaCon Program have
substanCally reduced the net Bnancial cost of the program to the company.” [CITATION Coy02 \p
16 \l 4105 ]
4. Based on the river blindness example, how would you describe the organizaConal culture of Merck
in the 1980s?
The organizaConal culture would seem to have been values-based and someone had
responsibility for meeCng with the World Bank to at least discuss philanthropy and, perhaps,
with U.S. federal tax oZcials to discuss the possibility of tax breaks. Notably, Merck donated
MecCzan, rather than just supplying it at a reduced rate. It was this act that made the program
excepConally successful from the point of view of NGDOs who might otherwise have been
unable to aPord the drug or have been able to distribute it as broadly.
“A number of organizaConal and health-related arrangements, made to suit or reassure Merck…
also contributed importantly to the success of the program.” For example, the choice of who
would receive the drug deliveries and distribuCon were not its responsibiliCes. In addiCon, “…a
system of monitoring adverse ePects served to preserve Merck's reputaCon and limit its risks.”
[CITATION Coy02 \p 22 \l 4105 ]
Finally, “… market and Bnancial features of the program…served to prevent any loss of business
for Merck and to minimize or even oPset enCrely its net expenditures for the program. The
human drug distribuCon did not interfere with Merck's exisCng or future markets for the wellestablished veterinary form of the drug. There was also li_le prospect of a future commercial
market for the human form of the drug, as Merck had already discovered at the
beginning...Finally, whatever Merck's real manufacturing, administraCon, and shipping costs
were and are, it has taken advantage of U.S. tax deducCons to minimize its net costs.” [CITATION
Coy02 \p 22 \l 4105 ]
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So the corporate culture of Merck in the 1980s was such that someone realized that some
beneBts could come from a drug that otherwise had li_le commercial value on the African
conCnent, since those who needed it there could not aPord it. Rather than shelve the drug,
Merck entered into a partnership that limited its risk and Bnancial expenditure while beneBwng
millions of people and creaCng a template for private/public partnerships in delivering
healthcare.
Useful Ar:cles, Links, and Videos
Coyne, Philip E., and David W. Berk [2002]. The Mec-zan (Ivermec-n) Dona-on Program for
Riverblindness as a Paradigm for Pharmaceu-cal Dona-on Programs 31570. [Washington, DC]:
[World Bank].
Hanson, Karmen (July 1, 2015). "MarkeCng and Direct-to-Consumer AdverCsing (DTCA) of
PharmaceuCcals." NSCL: Na-onal Conference of State Legislatures,
h_p://www.ncsl.org/research/health/markeCng-and-adverCsing-of-pharmaceuCcals.aspx
(accessed November 4, 2016).
Merck & Co., Inc. [USA]. "Our Values and Standards: The Basis of Our Success [Code of Conduct EdiCon
III]." View Our Code of Conduct (Our Values and Standards). [n.d.].
h_p://www.msd.com/about/how-we-operate/code-of-conduct/pdfs/OVS_v2_EN-US-CA.pdf
(accessed November 4, 2016).
Merck. Our History [Timeline]. 2016. h_ps://www.merck.com/about/our-history/home.html (accessed
November 4, 2016).
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5. Lululemon’s Ques6onable Leadership (Chapter 5, pages 299-300)
What this case has to oKer
This case describes what happened to the founder and the CEO aTer they made several gaPs and the
company unintenConally manufactured transparent yoga pants.
Teaching sugges:ons
I begin by asking how many students wear Lululemon clothing and why they like Lululemon products.
Normally, people talk about: the quality and durability of the products; the fact that they look good; that
they’re fashionable; and that they’re comfortable. Then we talk about the importance to the Brm of
delivering quality products. This makes the discussion more personal because most of the students have
Lululemon clothing.
Then I ask the students to deBne some of the responsibiliCes of the CEO of an organizaCon. Normally,
they talk about developing and execuCng strategy; overseeing the Brm’s Bnancial and operaConal
performance; supervising employees and building a culture; managing risks. This help to set the stage for
addressing CEO responsibiliCes when there are product failures.
Ingammatory statements by both former owner and Chair Chuck Wilson and CEO ChrisCne Day
contributed to Lululemon AthleCca’s negaCve press in 2013. ATer a company becomes publicly traded,
the entrepreneurial founder oTen Bnds it diZcult to adapt to greater challenges of management and/or
accountability, and ends up by leaving. Lululemon is an example of a company that outgrew its founder,
but the founder wouldn’t leave – resulCng in poor corporate governance because of the former owner’s
lingering control over the board, voCng plurality, and staggered board tenure, which contributed to poor
risk management, including poor crisis management and ethical and reputaConal risk management. The
company is also an example of a “Brst”: the Brst to make a_racCve clothes to sweat in. It had/has a cult
following, and sold a lifestyle, not just a brand – a characterisCc that early compeCtors lacked. It was also
a company that expanded incredibly rapidly, a factor in its operaConal issues.
Discussion of ethical issues
1. Do you think that the execuCves at Lululemon demonstrated ethical leadership? Could it have been
improved?
Chip Wilson became a liability—a reputaConal risk – to his own company, because it outgrew his
vision, and his management ability. The company became a feel-good illusion, and cult fashion
and yoga place for women. It came to have a “you can do it and look great!” aura, but Chip
Wilson may not have understood that. Lululemon is a perfect example of a company that had
outgrown its founder-owner. By blaming women’s bodies for the Luon pants problem, Chip
Wilson was throwing darts at the illusion*—the bubble that made store “guests” feel special
about the clothing. His comments did not live up to hypernorms: they did not show integrity
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(living up to the company’s perceived values and celebraCon of health and wellness and feeling
be_er about self), compassion (for all customers and their feelings), responsibility to his retail
employees who very much believed in the values aura, his ambassadors, et al.
[*“CompeCtors were slow to catch on to the fact that Lulu wasn’t selling workout clothes so
much as they were selling membership to a club with a very appealing uniform.” [ CITATION
Nel11 \l 4105 ]]
ChrisCne Day increased the number of stores and increased stock value gain 250% year-overyear from 2008 to 2011 [ CITATION Tay11 \l 4105 ] before she resigned in 2013, so was in the bad
books with loyal Lululemon followers who believed in the company’s manifesto[CITATION
Lul11 \l 4105 ]: a series of pithy slogans wri_en over its shopping bags, one of which is, “Friends
are more important than money.” ChrisCne seemed to be all about making money. And
expanding too quickly resulted in a number of operaCons issues, including colour dye bleeding
from pink and red clothing in 2012; transparent pants and pilling and seam problems in 2013;
and also intenConal product scarcity to increase demand in 2011. [ CITATION Bha13 \l 4105 ]
In 2013, Day blamed the transparent pants on the company’s supplier (who claimed the pants
were made to speciBcaCon approved by the company) [CITATION Str13 \t \l 4105 ], and sounded
dismissive and lacking responsibility to customers by saying, in ePect, that transparency wasn’t
seen as a problem unCl a wearer bent over.[CITATION Str131 \t \l 4105 ] Day seems to ignore
the fact that Lululemon had “… [earned] fans not just for its high-end athleCc wear but also for
its commitment to yoga’s high-minded principles” [ CITATION Lee14 \l 4105 ] and those fans
would expect higher quality control. Blogger “Lululemon Addict” said of Day, “’Day has ruined
everything special about Lululemon. The bullet proof quality, the Bt, the femininity, the
lululemoness of the product…She is a one-trick pony who grew the company through
expansion.’” [ CITATION Bus13 \l 4105 ]
So Day’s acCons did not live up to the hypernorms of fairness or responsibility, since she
incorrectly blamed manufacturers for the problem; nor compassion, since she didn’t apologize
for causing embarrassment to wearers of the transparent pants; nor predictability, since
customers will doubt the quality of Lululemon clothing and the CEO’s veracity.
2. Does a CEO have an ethical responsibility to step down as CEO when there is a producCon and
markeCng disaster that requires a product recall?
TheoreCcally speaking, a CEO would not, ethically, need to step down if problems were handled
diPerently than those at Lululemon. The CEO needs to accept responsibility for the problem and
apologize to those aPected and commit to Bxing the problems. The CEO, as a leader, must regect
the values of the company and guide its corporate culture. In the case of Lululemon, however,
CEO Day does, ethically, need to step down because she did not act ethically (see QuesCon #1)
and did not do those things.
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3. Does the chair of the board of directors have an ethical responsibility to step down as chair of the
board when there is a producCon and markeCng disaster that requires a product recall?
TheoreCcally speaking, a Chair would not, ethically, need to step down if problems were handled
diPerently than those at Lululemon. But in the case of Lululemon, the Chair is part of the
problem, and was a reputaCon risk and did damage to the Lululemon brand. The Chair needs to
accept responsibility for the corporate culture and ethics of a corporaCon, and must regect
those. In the case of Lululemon, however, Chair Chuck Wilson does need to step down because
he did not act ethically (see QuesCon #1); he does not understand or relate to how customers
view the company; he does not take responsibility for his disparaging comments, nor apologize
to customers, and his feeble apology to employees. [ CITATION Pet13 \l 4105 ]
4. Does the board of directors have an ethical responsibility to reprimand the chair of the board if the
chair makes controversial statements and comments to the press?
Yes! One of the responsibiliCes of a board is to imbed hypernorms in the corporate values
system (Chapter 5) and to guide corporaCon into develop and maintain an ethical corporate
culture (Chapter 5). It is the responsibility of the board to manage risk, including ethical and
reputaCon risk, and the CEO and Chair at Lululemon both represented reputaCon and ethical
risks. Usually, the board can hire a CEO and Chair; so reprimanding and Bring them are also
responsibiliCes. At Lululemon, however, in June 2014, Chair Wilson held nearly 27% of the
company shares, and threatened to use that stake to oppose the elecCon of two directors.
[ CITATION Lee14 \l 4105 ] This imbalance in shareholder power may have contributed to
Lululemon problems, because it raised obstacles to achieving an independent board able to
control Wilson. Ironically, Wilson said he lacked conBdence in the board, a PR gaP hours before a
shareholder meeCng[ CITATION Fri14 \l 4105 ].
Useful Ar:cles, Links, and Videos
Bhasin, Kim (June 10, 2013). "ChrisCne Day Steps Down as Lululemon CEO." Hucngton Post,
h_p://www.huZngtonpost.com/2013/06/10/chrisCne-day-steps-down-lululemonceo_n_3417495.html (accessed November 7, 2016).
Business Insider. "Lululemon AthleCca Inc. CEO ChrisCne Day should be Bred, fans say." (March 20, 2013).
Financial Post, h_p://business.Bnancialpost.com/business-insider/lululemon-see-through-pantsrecall-ceo (accessed November 7, 2016).
Friesner, Zach (June 26, 2014). "It's Time to Look at Lululemon's Corporate Governance Policies." Motley
Fool, h_p://www.fool.com/invesCng/general/2014/06/26/it-is-Cme-to-look-at-lululemonscorporate-governa.aspx (accessed November 7, 2016).
Lee, Adrian (July 11, 2014). "Lululemon boardroom Bght part of a corporate culture war: Lululemon isn’t
the only company being accused of selling out its principles for short-term gain." Maclean's,
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h_p://www.macleans.ca/economy/business/lululemon-a-growing-culture-war/ (accessed
November 7, 2016).
lululemon athleCca. Lululemon manifesto. 2011. h_p://staCc.lululemon.com/about/manifesto (accessed
November 7, 2016).
Nelson, Jacqueline (April 29, 2011). "Loco for Lulu." Canadian Business,
h_p://www.canadianbusiness.com/lifestyle/loco-for-lulu/ (accessed November 7, 2016).
Petri, Alexandra (November 12, 2013). "How not to apologize, with Chip Wilson of Lululemon."
Washington Post, h_ps://www.washingtonpost.com/blogs/compost/wp/2013/11/12/how-notto-apologize-with-chip-wilson-of-lululemon/ (accessed November 7, 2016). [Imbedded video of
Wilson's apology.]
Strauss, Marina (March 19, 2013a). "Supplier of too-sheer yoga pants insists it stuck to Lululemon
design." Globe and Mail, h_p://www.theglobeandmail.com/globe-investor/supplier-of-toosheer-yoga-pants-insists-it-stuck-to-lululemon-design/arCcle9948948/ (accessed November 7,
2016).
— (March 21, 2013b). "Lululemon backs oP supplier blame." Globe and Mail,
h_p://www.theglobeandmail.com/globe-investor/lululemon-backs-oP-supplierblame/arCcle10053046/ (accessed November 7, 2016).
Taylor, Timothy (November 24, 2011). "CEO of the Year: ChrisCne Day of Lululemon." Globe and Mail,
h_p://www.theglobeandmail.com/report-on-business/rob-magazine/ceo-of-the-year-chrisCneday-of-lululemon/arCcle4252293/ (accessed November 7, 2016).
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Cases on Bribery
6. SNC-Lavalin Missing Funds Topples CEO & Triggers Inves6ga6on (Chapter 5,
pages 300-302)
What this case has to oKer
The SNC-Lavalin case illuminates the challenges of doing business in many foreign jurisdicCons where
bribery is the normal pracCce and many businesses and businesspeople have come to believe that they
cannot operate successfully in those jurisdicCons without bribing directly or through agents, foreign
oZcials, and many other individuals with inguence. Sadly they forget or minimize the bigger picture of:
loss of reputaCon in other jurisdicCons, legal prosecuCon, Bnancial consequences, jail, loss of job, and
the diminishment of opportuniCes to garner business in the future. Perhaps they are unaware of the
changing view on the legiCmacy of bribery, and the new statutory and enforcement regimes that are
coming into place.
This case also gives the opportunity for students to understand: (1) the roles expected of execuCves, the
board of directors, and (2) the purpose and funcCon of company policies, and potenCal shorˆalls of
circumvenCon and the omission of key operaConal consideraCons such as the duty to report wrongdoing
to an ePecCvely placed and mandated representaCve of the board. Obviously, SNC-Lavalin did not have
an ethical tone at the top.
Teaching sugges:ons
To get the class thinking about bribery, and to make the subject relevant, I ask if anyone has seen or
heard of a case of bribery, and we discuss several of those so that they understand the issues: can
business be done without bribes, what is a facilitaCng payment, are bribes good, etc. I then have a
member of class introduce the case details, and then we work through the case quesCons. These
quesCons provide a plaˆorm to discuss what the new legislaCve and enforcement framework is, and why
and how it should be proacCvely dealt with.
Discussion of ethical issues
1. From a governance perspecCve, what can the Board of Directors do to make sure that the company’s
policies and procedure are adequate to ensure ethical and legal conduct by its employees?
While the Independent Review (see case) concluded that the company’s codes had provisions
idenCfying bribery as bad, there was no requirement to report bribery to an oZcial who could
invesCgate and whose role included informing the board of directors. The existence of these
weaknesses should have been picked up by a periodic review commissioned by the board at an
earlier date. However, the board seemed unaware that there was a shiT from considering
bribery unethical to making it illegal, and that the hardening of concern against bribery would
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make consideraCon of old cases of bribery prosecutable retroacCvely. A periodic review of
policies by outside experts would have idenCBed this trend in concern, and would have
recommended the insCtuCon of a proper reporCng and invesCgaCon system, reporCng to either
the Audit Commi_ee of the Board, or the Governance Commi_ee on an ongoing basis. As part
of the system, there should be a system of ethics code training which should have introduced
the values of the company, and which should have been supported and reinforced by the CEO
and senior execuCves. It is the responsibility of the board to ensure that the anC-bribery policy
of the company is up-to-date and ePecCve as part of their risk management responsibility. The
company policy should indicate that consultaCon is required when an acCon might be
considered unethical or illegal.
In addiCon to the insCtuCon of strong policies, the board should ensure that internal audit or
some other group is mandated to endure that the policy is being followed, and that problems
are being followed up, brought to the a_enCon of the board, and punished.
2. Mr. Aissa and Mr. Duhaime were not demonstraCng strong ethical leadership. What can a Brm do to
improve its ethical tone at the top?
A company should screen senior employees for their ethical values as indicated from penetraCng
quesCons, reacCons to scenarios posed, and reference checks, not only as to their own acCons
but also with respect to their support for reporCng and whistleblowing. Internal audit should
report instances to the board where senior execuCves are not supporCng the company policy,
and an assessment of ethical performance should be an important component of remuneraCon
and promoCon decisions.
3. Is it appropriate for a company to do business in a country with an oppressive regime? Why and why
not?
It depends upon whether the company’s acCviCes can be conducted in an ethical manner, and
whether the support given to the ciCzenry as a whole outweighs the favourable impact on the
oppressive regime. At some stage, it may be ethically responsible to withdraw services from the
country if to do so would serve a greater purpose. This was the considered the case during
apartheid in South Africa. However, some companies remained in South Africa to do good
according to the Sullivan Principles (downloadable at
h_p://www1.umn.edu/humanrts/links/sullivanprinciples.html). The board of directors of a
company doing business with a repressive regime must reconsider their involvement on a
conCnuing basis in order to assure it is responsible.
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4. If the decision is made to do business in a country with an oppressive regime, what limitaCons that
should be put in place by the company to guide its employees against unethical involvement?
There should be an ePecCve statement of policy, plus clear guidelines and rules where
necessary. A training session should be undertaken. In any case of uncertainty, a consultaCon
regime should be mandated where employees would have to consult an advisor for direcCon. To
minimize risk taking, acCons should be judged by what would be acceptable in the most rigorous
jurisdicCon the company faces or intends to face in customer or capital markets in the future.
Update on charges
Useful Ar:cles, Links, and Videos
The FiTh Estate (April 3, 2013). “Mission Improbable—Preview [video].” CBC,
h_p://www.youtube.com/watch?v=maYrZc1yVzY&feature=youtu.be
Preview of the CBC-TV’s FiTh Estate documentary described in the CBC Media Centre press
release, (below), which aired April 5, 2013.
For a synopsis of the documentary and link to the video, see CBC Media Centre (April 4, 2013).
“On CBC News’ The FiTh Estate: SNC Lavalin’s GadhaB ConnecCon and One Woman [Cyndy
Vanier] Caught In The Middle.” h_p://www.cbc.ca/mediacentre/press-release/on-cbc-news-theBTh-estate-snc-lavalins-gadhaB-connecCon-and-one-womanNagel, Edward (January 2014). “Taking a bite out of corrupCon, one bribe at a Cme.” Chartered
Professional Accountants of Canada (CPA): Conversa-ons about Forensic Accoun-ng, accessed at
h_p://www.cica.ca/focus-on-pracCce-areas/forensic-accounCng/conversaCons-about-forensicaccounCng/entries/item77750.aspx on September 23, 2014.
Though not directly related to SNC-Lavalin, the arCcle discusses the Brst convicCon under
legislaCon under which SNC-Lavalin has been scruCnized. The author of the arCcle discusses “…
one of the big stories from 2013-at least from the perspecCve of forensic and invesCgaCve
accounCng…the Brst trial and convicCon that occurred under the Canadian CorrupCon of Foreign
Public OZcials Act (“CFPOA”). The case which is known as R. v. Karigar 2013 ONSC 5199,
involved Mr. Nazir Karigar, who in his capacity as an agent for an O_awa-based technology
company, Cryptometrics Canada, was convicted of conspiring to bribe foreign public oZcials at
Air India and India’s Minister of Civil AviaCon.”
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7. Rio Tinto’s Bribes in China (Chapter 5, pages 302-304)
What this case has to oKer
Bribery cases oTen involve a company making illegal payments to government oZcials in order to land
lucraCve contracts. SomeCmes, however, bribery can be between two or more companies, as it was the
case involving Rio Tinto, the Anglo-Australian mineral company, and several Chinese steel companies. Rio
Tinto execuCves received bribes from Chinese steel manufacturers in exchange from giving these steel
manufacturers preferenCal business treatment. Moreover, the same Rio Tinto execuCves bribed Chinese
oZcials to receive conBdenCal informaCon that led their company to increase the price of iron ore sold
to Chinese steelmakers.
Teaching sugges:ons
There are several quesCons related to bribery between companies that may help to start the class
discussion, for example: is a bribe between companies the same as a bribe given to a government
oZcial, would a bribe given to other company just be “part of doing business, and how is a bribe
diPerent from a giT. Finally, it is useful to discuss the importance and beneBts of a strong ethical culture
to deter unethical behavior.
Discussion of ethical issues
1. The culture of giving and receiving payments is ingrained in China. On the other hand accepCng and
paying bribes is a violaCon of Rio Tinto’s code of conduct. When does a payment stop being a giT
and turn into a bribe?
It is someCmes diZcult to determine whether a giT is really a bribe. The following quesCons
should help to separate giTs from bribes.

Is it nominal or substanCal?

What is the intended purpose?

What are the circumstances?

Is the person who receives the payment in a posiCon of sensiCvity?

What is the accepted pracCce?

What is the Brm/company policy?

Is it legal?
Several of these quesCons address the issue of whether or not a giT has an intenCon to “unduly
inguence” or “obligate” the recipient to reciprocate by giving preferenCal treatment to the giver.
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Similarly, Rio Tinto’s Code of Conduct, a document named “The Way We Work” (Rio Tinto 2009),
states that:
“There are several quesCons that we should ask ourselves when confronted with a business
decision:

Is it legal?

Are my acCons consistent with The Way We Work and associated Rio Tinto
policies and standards?

Will there be any direct or indirect negaCve consequences for Rio Tinto?

What would my family, friends or neighbours think of my acCons?

Would I prefer to keep this secret?

Would I want my acCons reported on the front page of the newspaper?
If you do not feel comfortable with any of the answers, then the best response is not to do
it.”
Moreover, the company’s Code of Conduct explicitly prohibits bribery:
“Rio Tinto prohibits bribery and corrupCon in all forms, whether direct or indirect. We do
not oPer, promise, give, demand or accept any undue advantage, whether directly or
indirectly, to or from:

a public oZcial;

a poliCcal candidate, party or party oZcial;

a community leader or other person in a posiCon of public trust; or

any private sector employee (including a person who directs or works for a
private sector enterprise in any capacity.”
Finally, the company’s policy on giTs and entertainment is:
“GiTs and entertainment given and received as a reward or encouragement for preferenCal
treatment are not allowed.
In certain circumstances, the giving and receiving of modest giTs and entertainment is
perfectly acceptable. A business meal, for example, can provide a relaxed way of exchanging
informaCon. Nonetheless, depending on their size, frequency, and the circumstances in
which they are given, they may consCtute bribes, poliCcal payments or undue inguence.
The key test we must apply is whether giTs or entertainment could be intended, or even be
reasonably interpreted, as a reward or encouragement for a favour or preferenCal
treatment. If the answer is yes, they are prohibited under Rio Tinto policy. Exchanges of giTs
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and entertainment, including the payment of travel expenses, must be in accordance with
Rio Tinto’s Business integrity standard.”
2. The smaller Chinese steel companies bribed the Rio Tinto execuCves because of Rio Tinto’s policy of
only dealing with large state-run steel companies. Can a business policy, such as giving priority to
only one set of Brms, be unethical? Is Rio Tinto ethically responsible for the bribes that were given to
its employees because of its policy?
A business policy to give preferenCal treatment to some clients is not necessarily unethical.
Nevertheless, the company should think about whether the policy encourages its employees to
behave ethically or to behave unethically. Rio Tinto is responsible not only for having a policy on
bribing and a code of conduct, but also for having a comprehensive internal control system. As
stated in the OECD recommendaCons for internal controls, ethics and compliance with anCbribery regulaCons (OECD 2010):
“EPecCve internal controls, ethics, and compliance programmes or measures for prevenCng
and detecCng foreign bribery should be developed on the basis of a risk assessment
addressing the individual circumstances of a company, in parCcular the foreign bribery risks
facing the company (such as its geographical and industrial sector of operaCon). Such
circumstances and risks should be regularly monitored, re-assessed, and adapted as
necessary to ensure the conCnued ePecCveness of the company’s internal controls, ethics,
and compliance programme or measures.”
The company has to be aware that China’s two-Cered system for purchasing iron ore may
encourage corrupCon. While big steel mills are allowed to negoCate long-term Bxed price
contracts, most small and medium-size steel mills are supposed to buy from the spot market, the
more volaCle open market. The system creates arbitrage opportuniCes, allowing big steel mills
with Bxed contracts to buy far more supplies than they need and then proBtably sell excess
supplies to smaller mills on the black market.
3. Why were these bribes prosecuted?
It is not enCrely clear why these bribes were prosecuted. Several Australian oZcials criCcized the
detenCon of the Rio Tinto employees and suggested that Beijing was retaliaCng against Rio Tinto
for calling oP a $19.5 billion deal that would have given a Chinese state-owned company, called
Chinalco, a large stake in the mining giant.
On the other side, the Chinese government argued it was an isolated case of espionage that
seriously harmed the country’s economic security and interests.
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4. What lessons should be taken from these convicCons:
a. For foreign governments?
Foreign governments should warn their companies and ciCzens of the business condiCons in
China, encourage them to behave ethically, and to strengthen their internal controls when
dealing with Chinese companies.
b. For corporaCons trading in and with China?
Companies trading in and with China should be careful and strengthen their internal controls.
Moreover, these companies have to be aware that businesses operate in China under strict
control of the government and that poliCcal events may inguence the way business have to be
conducted there. The Rio Tinto case happened shortly aTer Google decided to pull its search
engine out of China. Both cases highlight several issues that foreign companies have to consider
when doing business in China.
In addiCon, companies have to be aware that it might be hard to Bght against the Chinese
government in court. Rio Tinto’s employees were prosecuted largely in closed-door proceedings.
The trials appeared to favor the prosecuCon and deny the defendants due process.
c. For individual employees?
Employees should be aware that even when they appear to be acCng in the best interest of their
companies, they may be acCng unethically and illegally. If they obtain business opportuniCes
through bribes, then they can face the direct consequences of their acCons, without the support
of their companies. IniCally, Rio Tinto stated that the allegaCons of bribery of oZcials at Chinese
steel mills were wholly without foundaCon; however, later on the company blamed the
employees and denied any corporate responsibility for the bribes.
d. For possible investors in China?
Investors in China have to be aware of the potenCal ethical and reputaConal issues involved in
doing business there. These include: dealing with state-controlled enCCes, corrupCon, limited
civil rights, etc.
5. Should Rio Tinto have been charged?
The bribes were given over a number of years from 2003 to 2009. It is hard to believe that the
bribes, and parCcularly the ones paid by Rio Tinto employees, were totally unknown to the
company.
Although this case might serve as a warning for the company, it seems that the company should
also have been punished in this case. Moreover, the company failed to have adequate internal
controls to prevent the bribes.
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Useful Ar:cles, Links, and Videos
OECD (2010). Good Prac-ce Guidance on Internal Controls, Ethics, and Compliance.
h_p://www.oecd.org/dataoecd/5/51/44884389.pdf
From the cover: “This Good PracCce Guidance was adopted by the OECD Council as an integral
part of the RecommendaCon of the Council for Further CombaCng Bribery of Foreign Public
OZcials in InternaConal Business TransacCons of 26 November 2009.”
Rio Tinto (2009). The way we work. Our global code of business conduct.
h_p://www.rioCnto.com/documents/The_way_we_work.pdf
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8. Daimler SeYles U.S. Bribery Case for $185 Million (Chapter 5, pages 304-306)
What this case has to oKer
This is a good case to discuss the implicaCons from bribery, the need for an ethical culture within a
company, the role of whistleblowers in raising red gags about bribery, and the prospect of bribery
charges arising from U.S. and U.K. legislaCon even though the bribery occurred in other jurisdicCons. A
company employee, David Bazze_a learned in July 2001 at a corporate audit execuCve commi_ee
meeCng in Stu_gart Germany, that DaimlerChrysler had secret bank accounts to bribe foreign
government oZcials. As a result, he Bled a whistleblower complaint under the U.S. Foreign Corrupt
Prac-ces Act (FCPA) that ulCmately led to a mulC-year invesCgaCon of surprising scope and U.S. charges
against a company headquartered in Germany, for bribes made to foreign oZcials around the world.
Teaching sugges:ons
I start this case asking students how a bribe can be detected by a company or by the government.
Arguably, detecCng bribes could be diZcult in a large company such as DaimlerChrysler, with worldwide
operaCons, a large number of bank accounts and a complex Bnancial reporCng system. In these
circumstances, the best possible control is a strong ethics program, discouraging employees to act
unethically and giving whistleblowers the means to report these acCons within the company. Moreover,
the U.S. government incenCves to report bribes within the FCPA consCtute a strong incenCve to report
bribery acCvity outside the U.S.
This case also represents a good example of a change in percepCons about bribery, and in the real legal
consequences that now can gow from it. This case can foster the discussion about the measures that a
company should take to Cmely react to changes in stakeholders’ expectaCons about acceptable or
ethical business pracCces.
Discussion of ethical issues
1. Apparently Daimler execuCves were not concerned enough with personal sancCons to change the
company’s bribery pracCces to comply with German and U.S. statutes. How can these awtudes be
changed?
Daimler execuCves have to be made aware of the potenCal consequences of giving a bribe. The
U.S. FCPA (q.v.) includes the following sancCons for bribing a foreign oZcial:
“CRIMINAL: The following criminal penalCes may be imposed for violaCons of the FCPA's
anC-bribery provisions: corporaCons and other business enCCes are subject to a Bne of up to
$2,000,000; oZcers, directors, stockholders, employees, and agents are subject to a Bne of
up to $100,000 and imprisonment for up to Bve years. Moreover, under the Alterna-ve
Fines Act, these Bnes may be actually quite higher -- the actual Bne may be up to twice the
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beneBt that the defendant sought to obtain by making the corrupt payment. You should also
be aware that Bnes imposed on individuals may not be paid by their employer or principal.
CIVIL: The A_orney General or the SEC, as appropriate, may bring a civil acCon for a Bne of
up to $10,000 against any Brm as well as any oZcer, director, employee, or agent of a Brm,
or stockholder acCng on behalf of the Brm, who violates the anC-bribery provisions. In
addiCon, in an SEC enforcement acCon, the court may impose an addiConal Bne not to
exceed the greater of (i) the gross amount of the pecuniary gain to the defendant as a result
of the violaCon, or (ii) a speciBed dollar limitaCon. The speciBed dollar limitaCons are based
on the egregiousness of the violaCon, ranging from $5,000 to $100,000 for a natural person
and $50,000 to $500,000 for any other person [i.e. a corporaCon].
The A_orney General or the SEC, as appropriate, may also bring a civil acCon to enjoin any
act or pracCce of a Brm whenever it appears that the Brm (or an oZcer, director, employee,
agent, or stockholder acCng on behalf of the Brm) is in violaCon (or about to be) of the anCbribery provisions.
OTHER GOVERNMENTAL ACTION: Under guidelines issued by the OZce of Management and
Budget, a person or Brm found in violaCon of the FCPA may be barred from doing business
with the Federal government. Indictment alone can lead to suspension of the right to do
business with the government. The President has directed that no execuCve agency shall
allow any party to parCcipate in any procurement or non-procurement acCvity if any agency
has debarred, suspended, or otherwise excluded that party from parCcipaCon in a
procurement or non-procurement acCvity.”
2. What internal controls could have been usefully introduced to prevent bribery at Daimler?
The OECD (OECD 2010) has published a document lisCng 12 recommendaCons for internal
controls, ethics and compliance with anC-bribery regulaCons, including:
1. Strong, explicit and visible support and commitment from senior management to the
company's internal controls, ethics and compliance programs or measures for prevenCng
and detecCng foreign bribery;
2. A clearly arCculated and visible corporate policy prohibiCng foreign bribery;
3. Compliance with this prohibiCon and the related internal controls, ethics, and
compliance programs or measures is the duty of individuals at all levels of the company;
4. Oversight of ethics and compliance programs or measures regarding foreign bribery,
including the authority to report ma_ers directly to independent monitoring bodies such
as internal audit commi_ees of boards of directors or of supervisory boards, is the duty
of one or more senior corporate oZcers, with an adequate level of autonomy from
management, resources, and authority;
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5. Ethics and compliance programs or measures designed to prevent and detect foreign
bribery, applicable to all directors, oZcers, and employees, and applicable to all enCCes
over which a company has ePecCve control, including subsidiaries on the following
areas:

giTs;

hospitality, entertainment and expenses;

customer travel;

poliCcal contribuCons;

charitable donaCons and sponsorships;

facilitaCon payments; and

solicitaCon and extorCon;
6. Ethics and compliance programs or measures designed to prevent and detect foreign
bribery applicable, where appropriate and subject to contractual arrangements, to third
parCes such as agents and other intermediaries, consultants, representaCves,
distributors, contractors and suppliers, consorCa, and joint venture partners (hereinaTer
“business partners”), including the following essenCal elements:

Properly documented risk-based due diligence pertaining to the hiring, as well as
the appropriate and regular oversight of business partners;

Informing business partners of the company’s commitment to abiding by laws
on the prohibiCons against foreign bribery, and of the company’s ethics and
compliance program or measures for prevenCng and detecCng such bribery;
and,

Seeking a reciprocal commitment from business partners;
7. A system of Bnancial and accounCng procedures, including a system of internal controls,
reasonably designed to ensure the maintenance of fair and accurate books, records, and
accounts, to ensure that they cannot be used for the purpose of foreign bribery or hiding
such bribery;
8. Measures designed to ensure periodic communicaCon, and documented training for all
levels of the company, on the company’s ethics and compliance program or measures
regarding foreign bribery, as well as, where appropriate, for subsidiaries;
9. Appropriate measures to encourage and provide posiCve support for the observance of
ethics and compliance programs or measures against foreign bribery, at all levels of the
company;
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10. Appropriate disciplinary procedures to address, among other things, violaCons, at all
levels of the company, of laws against foreign bribery, and the company’s ethics and
compliance program or measures regarding foreign bribery;
11. EPecCve measures for:

Providing guidance and advice to directors, oZcers, employees, and, where
appropriate, business partners, on complying with the company's ethics and
compliance program or measures, including when they need urgent advice on
diZcult situaCons in foreign jurisdicCons;

Internal and where possible conBdenCal reporCng by, and protecCon of, directors,
oZcers, employees, and, where appropriate, business partners, not willing to violate
professional standards or ethics under instrucCons or pressure from hierarchical
superiors, as well as for directors, oZcers, employees, and, where appropriate,
business partners, willing to report breaches of the law or professional standards or
ethics occurring within the company, in good faith and on reasonable grounds; and

Undertaking appropriate acCon in response to such reports;
12. Periodic reviews of the ethics and compliance programs or measures, designed to
evaluate and improve their ePecCveness in prevenCng and detecCng foreign bribery,
taking into account relevant developments in the Beld, and evolving internaConal and
industry standards.
3. What should Dieter Zetsche do to ensure the highest compliance standards?
The change of a company’s culture is a long process that takes Cme and a strong commitment by
top management to promote and enforce high ethical standards. It is important to make sure
employees at all levels of the company know that bribes and other similar unethical acCons will
not be tolerated. The recommendaCons outlined in the answer to the previous quesCon may be
a good way to start developing a strong compliance program. Whatever steps Mr. Zetsche takes,
he must speak out ac-vely in support of the anC-bribery policy and its enforcement – in other
words he must provide strong ethical leadership – or his employees will not take noCce of the
new policies.
4. Whistleblowers on FCPA ma_ers are eligible for up to 25% of the se_lement and/or Bne that results
depending on a hearing by a tribunal on the import of their evidence (see Chapter 1, page 15 for a
discussion of this). How much of the $91.4 million resCtuCon payment would you award David
Bazze_a if you could make the decision? Provide your reasons for the choice you advocate.
Whistleblowers providing “original informaCon” leading to a successful enforcement acCon
resulCng in monetary sancCons exceeding $1,000,000 may be paid between 10 and 30 percent
of any money the government collects as a result of the provided informaCon. In this case, if the
evidence provided by Mr. Bazze_a becomes central to the prosecuCon of this case, he deserves
the maximum possible award.
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5. Did David Bazze_a do what was expected of him as a professional accountant?
A professional accountant has the responsibility to not be associated with misleading or false
informaCon. Mr. Bazze_a acted ethically in this case; however, it is debatable whether he should
have gone public right away or he should have reported this ma_er within the company Brst. Mr.
Bazze_a could have a_empted to reach the Board of Directors before Bling a complaint with the
U.S. Department of JusCce. It may have been a reasonable judgment on his part that, at the
Cme, his internal report would have been ignored, or that he might have been discriminated
against or prosecuted.
Useful Ar:cles, Links, and Videos
OECD (2011). Bribery in Interna-onal Business.
h_p://www.oecd.org/document/13/0,3746,en_2649_34855_39884109_1_1_1_1,00.html
U.S. Department of JusCce. Foreign Corrupt Prac-ces Act of 1977 (15 U.S.C. §§ 78dd-1, et seq.)
h_p://www.jusCce.gov/criminal/fraud/fcpa/docs/fcpa-english.pdf
OECD (2010). Good Prac-ce Guidance on Internal Controls, Ethics, and Compliance.
h_p://www.oecd.org/dataoecd/5/51/44884389.pdf
U.S. Department of JusCce (2011). Lay-Persons’ Guide to FCPA.
h_p://www.jusCce.gov/criminal/fraud/fcpa/docs/lay-persons-guide.pdf
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9. HP Bribery for Russian Contract with An6-Bribery Prosecutor’s O^ce (Chapter 5,
pages 306-307)
What this case has to oKer
This case describes how Hewle_ Packard bribed oZcials at the government oZce that is responsible for
prosecuCng bribery cases in Russia. It is a good case to discuss the implicaCons of giving a bribe in a
foreign jurisdicCon based on the assumpCons that it is OK since everyone is doing it, or that since bribery
is OK at the Cme of the bribe, it not result in charges and/or convicCons forever.
Teaching sugges:ons
I start this case by asking students how is it possible for a company to bribe a government oZcial
without being discovered. This case is interesCng because HP tried to bribe oZcials within the anCbribery oZce itself. Furthermore, I discuss whether a company that bribes oZcials in a given country has
to worry about penalCes in its home country. The Daimler’s SeBles U.S. Bribery Case for $185 million
Case is a useful companion case on this ma_er. Also, the new U.K. Bribery Act includes an extraterritorial reach.
Discussion of ethical issues
1.
Why would HP bribe think they could get away with bribing an employee in
the Russian anC-bribery prosecutor’s oZce?
There could be several reasons, for example:
2.

HP used several bank accounts and indirect money transfers that would make diZcult to
trace back the money to HP;

The bribe could have been masked as a legiCmate payment; and,

HP’s execuCves may thought that the Russian authoriCes were so corrupt that they
would never be prosecuted in Russia, without considering that they were subject to the
Foreign Corrupt Prac-ces Act (FCPA).

Actually, under German law, HP could not be charged, so senior oZcials may have
induced other employees to bribe to beneBt the company thinking erroneously that
problems, if any, would fall on the individual, not HP.
Why was it done through a series of companies in diPerent countries?
It was done in that way to try to make it diZcult to trace the money back to HP and probe that
these payments were bribes.
3. What has changed to now allow invesCgators to unravel such a series, whereas in the past they
would have found it almost impossible?
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The following changes have enabled the prosecuCon under the FCPA:

On November 21, 1997, the 29 member naCons of the OrganizaCon for Economic
CooperaCon and Development ("OECD") and Bve non-member naCons adopted the
"ConvenCon on CombaCng Bribery of Foreign Public OZcials in InternaConal Business
TransacCons." The OECD ConvenCon, which was signed on December 17, 1997, and
raCBed by the U.S. Senate on July 1, 1998, sets forth the essenCal elements of a Foreign
Corrupt PracCces statute that each country should enact into a law.

New whistleblower provisions will moCvate insiders to provide evidence aiding the
prosecutors. Whistleblowers providing “original informaCon” leading to a successful
enforcement acCon resulCng in monetary sancCons exceeding $1,000,000 may be paid
between 10 and 30 percent of any money the government collects as a result of the
provided informaCon. Whistleblowers will also be paid if their informaCon leads to
successful “related acCons,” i.e., administraCve or judicial acCons brought by other
agencies, including the U.S. Department of JusCce, federal and state regulatory
authoriCes, and foreign law enforcement agencies.

The passage of the InternaConal Money Laundering Abatement and AnC-terrorist
Financing Act of 2001 has made internaConal money transfers more transparent to
regulators and easier to trace back to the original source.
4. If a company decides to bribe, how many years need to go by so that they are safe from
prosecuCon?
The violaCons to the FCPA can be prosecuted anyCme, regardless of the number of years that have
passed since the bribe was given. Moreover, if a company acquires another company, the parent
company is responsible for the past acCons of the acquired company.
5. Even though German law does not allow companies to be charged, what are the possible
consequences of the alleged bribery for HP?
HP may face the following consequences:

Loss of reputaCon and future government contracts in Germany and other countries;

Increased Cme dealing with regulators in several jurisdicCons as this incident may cause
other similar invesCgaCons; and,

Possible prosecuCon in the U.S. under the FCPA.
Useful Ar:cles, Links, and Videos
OECD (2011). Bribery in Interna-onal Business.
h_p://www.oecd.org/document/13/0,3746,en_2649_34855_39884109_1_1_1_1,00.html
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U.S. Department of JusCce. Foreign Corrupt PracCces Act of 1977 (15 U.S.C. §§ 78dd-1, et seq.)
h_p://www.jusCce.gov/criminal/fraud/fcpa/docs/fcpa-english.pdf
Cases on Corporate Governance & Managerial Opportunism
10. Spying on HP Directors (Chapter 5, pages 307-310)
What this case has to oKer
This is a good case to discuss the ethical implicaCons from obtaining and using informaCon from the
company’s employees in general. It also illustrates the perils of conducCng secret invesCgaCons of board
members. In addiCon, the HP case highlights the importance of ethical guidance for the board of
directors and the need for limits to the power of the chairman of the board. The board of directors
exists to monitor management and it is appointed to act in the best interest of the company’s
shareholders. Nevertheless, there are few internal mechanisms that are needed to ensure the proper
funcConing of the board.
On one side, it was the responsibility of the chair to invesCgate the origin of the leak of conBdenCal
informaCon and keep the invesCgaCon secret in order to discover the person who was leaking the
informaCon; however, on the other side the invesCgaCon should have been conducted within ethical and
legal boundaries.
On September, 2006 the press revealed that the chairwoman of Hewle_-Packard (HP), Patricia Dunn, had
hired a team of independent electronic-security experts that later spied on HP board members and
several journalists, to determine the source of leak of conBdenCal details regarding HP's long-term
strategy in January, 2006. The independent consultant obtained phone call records of HP board
members and nine journalists, including reporters for CNET, The New York Times, and The Wall Street
Journal using an unethical and possibly illegal pracCce known as pretexCng. Patricia Dunn claimed she
did not know the methods the invesCgators used to determine the source of the leak and resigned aTer
the scandal. George Keyworth, the director responsible for the leak, resigned from HP’s board aTer 21
years of service.
Teaching sugges:ons
I start the class asking the students who should be in charge of monitoring the CEO, and then follow up
by asking who should monitor the board of directors, and how?
This sets up the quesCons at the end of the case for further discussion in order.
Discussion of ethical issues
1.
Should the chair of the board of directors be allowed to iniCate
invesCgaCons into weaknesses in a company’s internal control systems?
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The invesCgaCon of internal control weaknesses is usually a management funcCon; however, as
stated in the COSO integrated framework “Management is accountable to the board of directors,
which provides governance, guidance and oversight. A strong, acCve board, parCcularly when
coupled with ePecCve upward communicaCons channels and capable Bnancial, legal and
internal audit funcCons, is oTen best able to idenCfy and correct such a problem.”
The provisions of SOX SecCon 302 require CEOs and CFOs to cerCfy that they are responsible for
internal controls and have evaluated the company’s internal controls. Nonetheless, in this case it
seems that the chair had the responsibility to invesCgate the leak of strategic informaCon given
that some of the suspects were members of the board of directors.
Under the circumstances, it would have been prudent for Ms. Dunn to share her plan with the
ExecuCve Commi_ee of the board and get their guidance and blessing.
2. Is the strategy of pretexCng an acceptable means in order to obtain criCcal informaCon that will
strengthen a company’s internal control system?
The legal opinion given to HP on pretexCng is a masterpiece of doubletalk, and of li_le value. As
it turned out, using pretexCng is/was deBnitely not acceptable from several diPerent points of
view:
3.

It involves misrepresentaCon designed to get informaCon by deceit, which is quite
unethical as it is unfair and violates the rights of the subjects involved.

Patricia Dunn herself recognized in her resignaCon le_er (Chapter 5, page 309 in the
case) that “The unauthorized disclosure of conBdenCal informaCon was a serious
violaCon of our code of conduct”;

HP se_led a State lawsuit paying $14.5 million in Bnes and promising to improve its
corporate governance pracCces;

HP agreed to a Bnancial se_lement with The New York Times and three BusinessWeek
magazine journalists; and,

PretexCng invades privacy and is a quesConable pracCce involving the impersonaCon of
somebody in order to trick phone companies into handing over the calling records of
that person’s personal phone accounts.
Should the reasons for resignaCons from a board of directors always be made
public?
In general, a policy of transparency and full disclosure should be in the best interest of the
company’s shareholders. Without complete informaCon it would not be possible for
shareholders to ePecCvely monitor agency problems within the company.
Some people may disagree with this posiCon and could argue that shareholders would be worse
oP if informaCon that impacts stock prices negaCvely is made public. In this case, HP made
Perkins resignaCon public without disclosing the reasons for his departure. HP reported Perkins’
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resignaCon to the SEC four days later, again giving no reason for his resignaCon. In pracCce,
most resignaCons are accompanied by boilerplate statements that are uninformaCve to the
public; however, in a full disclosure environment, the impact of full disclosure on director’s
reputaCon should be an incenCve to act in the best interest of the company’s shareholders.
Useful Ar:cles, Links, and Videos
“HP’s Boardroom Drama” (May 8, 2007). CNET News Special Coverage, h_p://news.cnet.com/HPsboardroom-drama/2009-1014_3-6112817.html
To access the arCcle, use the search feature on the website. This website provides current and
previous coverage. At the Cme of the issue, coverage was provided on the internal invesCgaCon
into media leaks at HP. It provided links to the legal invesCgaCon and highlights congressional
hearings, press conferences, commentary and video footage across the scandal.
Commi_ee of Sponsoring OrganizaCons of the Treadway Commission (COSO). (2004). “Enterprise Risk
Management —Integrated Framework.” h_p://www.coso.org/guidance.htm
“Feds charge invesCgator in H-P boardroom case.” (Jan 11, 2007). Market Watch,
h_p://www.marketwatch.com/story/feds-charge-invesCgator-in-h-p-pretexCng-case
HelT, Miguel (September 30, 2006). “H.P. Read Instant Messages of Reporter.” New York Times,
h_p://query.nyCmes.com/gst/fullpage.html?
res=9D04E0DB1730F933A0575AC0A9609C8B63&sec=&spon=&pagewanted=1
Hewle_-Packard (September 22, 2006). “News release: Patricia Dunn Resigns from HP Board.”
h_p://www.hp.com/hpinfo/newsroom/press/2006/060922a.html
Hewle_-Packard (September 12, 2006). “News release: George Keyworth Resigns as HP Director.”
h_p://www.hp.com/hpinfo/newsroom/press/2006/060912b.html
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11. Lord Conrad Black’s Fiduciary Duty? (Chapter 5, pages 310-314)
What this case has to oKer
This is an excellent case to discuss:

the congicts of interest risks arising when management or a dominant owner has ePecCve
control of a public company, and

appropriate governance controls needed to safeguard the interests of other shareholders and
stakeholders.
Conrad Black ePecCvely controlled Hollinger InternaConal, Inc. without a majority of the corporaCon’s
equity, through special Class B shares that carried a 10-1 voCng preference over class A Shares. Using his
controlling privileges, Conrad Black and other execuCves obtained from Hollinger payments alleged to be
self-dealing without fully and properly informing the board of directors whom he had personally
selected.
The case highlights the importance of an independent, objecCve, courageous board of directors, with
acCve and knowledgeable commi_ees (i.e. audit, compensaCon and corporate governance). It provides
an opportunity to discuss ethical decision-making when a legal transacCon might be ethically dubious. It
also highlights the importance of the Bduciary duty owed to the company – to all shareholders, not just a
select few – by managers and directors, acCng as trustees of the shareholders’ wealth.
Teaching sugges:ons
To start out, students can be asked three central quesCons on corporate governance:

why companies have a board of directors,

who should appoint the members of the board, and

what is the duty that these members owe to the company’s shareholders?
One of the board’s most important roles is to oversee the company’s management for the good of the
company (on behalf of all the shareholders). Otherwise, managers will be tempted to line their own
pockets as Black did, and misrepresent facts and earnings to suit their own interests. Since it is rare that
anyone can ePecCvely monitor themselves, there needs to be a separaCon of management from
ownership. It is not surprising, therefore, that boards of directors have the following basic objecCves, as
well as several others:

To raCfy management’s strategies and monitor their performance and progress;

To hire, Bre and compensate management; and,

To ensure that complete and accurate informaCon to assess the company’s performance is
publicly disclosed.
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The students can then be asked what problems may arise if the selecCon of directors is leT to the
discreCon of the parCes whose behavior the board is supposed to monitor, especially when the company
is controlled by a small group of investors that also hold execuCve posiCons in the organizaCon.
The details of the case can then be reviewed, quesConing the role of the board in authorizing
management’s regular compensaCon and one-Cme payments.
Finally it is useful to ask if all forms of management’s compensaCon authorized by the board of directors,
even when perfectly legal, are ethical and in the best interest of the company’s shareholders.
Discussion of ethical issues
1.
What congicts of interest may have been involved in Black’s acCviCes?
Conrad Black was, through a structure of holding companies, the controlling shareholder of
Hollinger InternaConal Inc. even though he did not own the majority of the corporaCon’s total
equity. Black’s potenCal congicts of interest included:

with a partner, he negoCated deals selling company-owned newspapers to other
enCCes, but included non-compeCCon payments directly to himself and other
execuCves.

paid personal expenses and bought an apartment with company’s money.

selected the members of the board of directors, who were supposed to oversee his
acCviCes.
The congicts of interest are evident. Black was CEO of the company, controlling shareholder
without a majority of shares, and the person in charge of appoinCng members of the board. He
could and did choose people who were his friends or admirers, or who were unlikely to
challenge him objecCvely and independently.
2.
Were Black’s non-compete agreements and payments unethical and/or illegal?
These payments seem to be on the borderline of legality. If the board of directors approved the
payments (there is some doubt about the quality of informaCon provided them) and Conrad
Black is able to prove that he did not conceal self-dealing causing damages to other
shareholders, the payments might be deemed legal. [In fact, he was convicted on some, but not
all of the deals.
Even if the payments are considered legal, they are unethical. Black was receiving remuneraCon
as CEO of the company selling the newspapers and should be acCng in its best interests. All
proceeds of the sale should have gone to Hollinger unless the directors knowingly approved a
change in his remuneraCon. The fact that he and his partner wanted to be paid for not
personally compeCng with the newly sold newspaper congicts with their role as oZcers of
Hollinger. They should have been acCng in the interest of the company, not of themselves. If
the company buying the newspapers wanted personal protecCon from Black and his partner,
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that should have been a separately negoCated contract. 1 By including the non-compete
payments, the rights of other shareholders were negaCvely aPected, and since the disclosure to
the board was not Cmely or transparent, the interests of the board and other shareholders were
dealt with unfairly. While it is possible to argue that Black and his partners were shareholders,
so they were in a sense short-changing themselves, that argument overlooks the injusCce done
to the other shareholders who did not receive direct payments. Black and his partners were
clearly self-dealing. He appears to have had the perspecCve that he built the company and could
do what he liked with it and its resources. While this may be Bne if he was the sole owner, when
equity is raised from public shareholders, their interests need to be recognized and protected.
3.
What quesCons should have been asked by InternaConal’s directors?
Directors should act in the best interest of all the company – of all its shareholders. They should
have:

discovered the non-compeCCon payments and other expenses,

asked how they could possibly increase the overall company’s value,

ensured that the company’s internal auditors should have been reporCng to the Audit
Commi_ee on these issues,

veriBed that that non-compete payments were actually received by Hollinger
InternaConal, or have arranged for internal auditors or counsels to do so, and

if reporCng on the non-compete agreement payments was opaque, the directors should
have demanded a full and transparent accounCng.
Obviously the directors were used to leaving such ma_ers to Black and his managers, and did
not exercise independent and objecCve judgment, or have the courage to confront Black.
4.
If the boards of directors of his various companies approved these non-compete
agreements, are the board members on the hook and Black oP?
Not necessarily. The directors’ liability will depend on the kind and quality of informaCon they
received from Black and how they validated such informaCon in approving the non-compeCCon
fees. Directors can raise a "good faith reliance" defense to many of the liabiliCes to which they
are subject. This defense allows directors to point to a reliable source of informaCon as
jusCBcaCon for their acCons. However it does not permit them, in the absence of that speciBc
jusCBcaCon, to show that they acted reasonably. Therefore it is not clear if the directors will be
completely responsible, thus leaving Black free of guilt.
1 In fact, two of the three fraud convicCons were in cases where the buyers Brst refused to pay Black and his
partner, but were coerced to do so in order to make the deal go through. The third convicCon was for a case (if you
can believe it) where Black and his partner arranged the sale of a newspaper to themselves, but decided to include
non-compete payments to themselves in the deal so that they wouldn’t compete later with themselves.
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Conrad Black can sCll be charged if the non-controlling shareholders can prove that he breached
Bduciary duCes owed to Hollinger by him as an employee through unfair use of the company’s
assets. It is also important to note that several provisions in securiCes legislaCon are intended to
protect minority shareholders from execuCve managers’ self-dealing. DeBnitely, he can be sCll
“on the hook” for these payments.
5.
Black controlled key companies through mulCple voCng rights a_ached to less than
a majority of shares. Was this illegal and/or unethical?
DiPerences in voCng rights and shareholding structures are common pracCce in public
companies. This pracCce is not illegal, provided it is properly disclosed.
Public companies are usually subject to the Market for Corporate Control Principle. Stockholders
have no loyalty to incumbent managers and, if the wish, they can usually chose to sell their
shares in a given company at the market price at any point in Cme. This sale will drive the stock
price down, a_racCng potenCal buyers and eventually cause a corporate takeover leading to
changes in execuCve management. However, when the primary controlling shareholder is also
the top execuCve, the market for corporate control might not be ePecCve enough to dislodge
him. It is then the responsibility of the board of directors to act for all shareholders with
independence and objecCvity in overseeing management’s performance. However, it would be
unethical, and perhaps illegal in some cases, for a controlling shareholder to use such majority
voCng rights to appoint the members of the board who are not likely to represent all
shareholders. Unfortunately, it has been known to happen, and is a governance gaw that
investors must consider prior to purchasing shares in such a company.
6. What risk management techniques would have prevented Black’s potenCal congicts from becoming
harmful?
A strong control environment consCtutes the most pervasive means to deter fraud. An
appropriate control environment includes a culture of ethical values such as integrity, honesty,
fair-dealing, and competence; as well as a management philosophy and operaCng style that
regects those values, and the reinforcing oversight, a_enCon and direcCon provided by a
supporCve board of directors. The awareness of company personnel, and internal controls that
correspond to this culture should provide reasonable assurance that fraud will be prevented or
detected.
Some elements of the control structure that might prevent or early detect congicts of interest
include legal, accounCng, and internal audit departments, as well as an independent board of
directors. The legal department, or oZce of the general counsel, typically plays a key role in
reviewing disclosure documents for compliance with applicable laws and regulaCons. The
internal audit funcCon performs a supervisory funcCon within the company to examine, analyze,
and make recommendaCons on ma_ers aPecCng the company's internal controls. The audit
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commi_ee of the board of directors has a responsibility to the company's shareholders to
oversee management's performance.
Subsequent events
On December 10, 2007, Judge Amy J. St. Eve of United States District Court sentenced Lord Black to six
and a half years in prison on three fraud charges involving self-dealing, non-compete payments and one
charge of obstrucCon of jusCce for removing 13 boxes of documents from the Toronto oZces of
Hollinger InternaConal. Instead of keeping a low proBle aTer his convicCon, Mr. Black became even more
voluble. He managed to publish and publicize a 1,152-page biography, “Richard M. Nixon: A Life in Full”.
He spends his Cme in a Florida penitenCary teaching history to overgow classes of inmates, and wriCng
newspaper columns.
Useful Ar:cles, Links, and Videos
Heritage InsCtute (2007, 2008). “Conrad Black Trial Background.”
h_p://www.heritageinsCtute.com/governance/black/background.htm
This website provides informaCon under many headings, including: accusaCons, criminal
charges, the trial and the trial in depth. The Heritage insCtute also provides a link to a report
from the internal commi_ee at Hollinger that iniCally accused Black and his partner David Radler
of operaCng a "corporate kleptocracy" and allegedly stealing more than $400 million from the
corporaCon.
Waldie, Paul (July 23, 2010). “Black can’t return to Canada yet.” Globe and Mail,
h_p://news.bbc.co.uk/2/hi/business/3276689.stm
“Conrad Black Trial Excerpts.” (March 21, 2007). CBC News In-Depth Coverage,
h_p://www.cbc.ca/news/background/black_conrad/trial-excerpts-cramer.html
[No longer available in 2017.]
“Conrad Black: Where did it all go wrong?” (Feb. 27, 2004). BBC World News,
h_p://news.bbc.co.uk/2/hi/business/3276689.stm
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12. Manipula6on of MCI’s Allowance for Doubaul Accountants (Chapter 5, pages 314-315)
What this case has to oKer
This case illustrates the problems an employee can get into when the Brm develops a high-paced culture
of growth at any cost and will not tolerate any dissenCon, even if the dissenCng opinion is the voice of
reason and prudence. It also illustrates that employees must have the courage to be forthright when
communicaCng bad news to their superiors.
Teaching sugges:ons
I would suggest that students in the class outline generally accepted accounCng principles with respect
to accounts receivable. Any student who has audit experience can explain the steps that auditors follow
in order to saCsfy themselves that the net accounts receivable and the bad debt expense are reasonably
stated.
Generally accepted accounCng principles require that accounts receivable be stated at the amount that
will ulCmately be collected. This is the gross amount, less the allowance for doubˆul accounts.
Although the true allowance cannot be predicted in advance, a reasonable provision can be esCmated
based on the available facts. These would include:

the Brm’s credit policy,

the age of the outstanding accounts, and

the history of collecCon and write-oP rates over a number of periods.
In the case of MCI, the credit policies were too lenient, and had not been reviewed or changed as a
result of economic condiCons and sales volumes. The aging was being arCBcially manipulated because
there were inadequate internal controls to prevent Walt Pavlo and his team from:

converCng delinquent accounts receivable to promissory notes,

accepCng common stock instead of cash, and

lapping payments.
Discussion of ethical issues
1. ATer being told that the guideline for bad debts for 1996 was $15 million, what should Walt do?
Walt should have been more forceful in his presentaCon to his boss. If his boss would not
acknowledge the problem then he should follow the chain of command and report the issue to
his boss’ boss. At the extreme, if all else fails, then Walt should consider becoming a whistleblower. He should raise the issue directly to the audit commi_ee or to the auditors. The
consequences of this could be dire, but not as severe as the $150 million write-oP that MCI
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eventually recorded aTer it was taken over by WorldCom. By accepCng the $15 million
guideline, Walt contributed to his own downfall and eventual penitenCary sentence.
2. What are the risks for MCI in sewng an unrealisCc allowance for doubˆul accounts?
The allowance is simply today’s esCmate of the amount of receivables that will not be collected
in the future. The actual amount of the uncollecCbles remains the same, regardless of the
amount of the esCmate. So, by sewng the allowance too low, the Brm is simply pretending that
a further loss recogniCon problem does not exist. The Brm can bury its head in the sand, but the
reality of the uncollecCbles will become apparent when the Brm does not receive the cash from
those customers in later periods.
The major risk of not having a reasonable allowance is that a controllable problem can go
unchecked and thereby increase to become a major issue. In the case of MCI, approximately
$180 million was not going to be received (this is the amount of the eventual write-down). But
sewng the allowance at only $15 million the Brm was not being honest with itself nor its
investors. The problem was not being acknowledged and therefore not being addressed on a
Cmely basis.
If investors and/or the government believe that the Brm deliberately overstated net income by
understaCng the bad debt expense by understaCng the allowance for doubˆul accounts, then
the Brm can be sued for fraudulent Bnancial reporCng.
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13. Stock Op6ons and Gibs of Publicly Traded Shares (Chapter 5, pages 316-317)
What this case has to oKer
This allows the students to discuss a variety of issues, including:

when does the exercise of CEO discreConary power become opportunisCc,

the ethics of a variaCon of the classic pump and dump strategy, the scheme whereby an investor
will arCBcially increase a Brm’s stock price with false or misleading informaCon, in order for the
investor to sell a price much higher than the purchase price of the shares, and

the professional and Bduciary responsibiliCes of accountants working within an organizaCon.
Teaching sugges:ons
This is a good opportunity to review the major ethical theories and apply them to corporate charitable
donaCons, redirecCng donaCons to stem cell research and managerial opportunism.
U-litarianism. Currently Revel Technologies donates to a variety of chariCes. Moving the funds from
many chariCes to only one charity may not be of the greatest beneBt to the largest number of people.
However, this argument implies that the social beneBts of the recipient agencies can be measured.
Students should be asked why they think that a cure for MLD will not result in other beneBts to society,
greater than perhaps the beneBts of curing cancer. It is important to stress with the students that
uClitarianism is a simple theory to arCculate, but is very diZcult to measure social costs and beneBts.
Deontology. This theory argues that we should not treat others as means to our personal ends. Is
redirecCng donaCons, to a charity that the CEO has a personal interest in, using Revel Technologies as a
means to the personal goal of the CEO? Does it violate the principles of jusCce and fairness that the
CEO is allowed to make arbitrary decisions? On the other hand, if the shareholders are prepared to
have Revel Technologies make charitable donaCons, then it may not ma_er to them where the
donaCons are directed, as long as they go to legiCmate chariCes. As such, the redirecCon does not
violate any understanding that the shareholders have with the organizaCon.
Virtue Ethics. Many people have strong views on the subject of stem cell research. Is it acCng virtuously
to allocate funds to a form of research that may be contrary to the religious convicCons of some of the
Brm’s shareholders? If the Brm is adopCng a more holisCc approach, should they be balancing their
donaCons based on the religious and social awtudes of their relevant stakeholder groups?
Discussion of ethical issues
1. Is it right that a CEO can direct the charitable donaCons of his company to the charity of his choice?
There is a separaCon between ownership and control. The shareholders own the Brm, but they
delegate running the business to the CEO. As such, the shareholders give a great deal of
discreConary power to the CEO to run the business as the CEO sees Bt. The CEO in turn reports
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to the board of directors who must assess whether the CEO has, in fact, been acCng in the best
interest of the shareholders. The board is to assist in strategic planning, and providing advice
and counsel on criCcal issues. They leave the rest of the decision-making to the CEO. As long as
the CEO does not use this discreConary power opportunisCcally, then there is no problem. A
problem only occurs when the CEO makes choices that are in the best interests of the CEO and
that may not be in the best interests of the Brm. In this case, is re-direcCng donaCons
opportunisCc or not?
2. Comment on the ethical aspects of Pierre’s stock opCon/stock donaCon strategy.
There are two diPerent strategies in this case: one quite legal and the other unethical, and
perhaps illegal.
Stock Dona-ons
Many wealthy CEOs have li_le surplus cash, but quite a lot of very valuable, in the money, stock
opCons. Many chariCes receive large giTs from wealthy business execuCves. However, the
chariCes were concerned that their cash receipts might decrease because these execuCves did
not have a lot of surplus cash. The Canada Revenue Agency plan, created a win/win scenario.
An execuCve can exercise stock opCons without incurring any capital gains tax as long as the
execuCve donated the shares to a registered charity. The execuCve would also receive a tax
receipt for the amount of the donaCon. The charity would receive common stock in a publicly
traded company that the charity could immediately sell for cash, or hold and receive dividend
revenue. So this was a win/win situaCon. The charity receives a marketable asset and the
taxpayer claims a charitable deducCon for tax purposes.
Pump and Dump Strategy
The pump and dump strategy involves arCBcially ingaCng the price of a stock, normally by
releasing false informaCon (pump), in order to be able to sell the stock (dump) at a price higher
than the iniCal purchase price. This case is a reverse of the technique. By withholding the
release of the Bnancial statements that contain bad news, Pierre is arCBcially keeping the stock
price at $19, higher than it would be if the investors knew the bad news. He will only release the
bad news aTer he donates his stock to the charity and receives a tax receipt at the arCBcially
high price of $19. Then the Bnancial statements will be released and the stock will drop to about
$17.
Pump and dump is an unethical strategy because it capitalizes on informaCon asymmetry. Pierre
has informaCon that is useful to the marketplace, but he withholds that informaCon for personal
gain. Pierre is using his insider informaCon to take advantage of all the other investors. As such
he is acCng opportunisCcally, using the other investors as a means to his own personal
advantage.
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3. If you were Gloria, what should you do? Would you change if you were a donaCons specialist, a
lawyer, or a professional accountant?
As a professional accountant, Gloria cannot be associated with any informaCon that is false or
misleading. She may consider that delaying the release of the Bnancial statements is misleading
to the other investors on the basis that if they had that informaCon then the stock would be
trading at the $17 level rather than the current $19 level. If so, then she has a professional
responsibility not to go along with Pierre’s schemes, and instead to report her concerns to the
audit commi_ee, or to the board of directors.
If Gloria is in-house counsel, then as a lawyer she has a Bduciary responsibility to look out for the
best interests of the Brm, which may not necessarily be the best interests of her boss. In this
case, Gloria should raise her legal concerns with Pierre. If that does not convince him to eschew
the strategy then she should report her concerns to the board of directors.
As a loyal employee Gloria has a duty as the donaCons oZcer to adhere to both her job
descripCon and the requests of her superior. One of the funcCons of a job descripCon and
standard operaCng procedures is to protect employees from doing quesConable acCons. Gloria
should, once again, remind Pierre that Revel Technologies has standard operaCng procedures,
and that if he wants the donaCons to be re-directed then he should make that request to the
donaCon commi_ee, not to her. If this does not work, then she should follow the chain of
command, and report the issue to the donaCon commi_ee. The commi_ee has the
responsibility for deciding whether or not they concur with Pierre.
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14.The Ethics of Repricing and Backda6ng of Employee Stock Op6ons (Chapter 5,
pages 317-318)
What this case has to oKer
This is a good case for addressing agency theory, execuCve compensaCon and stock opCons. Given that,
for many execuCves, there is a huge discrepancy between their cash compensaCon and the stock opCons
they receive, it is important for students to understand that when cash, bonuses and stock opCons lose
their proporConality, they may no longer be strong moCvaCon techniques for enhancing the long-term
value of the Brm.
Teaching sugges:ons
Consider bringing in a chart with the names of the highest paid execuCves, the amount of their cash
compensaCon, their bonuses, their stock opCons and their total pay. These data are available from many
periodicals, including Forbes, Business Week, and the Report on Business.
The following data are from USA Today on the 10 highest paid execuCves in 2007.
Name
J. Thain
L. Moonves
R. Adkerson
L. Ellison
B. Simpson
L. Blankfein
K. Chenault
J. Mack
G. Murphy
E. Breen
Company
Merrill Lynch
CBS
Freeport-McMoRan
Oracle
XTO Energy
Goldman Sachs
American Express
Morgan Stanley
Gap
Tyco
Salary
0
5.3
2.1
1.0
1.3
0.6
1.2
0.8
0.8
1.6
Bonus
15.0
18.5
5.4
8.4
35.5
27.0
6.5
0
2.2
3.2
Op:ons
68.0
43.5
55.0
50.1
19.5
26.0
41.3
40.2
35.8
28.3
Total
83.1
67.6
65.2
61.2
56.6
54.0
50.1
41.4
39.1
34.1
(h_p://www.usatoday.com/money/companies/management/2009-02-05-execuCve-compensaCon-2007_N.htm)
ATer reviewing the table, there can be a general discussion about compensaCon, its form and its
purposes. CompensaCon can be given through salary, bonuses, stock opCons, allowances and nonpecuniary perks such as vacaCon Cme, and large oZces with large staPs. CompensaCon is used to hire
and acquire employees, to moCvate them, to reward them for good performance, and to punish them
for poor performance. The problem with compensaCon is untangling the relaConship between each
part of compensaCon and the various purposes. Salary is used to acquire people, but does it moCvate
them to work hard? Is a bonus a reward for past performance, or a moCvaCon for future performance?
The students should realize that the term ‘compensaCon’ is mulCfaceted and mulClayered.
Next, consider discussing the fundamentals of agency theory. There is a separaCon between ownership
and control. Those who own the Brm want a reasonable return on their investment, but they do not
want to operate the Brm. Management is hired to operate the Brm, and is paid compensaCon to do so.
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However, the interests of management may not be aligned with the interests of the investors.
Management may not want to take risks on behalf of the investors lest the risky venture fails and the
manager is Bred. So, compensaCon schemes are set up to align the interest of the manager with the
investors by giving the manager an ownership interest in the Brm through stock opCons. Because they
are now owners of the Brm, their interest should be aligned. This is the basic raConale of agency theory.
Discussion of important issues
1. Do you think that stock opCons actually moCvate employees to work for the long-term good of the
company?
Stock opCons are an a_empt to align the interest of managers with those of the investors.
Investors are interested in a reasonable return on their investment; as result they are risk takers.
Managers are assumed to be interested in compensaCon and are risk averse. Stock opCons
allow the manager to acquire an ownership interest in the Brm. By having an ownership interest
in the Brm, the manager should be inclined to adopt an investor perspecCve, i.e. the manager
should work towards having the stock price increase thereby generaCng a reasonable return for
both the investor and the manager. So, according to agency theory, stock opCons should align
the interests of the manager with those of the investor.
The premise is that investors have a long-term perspecCve. However, if management can
exercise their stock opCons and then immediately sell their shares, then management may have
only a short-term perspecCve. As such, management may make decisions that have only a shortterm advantage, but no long-term beneBt of the Brm and the investors. Furthermore, if
management is risk averse, then managers would not want to hold shares in only one company.
Instead they would want a diversiBed porˆolio, in order to minimize their porˆolio risk. This also
contributes to short-term thinking by the manager. The manager exercises the stock opCons to
receive enough money to buy a long-term diversiBed investment porˆolio.
2. Do you think that stock opCons inadvertently encourage manager to engage in quesConable
accounCng acCviCes, such as earnings management, to arCBcially increase the company’s net
income and thereby the value of the execuCves stock opCons?
Stock opCons are a means of transferring risk onto the manager. Managers will take on risky
projects so as to increase net income and have the stock price rise. As the stock price increases,
the value of the opCons increase. When the opCons are exercised and the shares are then sold,
the manager receives cash, an indirect form of compensaCon. Managers know that if the risks
they take on behalf of the investor fail, then they will probably be Bred, and receive no more
compensaCon. Since managers normally have a short-term orientaCon, and they fear losing
their compensaCon, this encourages many managers to engage in earnings management.
Earnings management is a technique to arCBcially increase net income, and hopefully stock
price, through accounCng and operaConal strategies. For example, management may arCBcially
increase earnings by changing the allowance for doubˆul accounts, the inventory obsolescence
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reserve, the esCmated warranty provision and/or a pension cost esCmates. None of these
strategies alters cash gows but they do alter reported earnings. Other strategies, that will alter
cash gows, include changing credit terms and approvals, shipping goods before they are
ordered, altering the level of research and development and/or reducing adverCsing
expenditures. All of these are designed to reduce expenses, increase net income and increase
stock price so that the stock opCons become more valuable to the manager.
The students can then discuss the pros and cons of each strategy. Some aspects of the
accounCng strategies include the following.

Net income is altered without changing cash gows.

AccounCng esCmates reverse in the next period, so the strategies are normally shortterm.

These accounCng esCmates are not disclosed in the Bnancial statements, and so they
are not readily apparent to the investor.
Aspects of the cash gow strategies include the following.

Net income is reduced and short-term cash is saved.

These strategies may have a long-term detrimental ePect because important acCviCes
such as R&D and adverCsing are reduced or eliminated.
3. Do you agree or disagree with the four ethical arguments summarized above and contained in more
detail in the arCcle by Raiborn et al.? Explain why.
4. Should a board of directors approve repricing or backdaCng stock opCons for outstanding execuCves
whose current stock opCons are underwater due to uncontrollable economic factors, and who will
be lured away unless some incenCves to stay are created? What other incenCves might work?
Stock opCons are a means of transferring risk onto the manager, and risk means that there is the
possibility of both success and failure. If the Brm is unsuccessful, then net income falls as does
the stock. In this situaCon the investor has lost money and the value of manager’s opCons fall
and may be underwater (below the strike price). If the manager can have the opCons rewri_en,
so that they are no longer out of the money, then the manager has won while the investor has
lost. This is not fair. If both parCes are at risk, then they should both reap the beneBts when the
venture succeeds and both share the losses when it fails. To do otherwise is not treaCng equals
equally.
Stock opCons are a form of execuCve compensaCon. CompensaCon can be used to reward good
performance. By re-wriCng stock opCons, the Brm may be rewarding poor performance rather
than good performance.
Some will argue that stock opCons need to be rewri_en in order to prevent good managers from
leaving and joining another Brm. Managers are to be responsible for their decisions, both the
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successful and unsuccessful ones. Managers with integrity admit their mistakes and take the
consequences of their acCons. Irresponsible managers will a_empt to blame others while
moving to another Brm in order to minimize their Bnancial losses. Also, if the managers made
decisions that led to the losses of the Brm, the decrease in stock prices, and the opCons become
worthless, then these may not be the managers that the investors want to have operaCng the
Brm. It is best to not rewrite the stock opCons and instead let the managers leave.
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Cases on Fraudulent & Ques:onable Financial Repor:ng
15.Satyam Computer Services, The Enron of India (Chapter 5, pages 318-320)
What this case has to oKer
This case resembles several of the large accounCng scandals in the U.S. It highlights several failures
within the company’s corporate governance mechanisms and the negaCve consequences of excessive
power concentrated in the hands of the company’s Chairman, who allegedly perpetrated the fraud
alone.
Satyam is a company whose principal business is outsourcing, and the company relies highly on
reputaCon to a_ract clients. This case also raises concerns about the extent to which a company that
outsources operaCons to a third party should make sure that the third party behaves ethically and has
strong corporate governance and internal controls. The outsourcing company must ensure that
ulCmately the outsourced informaCon is processed safely and without any business interrupCons.
Finally, this case is an example of a successful turnaround aTer a large scandal. With the help of the
government of India and new investors, the company took several commendable acCons to clean its
reputaCon and conCnue operaCng.
Teaching sugges:ons
The Brst quesCons that come to mind in this case are what happened with the company’s controls over
Bnancial reporCng and who was responsible for the fraud. As it has been the case with previous
accounCng scandals, the fraud scheme seems to be relaCvely easy to idenCfy but nobody noCced it or
reported it. I go through the list of people that could have raised a gag but did nothing, for example:
directors, accountants, internal and external auditors. I highlight that it was unlikely that Mr. Raju
perpetrated the fraud by himself without the knowledge of anybody else within the company.
I also discuss the measures taken by the company aTer the fraud and whether or not they would be
ePecCve at restoring the company’s reputaCon and avoiding a similar fraud in the future.
Discussion of ethical issues
1. Will the Satyam fraud damage India’s reputaCon as a reliable provider of informaCon technology
outsourcing?
Given the size of Satyam and its importance as an outsourcing company, serving over one third
of the US Fortune 500 companies, this fraud could cause a major disrupCon of India’s enormous
outsourcing industry and may force many large companies to invesCgate and perhaps revamp
their back oZce operaCons in India.
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Before the company was acquired by Mahindra Group there was a high level of uncertainty
about the outsourcing operaCons of Satyam. The government of India’s speed and decisive
nature of acCons in the aTermath of the crisis helped to stabilize the company’s operaCons
during the Brst months of 2009. At the same Cme, a new board of directors nominated by the
government quickly idenCBed Mahindra as strategic investor for the company, which infused
funds and helped to restore conBdence among Satyam’s stakeholders.
2. How long will it take to restore Satyam Computer’s reputaCon, and how would you recommend that
the restoraCon be facilitated?
The recovery of the company’s reputaCon is going to be a long process that will take several
years. In the Chairman’s Le_er, published together with the Annual Report 2008-09 -- 2009-10
(Mahindra Satyam 2010), the new Chairman notes that:
“As you may be aware, the Mahindra Group has always been known for its value system,
which uncompromisingly applies to all the Group Companies:

Be responsive to customers

Zero tolerance on unacceptable standards for ethics and governance

Uphold the dignity of all associates

Provide an environment that values professionals

Make quality our mantra in all aspects of work”
In addiCon, the Le_er highlights the importance of strengthening internal controls:
“Strengthening our internal controls and reporCng systems has acquired its own
piquancy and urgency in the current context. We would wish to ensure that Bnancial
irregulariCes and frauds of the nature which the Company has gone through, can never
happen again. Measures have been iniCated for making the Bnancial systems robust,
tamper proof and transparent.”
The company seems to have taken a number of good steps to recover from the loss of reputaCon
aTer the fraud. Several acCons, already taken by the company, included:

Changing the composiCon of the board of directors to have a majority of
independent directors;

AppoinCng independent and Bnancially savvy directors to serve in the audit and
compensaCon commi_ees of the board of directors;
IniCaCng a review of compensaCon policy, performance management system, sales incenCve
policy, recruitment policy, travel policy, etc.;

AdopCng a whistleblower policy;
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
AdopCng a revised code of conduct and ethics policy for the board of directors and
employees of the company;

NominaCng a Corporate Ombudsman to monitor the implementaCon of the code of
ethics, including the whistleblower policy;

Strengthening the internal audit funcCon by appoinCng a reputed and independent
external agency as its internal auditor, under the oversight of the company’s audit
commi_ee; and,

Performing a company-wide internal control evaluaCon and strengthened several
weaknesses in controls over Bnancial reporCng.
Beyond these measures, the company must maintain high ethical standards for many years
before its reputaCon will be fully restored. As a company whose principal business is
outsourcing, Satyam relies highly on reputaCon to a_ract clients that need their back oZce
informaCon safely processed and without business interrupCons.
3. Mr. Raju did not commit this fraud on his own. What types of individuals probably assisted him
either acCvely or by keeping quiet about what they knew he was doing?
In a fraud of this magnitude, several individuals probably assisted Raju or kept quiet about the
fraud. This would include, for example, the company’s CFO, the Chief Auditor, and other
accounCng and internal audit personnel. Moreover, the board of directors and the external
auditors were also parCally responsible for failing to exercise proper due care in overseeing the
company’s Bnancial reporCng.
4. To whom should potenCal whistleblowers have complained?
A potenCal whistleblower could have gone through the following steps to complain:

Talk to an immediate superior or relevant company oZcials in the accounCng or internal
audit department;

NoCfy the audit commi_ee of the board of directors;

Communicate with the external auditors;

Present a formal complaint to the Indian SecuriCes and Exchange Board; and,

Go public as a last resource (aTer seeking appropriate legal counsel).
5. Mr. Raju likened his fraud experience to “riding a Cger, not knowing how to get oP without being
eaten.” This is an aspect experienced by some people trapped on a slippery slope from small to ever
larger fraudulent acts. If Mr. Raju had come to you for advice during the Cger ride, what would you
have advised him?
Mr. Raju has to understand that sooner or later the fraud will be uncovered and that accounCng
fraud is a crime. As Cme goes by the size of the fraud and its consequences will be bigger. He has
to think about the consequences for his family, colleagues, and the thousands of employees
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working for the company. He also has to learn from several other large corporate frauds that
ended badly for their perpetrators. He could avoid a larger disaster by acCng sooner.
6. Should PwC worldwide have to pay any investors for their losses caused by faulty audit work of
personnel in PW India?
It depends on the type of agreement between the aZliate of the accounCng Brm in India and
the global partnership. In principle, just by sharing a common name, PwC has already been
aPected by the fraud. Furthermore, the global partnership is liable if it failed to ensure that the
audit conducted by its aZliates in India complied with the Brm’s global audit standards and
procedures.
In general, external audits are not designed to detect fraud, but it seems that relaCvely straight
forward audit procedures such as thorough bank conBrmaCons and reconciliaCons, as well as
other forms of asset veriBcaCons, would have uncovered the fraud.
Useful Ar:cles, Links, and Videos
Mahindra Satyam (2010). Annual Report 2008-09 -- 2009-10.
h_p://www.techmahindra.com/sites/resourceCenter/Financial%20Reports/mahindra-satyamannual-report-2008-09-and-2009-10.pdf
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16.Nortel Networks’ Audit CommiYee Was In The Dark (Chapter 5, pages 320-329)
What this case has to oKer
Nortel Networks is one of the most notorious companies to emerge from the 1990’s dot-com stock
bubble that burst spectacularly. Nortel’s own stock – which accounted for more market capitalizaCon
than any other stock in Canada – went from $124.50 to $0.63. Following the collapse of its Internet
business, Nortel entered into a dramaCc restructuring process focusing on containing losses and
returning to proBtability. The company’s downsizing and restructuring ePorts lowered morale and
moCvated Nortel’s management to manipulate proBts by recording and releasing inappropriate
accruals/provisions. Even though these provisions were not material in an individual basis, their
aggregate value made the diPerence between a proBt and a reported loss. Achieving proBtability
triggered rewarding bonuses to all Nortel employees and signiBcant bonuses to senior management.
The inappropriate provisioning was discovered aTer the Audit Commi_ee of Nortel’s board of directors
hired a legal Brm to review a restatement of $900M of liabiliCes in the third quarter of 2003. These
inadequate pracCces began in early 2002, when the company started its restructuring ePorts.
The case oPers several interesCng points for discussion, including:

Nortel’s loss of its earlier strong ethics reputaCon, and its ethical culture,

Audit Commi_ee processes and how they might have avoided Bnding themselves in the dark,
unaware of the fraudulent “cookie jar” accounCng manipulaCon going on,

Techniques for accounCng manipulaCon, and the role of provisions and conCngencies as “cookie
jar” reserves,

Audit processes and why the auditors were unaware of the fraud,

The potenCal negaCve impact of a management compensaCon scheme strongly Ced to pro
forma proBtability,

Management of an invesCgaCon into fraudulent accounCng manipulaCons.
Teaching sugges:ons
I start the case with a brief background of Nortel, giving the students a sense for the company's size,
operaCons, and signiBcant market changes that drove its share price up to C$124.50 and eventually
down to less than one dollar in 2002. In light of these events, I ask the students what acCons could have
been taken to restructure the company and build back Nortel’s share value. I also ask what the
implicaCons of the Internet’s business downturn were. My objecCve here is to show that the company
needed a thorough strategic change including a new compensaCon scheme Ced to strategic milestones
beyond pro forma earnings.
Then I ask my students to what extent they believe a company's success is a direct result of its top
execuCves' performance. Later I inquire who should be sewng the top execuCves' incenCve package. I Ce
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their answers to the role of the board of directors and the responsibiliCes of its commi_ees. The board
needs independent and objecCve members with strong industry, strategic, governance and Bnancial
skills. In order to fulBll speciBc purposes, the board appoints specialized commi_ees such as audit,
conduct review, compensaCon and corporate governance. Nortel’s board and its audit commi_ee did not
exercise enough due care asking enough quesCons, in a Cmely manner, regarding the provisioning
process and overall control structure. Nor did they – like the Enron board – have any whistleblowers
Cpping them about the manipulaCons going on; probably due to a failure to create an ethical corporate
culture that encourage such openness.
I then deal with the quesCons posed at the end of the case, which follow below, stressing the role of the
various players and pieces of an ethical culture. All are required to ensure that problems are minimized.
Even when they are all operaCng ePecCvely – a due diligence requirement of the board – unethical
problems cannot be eliminated enCrely.
Discussion of important issues/ques:ons
1. Why would Nortel Networks, a Canadian company, hire a U.S. law Brm to undertake an independent
review of factors that led to restatement of accounCng reports?
The choice of an invesCgator was mulCfaceted. A law Brm was probably chosen so that any
Bndings not reported publicly could be held in conBdence due to the a_orney-client privilege
that is not available with accounCng, consulCng, or invesCgaCve Brms. This would prevent other
Bndings from being used against the directors in a lawsuit. The law Brm could (and did) employ
an invesCgaCve Brm and their Bndings would similarly be protected. In addiCon, hiring a wellknown U.S. Brm with contacts and standing with the SEC – the most aggressive regulator facing
Nortel – would add credibility to the exercise and lend support to the stock valuaCon during the
invesCgaCon.
2. Why did the independent review focus on the “establishment and release of contractual liability and
other related provisions” (also called accruals, reserves, or accrued liabiliCes)?
The legal review mandated by the audit commi_ee expected to verify the company’s liability
restatement of $900M. The audit commi_ee wanted to gain understanding of the events that
caused signiBcant excess liabiliCes to be maintained on the balance sheet. These contractual
liabiliCes were a result of previous years' provisioning process, based on judgments made of the
company's obligaCons.
3. How did the failure to follow U.S. GAAP permit the manipulaCon of Earnings before Taxes (EBT) and
lead to fraudulent behavior?
As per general accounCng principles, accrued liabiliCes arise from recogniCon of expenses for
which payment of cash or other assets will be made in a future period (i.e., interest, taxes, and
payroll payable). SomeCmes the amount of a future payable is uncertain due to future
condiCons and/or external factors, and the amount of the liability has to be esCmated using the
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best informaCon available at the Cme. In such cases a provision is made for the esCmated
amount, thus charging an expense against proBt. When the actual event occurs (creaCng a
triggering event), any unused provision is supposed to be reversed, creaCng a credit that
enhances proBt. Nortel execuCves chose to add to and reverse or draw down its reserves
arbitrarily without regard to a proper triggering event, thus manipulaCng proBt up or down to
qualify for bonuses based on pro forma proBt targets.
ConCngent losses are one type of these esCmated liabiliCes. A conCngent loss is a possible loss
(or expense), derived from past events, which will be resolved as to existence and amount by
some future event conBrming or rejecCng the loss. Nortel overstated conCngent contractual
agreements (debit in the liability side) and losses (credit expenses) in 2002 and subsequently
released or reversed these accruals (esCmates) increasing revenue and decreasing liabiliCes. The
contractual liabiliCes acted as “cookie-jars, overstaCng losses in a bad year and then reversing
these losses into income in the following periods.
4. Describe the Nortel Return to ProBtability (RTP) and Restricted Stock Units (RSU) bonus plans. What
did the board of directors expect these plans to achieve?
The board intended to moCvate employees to stop losses and generate proBts, while moCvaCng
employees to stay with Nortel. The bonus plans also were intended to moCvate execuCves over
Cme to maintain a proBt trend.

The RTP bonus plan contemplated a one-Cme bonus payment to every employee, save
43 top execuCves, in the Brst quarter in which Nortel achieved pro forma proBtability.
The 43 execuCves were eligible to receive 20% in the Brst proBts quarter, 40% in the
second, and 40% upon four following quarters of cumulaCve proBtability. Pro forma
proBts had to exceed or equal the total cost of the bonus in that quarter.

The RSU bonus plan made a signiBcant number of share units available for award by the
board of directors to the same 43 execuCves in four installments Ced to proBtability
milestones.
5. Were the misstatements of EBT and bonuses paid material in an accounCng sense?
Materiality – measured by the ability of a change to aPect the decision of an informed lay reader
of Bnancial statements – refers to a threshold that varies somewhat depending on the
circumstances. In a normal audit, for example the aggregate materiality threshold may be set as
a percentage of net income (i.e., 5%). However in this case, given the importance of the Cpping
point turning a loss into proBt, and its connecCon with bonus payments, the draw downs of
provisions (reversals) would have been less than 5% of proBt, but since they turned a loss into a
proBt – an important Cpping point – they were deBnitely considered to be material. The
company released $361M in Q1 2002, and $370 in Q2 2002.
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6. Why didn’t Nortel’s auditor discover the misstatements?
At the Cme of wriCng, we do not know why the auditors did not discover the cookie jars or there
fraudulent use. Provisioning involves signiBcant judgment on the part of company execuCves.
Auditors review and challenge the provision esCmates but rarely have more experCse than client
personnel, and do not hire outside valuaCon experts unless there is reason to suspect
misrepresentaCon.
Nortel’s Bnance execuCves apparently stretched the judgment inherent in the provisioning
process to create a gexible tool to achieve EBT targets. Making accounCng esCmates frequently
requires management to develop models and assumpCons regarding possible outcomes,
including Cming, transacCons or events that are uncertain at the Cme of the esCmaCon.
Guidance on audit procedures for validaCng accounCng esCmates, including materiality and
restatements, remains unclear and dispersed throughout diPerent secCons of the AudiCng
Standards. However, auditors should ensure that the client is using an appropriate model and
considering reasonably accurate assumpCons. In some cases auditors may opt for consulCng
with legal or actuarial experts in reviewing very material esCmates.
SomeCmes auditors are too concerned with the present year and place too much conBdence on
previous years’ judgment. If the auditors deem a liability to be valid because it was reviewed in
previous years, they may only ask management for current explanaCons to validate the liability’s
reversal. Auditors should also verify the validity of the original liabiliCes when they were
subsequently reversed. It is conceivable that the auditors did not thoroughly review the end-ofperiod adjusCng entries related to the cookie jar reversals because they were unaware of them,
or considered them to be not material.
7. Why did the audit commi_ee or the board as a whole, not anCcipate the manipulaCons?
The audit commi_ee should have queried management regarding the components of the
income statement, including the accrual reversals, parCcularly when the Bnancials triggered the
pro forma based bonus plans. It appears that Nortel's directors did not ask the appropriate
quesCons, or did not receive straight answers. Nortel’s audit commi_ee did not demonstrate
enough accounCng experCse and savvy to direct internal auditors to review and report on endof-period and other discreConary adjustments (where there is potenCal for management
override of internal controls) before approving the Bnancials and the bonus payouts. Apparently
the audit commi_ee placed too much trust in management.
The board of directors as a whole failed to:

Foster an adequate control environment;

Assess Bnancial reporCng risk appropriately;

Ensure that adequate people and systems supported the control structure; and,

Exercise adequate monitoring of management esCmates.
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When businesses are restructuring, management is generally concerned with earnings targets
and oTen cut expenses dedicated to internal controls. There is li_le a_enCon paid to “back
oZce” funcCons including accounCng, internal audit and human resources. As a result, increased
control risk result in a higher chance that management’s manipulaCon of earnings may occur
without detecCon.
8. What quesCons should the Audit Commi_ee of the board have asked?
See discussion above. Also they should have asked quesCons targeted to address achieving not
only earnings targets but also key strategic milestones to rebuild shareholder value. Also, they
should have asked what was the role of the reversals and how these reversals were determined.
9. What internal control gaws permi_ed the fraudulent manipulaCon to occur without detecCon?
The following is a list of potenCal gaws. Some will not be clariBed unCl expert witnesses tesCfy.


Control environment:
o
Lack of thoroughness in audit commi_ee oversight
o
Lack of accounCng knowledge of audit commi_ee members
o
Lack of auditor's due care in examining management's esCmates
o
Unclear control structures, roles and responsibiliCes
o
Weak ethical culture and lack of a thorough ethical awareness program
Risk assessment:
o

InePecCve risk assessment by the board of directors, failing to idenCfy risk factors
(business risk), dubious transacCons (opportunity to commit fraud), and inadequate
compensaCon programs (moCve for fraud)
Control acCviCes:
o
Lack of personnel with strong accounCng and reporCng skills and experCse, and
proven records of integrity and ethical behavior, parCcularly in key Bnance posiCons
o

InformaCon and communicaCon:
o

Inadequate training in accounCng issues
Inadequate ongoing communicaCon between audit commi_ee, internal and external
auditors, and management
Monitoring:
o
Lack of ePecCve whistleblower programs
o
Lack of ePecCve internal and external audits
10. Would the new SOX requirements have prevented the manipulaCon per se –why or why not?
The Sarbanes Oxley Act of 2002 includes helpful broad provisions such as establishing a Public
Company AccounCng Oversight Board (PCAOB), maintaining auditor independence, improving
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corporate responsibility and enhancing Bnancial disclosure. In addiCon, it spawned several more
speciBc requirements that might have prevented this manipulaCon. For example, SOX requires a
complete evaluaCon, CEO and CFO cerCBcaCon, and audit of the company’s internal controls and
Bnancial reporCng system (SecCon 404) , creaCon of enCty level controls such as whistleblower
programs, and accountability of senior manager and directors for Bnancial informaCon (SecCon
302 cerCBcaCon), while emphasizing directors’ and auditors’ independence. On the other hand,
they might not have prevented this manipulaCon because of the risk of management override in
a weak control environment, and the fact that internal controls cannot prevent all frauds – they
can only minimize the possibility of fraud occurring.
11. How have the expectaCons of the Audit Commi_ee changed since SOX with regard to corporate
culture? How can the audit commi_ee ensure that these are met?
Prior to the enactment of SOX, there was a general sense that the CEO was really in charge of
the company and its aPairs. SOX reaZrmed the primacy of the board of directors, clariBed roles
and set expectaCon for performance. In the new framework, the audit commi_ee is the overall
guardian of Bnancial integrity for shareholders. Audit commi_ee members must be criCcally
aware of their oversight responsibiliCes, and must completely understand them. How their
responsibiliCes are carried out may vary, but a failure to address them may have consequences
for the audit commi_ee, the board and, most of all, the shareholders. Every audit commi_ee
must assume three fundamental responsibiliCes:

Overseeing the process related to the company’s Bnancial risks and internal control;

Overseeing Bnancial reporCng and related systems; and

Overseeing internal and external audit processes.
There is a new understanding of the importance of corporate culture as part of the internal
control system that is essenCal to the preparaCon of reliable accurate Bnancial reports.
Consequently, the audit commi_ee would have to report and remedy any cultural inadequacies
as part of their duty to review internal controls. The audit commi_ee is now seen to be in
charge of the internal and external auditors – serving as the funcConal head of the internal audit
department and also assuming the dominant role in appoinCng and reviewing the work of
external auditors – and acCvely quesConing management in Bnancial reporCng integrity issues.
External auditors must now report to the audit commi_ee discussions with management,
opinions expressed and where those opinions were not followed.
12. Should the Audit Commi_ee or the whole board be held legally liable for the weaknesses noted in
the review? Why and why not?
Management is responsible for designing and implemenCng an ePecCve system of internal
control. The audit commi_ee must determine that management has implemented policies that
ensure the company’s risks around Bnancial reporCng are idenCBed and that controls are
adequate, in place, and funcConing properly. As part of its assessment of the processes relaCng
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to a company’s risks and control environment, the audit commi_ee should request from
management an overview of the risks, policies, procedures, and controls surrounding the
integrity of Bnancial reporCng. The audit commi_ee should supplement those representaCons
with informaCon from the internal and external auditors. The audit commi_ee makes inquiries
of the internal and external auditors regarding internal controls as part of its responsibiliCes for
overseeing the controls over Bnancial reporCng.
The audit commi_ee and other members of the board are liable if they are negligent in
performing their oversight duCes. While the board delegates its authority for close scruCny of
Bnancial ma_ers to the audit commi_ee, they cannot escape liability for negligence unless they
can demonstrate that they checked that the work of the audit commi_ee was been done
properly. However, the members of the audit commi_ee are the front line of defense and
usually possess higher levels of Bnancial experCse than the rest of the directors, so their
responsibility and liability would be greater. Case law will determine the relaCve levels of
liability during the next 5-10 years.
13. In February 2005, Nortel hired a new Chief Ethics and Compliance OZcer using an incenCve
compensaCon scheme based upon proBts. Is this a sound arrangement?
Given the recent fraud moCvated by Nortel’s bonus scheme, this is not the best way to maintain
or appear to this oZcer's independence and objecCvity. SensiCve posts such as this should be
structured to maintain independence not only in substance but also in appearance.
Furthermore, it is a basic assumpCon of any compensaCon scheme that employees should be
rewarded only for achieving milestones on variables directly controllable by them. It is unlikely
that the ethics oZcer will have any direct impact on the company's proBts in the short run, so if
a bonus plan must be employed, it would be be_er to use stock opCons that would not be able
to be sold unCl a year or so aTer the departure of the execuCve.
14. Nortel has issued a new code of conduct with striking similarity to their previous version. Why might
this new code be more ePecCve than the last?
A code of conduct has to be part of a thorough and comprehensive ethics program to be
successful. An ethics program cannot succeed unless all elements of the plan as discussed in the
text, are in place. Most importantly, the outspoken commitment (see text discussion on ethical
leadership) of senior execuCves is essenCal to get employees to be concerned about ethical
behavior and buy into the program. In the Nortel situaCon, with so recent a fraud in everyone’s
mind, a new code, even if li_le changed, will resonate with all employees and leaders should
have no problem exhorCng adherence.
15. In retrospect, what were the major failings of the Nortel Audit Commi_ee? Were they the same as
those for the board as a whole?
As noted in the answer to quesCon 12, the board and the audit commi_ee have overlapping
responsibiliCes.
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The board of directors failed to oversee management in maintaining an adequate control
environment and ensuring the integrity of Bnancial reporCng. The integrity and awtude of senior
management and the board of directors, including its commi_ees (referred to as the “tone at
the top”) is the most important factor contribuCng to the integrity of internal controls, including
those surrounding the Bnancial reporCng process. The “tone at the top” becomes the cultural
core of the company and suggests a model of appropriate conduct for every level.
The audit commi_ee failed, at a more technical level, to oversee the compliance with GAAP and
the integrity of the provision process. Moreover, besides their technical accounCng role, the
audit commi_ee is expected to conCnuously evaluate speciBcally whether management is
properly promoCng an ethical culture (which is supporCve of strong internal control systems). To
facilitate the review, the commi_ee should request updates and brieBngs from management and
others (internal and external auditors, chief ethics oZcer, and so on) on how compliance with
policies and other relevant company procedures is being achieved.
Useful Ar:cles, Links, and Videos
“Canada’s technology star becomes Bnancial black hole.” (September 16, 2009), CBC News,
h_p://www.cbc.ca/money/story/2009/01/14/f-nortel-backgrounder-january09.html
“RCMP lay fraud charges against former Nortel execs.” (June 19, 2008). CTV News,
h_p://www.ctvnews.ca/rcmp-lay-fraud-charges-against-former-nortel-execs-1.303457
“CBC Archives: In Depth Nortel.” (February 27, 2008). CBC News,
h_p://www.cbc.ca/news/background/nortel/newsarchive.html
[Link no longer valid in 2017.]
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17.Adelphia – Really the Rigas’ Family Piggy Bank (Chapter 5, pages 329-333)
What this case has to oKer
This case focuses on the Bduciary duty of managers, directors and auditors and allows examinaCon of
the potenCal implicaCons of family control in publicly-owned companies. It oPers a lesson about the
importance of an independent and objecCve board of directors that ePecCvely challenges management,
with the necessary technical skills and knowledge to understand the business and its Bnancial reporCng.
Adelphia, controlled by the Rigas’ family, grew rapidly from a local cable company to an internaConal
telecommunicaCons provider. However, unrestricted (unchallenged, really) access to company resources,
allowed execuCves to use company funds for personal gain. To cover extensive self-dealing and overall
poor Bnancial performance, the company understated its debt by $16 billion, overstated revenue, and
misrepresented its customer numbers in press releases.
As oTen happens, a person or family that begins a business, or takes it to considerable success, forgets
that using money from the public requires accountability to the public and their regulators – they can’t
just conCnue to use company resources as if they were the sole owners with accountability only to
themselves.
Teaching sugges:ons
I suggest starCng by asking students what is the major problem presented by the case and managing the
discussion unCl it produces the paragraph immediately above. This will facilitate a discussion of:

diPerences between family-owned and publicly-owned businesses,

what the responsibiliCes are of a public company to its investors,

what these responsibiliCes imply for the Bduciary duty of managers and directors

what allowed the Rigas’ Family to set these duCes aside, and

what barriers should be in place to stop management’s opportunisCc behavior.
Finally, a discussion is in order of the auditors’ responsibility in case of fraud, and the need for a sound
evaluaCon of potenCal risks linked to appropriate audit procedures.
Discussion of ethical issues
1. What breaches of Bduciary duty does the Adelphia case raise?
Fiduciary duty involves the responsibility of a second party to act in the best interest of a Brst
party in a relaConship of trust. This duty is especially important when the Brst party is vulnerable
to the acCons of the second party. There are four elements to consider in determining breach of
Bduciary duty: the duty itself, breach of duty, direct causaCon and damages.
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Breach of duty becomes likely when the second party does not behave in a way that a
reasonable person acCng in the Brst party’s best interest would have behaved under similar
circumstances. Note that professionals are held to a higher standard of care than an ordinary
reasonable person would be. They should put the interests of their clients before their own, hold
themselves free of congicts of interest, and be reasonably knowledgeable of their profession
abiding a professional code of conduct.
Managers and directors are considered trustees of the shareholders’ property. In Adelphia’s case
there is a clear breach of Bduciary duty of the Rigas’ family as managers and of all members of
the Board, who were supposed to act in the public shareholders’ best interest, but acted against
the public shareholders (and other stakeholders) and for themselves, disregarding evident
congicts of interest.
As for the auditors’ responsibility to Adelphia’s shareholders, other factors should be taken into
account including vulnerability, trust, reliance, discreCon and the professional's code of conduct.
However, the Auditors would not breach that duty if they performed their audit according to the
professional standards of care.
2. Why do you think the Rigas family though they could get away with using Adelphia as their own
piggy bank?
A potenCal raConalizaCon argument is possible if the Rigas’ Family, former sole proprietors of
the business, mistakenly think that other minority shareholders “owe” them for creaCng and
expanding the company in their behalf.
3. What allowed the Rigas family to get away with their fraudulent behaviour for so long?
The Rigas’ family got away with their fraudulent behavior for so long due to several weaknesses
in the control environment: Rigas’ family members occupied key management posts;
management’s lack of integrity, poor ethical values, competence, and an understanding of
legiCmate expectaCons of ethical behavior; management's aggressive growth philosophy and
operaCng style; family preferences assigning authority and responsibility; and, weak oversight
from a non-independent board of directors with a majority of family members.
The external auditor’s oversight was limited by management’s misrepresentaCon. An auditor’s
responsibility involves the detecCon of material misstatements caused by fraud, but normal
audit procedures are not directed to speciBcally uncover fraudulent acCvity. However, audit risk
assessment should include an evaluaCon for potenCal fraud, and signiBcant risks should be
invesCgated.
4. What concerns should have been raised in the following areas of risk assessment in Adelphia’s
control environment: integrity and ethics, commitment, Audit Commi_ee parCcipaCon,
management philosophy, structure, and authority?
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A company’s control environment, or internal control environment, refers to the framework of
awtudes, awareness, and acCons of directors and management that are needed to support
adherence to the company’s policies, its acCons in support of its objecCves, and the accuracy of
its Bnancial reports. A wholesome control environment incorporates appropriate philosophy
and values into the corporate policies and its culture, organizaConal structure and processes,
operaCons, and human resource pracCces. In the Adelphia case, while stated policy was
saCsfactory, quesCons should have idenCBed the weaknesses that allowed the Rigas family to
misdirect company resources, falsify documents, and manipulate company disclosures to cover
their massive misuse of company resources as if the company was their private piggy bank.
Concerns should have been raised about:
•
The competence, independence, professionalism, ethical awareness and ethicality of
senior accounCng, Bnancial, and legal management who should have recognized and
reported family misdeeds.
•
How commi_ed where these senior people, as well as middle management, to an
ethical culture that placed duty to all shareholders above their duty to the Rigas family?
•
Did company policy and procedures clearly regect the need for adherence to values and
procedures that regected this duty to all shareholders?
•
The independence, competence, ethical awareness and ethicality of board members
(parCcularly since the majority were family insiders), and parCcularly of those on the
Audit Commi_ee who should have understood that they needed to protect the interest
of all public shareholders, not just the Rigas family.
•
The existence and eZcacy of a whistleblowing program, and the encouragement of its
use by employees. Did the person in charge of the program understand their duCes and
report directly to the Audit Commi_ee?
•
Since the company had been created and run by the founder and his family, did
management realize that once non-family shareholders were involved, they should be
wary of doing anything they were asked to do by the family? Was there a mechanism in
place for concerns on the part of employees who quesConed their instrucCons to seek
advice and/or report the acCons in quesCon?
5. What concerns should have been raised in the following areas of risk assessment in Adelphia’s
strategy: changes in operaCng environment, new people and systems, growth, technology, new
business, restructurings, and foreign operaCons?
In Adelphia, the need for meeCng targets and for keeping the company’s debt levels within
market averages provided strong moCvaCon to commit fraud. Opportunity for fraud was present
due to lack of independent directors, quick changes in operaCng environment, and risk of
collusion due to family relaConships in key management posiCons.
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6. What is your opinion on the importance of independence in corporate governance? What are the
most recent rules on corporate governance for public Brms?
Independence is a basic element to ensure objecCve judgment. Directors and auditors are key
control elements that can assess and stop management’s opportunisCc behavior in a Cmely
manner. Recent SOX and market regulaCons, such as the NYSE Corporate Governance Rules
(NYSE 2017), require a majority of independent directors in public companies. Under these rules,
no director qualiBes as independent unless the board of directors aZrmaCvely determines that
the director has no material relaConship with the listed company (either directly or as a partner,
shareholder or oZcer of an organizaCon that has a relaConship with the company). Companies
must idenCfy which directors are independent and disclose the basis for that determinaCon. The
relaConship includes Ces such as previous employment with the company in the last three years,
and relaConships of immediate family members.
As for external auditors, the Sarbanes-Oxley Act and accounCng Codes of Professional Conduct
require independence from the client in fact and appearance, precluding the auditor from
personal relaConships with the auditee as partner, shareholder or oZcer in the year of the audit
and a period before and aTer the engagement. In addiCon, the audit Brm must not provide
signiBcant consulCng services that may impair professional judgment in audiCng the client’s
Bnancial statements. Consult the text for SOX/SEC recommendaCons/regulaCons.
7. Discuss which changes could be done to the Adelphia’s control system and corporate governance
structure to miCgate the risk of accounCng fraud in future years.
The invesCng public and lending insCtuCons must ensure that there is suZcient independence of
mind and experCse on the board to create and monitor an ePecCve governance system. At the
outset, a thorough review of Adelphia’s exisCng governance system and key people is called for
by an independent Brm, and key employees (CFO, CIO, Chief General Counsel, Chief Ethics
OZcer, and Chief Internal Audit OZcer) should be replaced. The internal audit group should be
charged with ongoing review of the policies and compliance, and should report to the reformed
Audit Commi_ee. A protected whistleblowing mechanism should be insCtuted that also reports
on Bnancial and non-Bnancial ma_ers to the Audit Commi_ee and the Governance Commi_ee.
SOX/SEC regulaCons are to be followed, and ethics training is to be undertaken. Above all,
execuCves are to be hired who have demonstrated the proper ethical “tone at the top” and are
proacCve and outspoken in regard to the need for high ethical standards.
8. What is the auditor’s responsibility in case of fraud?
Although fraud risk factors (moCve, opportunity, lack of ethics or raConalizaCon) do not
necessarily indicate that fraud exists, they oTen do warn accurately. When obtaining informaCon
about the enCty and its environment, the auditor should consider whether the informaCon
indicates that one or more fraud risk factors are present.
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Auditors should idenCfy risk factors in planning the audit, in their consideraCon of internal
control and inherent risk, and from past knowledge of the client and the industry. Moreover,
they should be aware of the risk factors throughout an audit, not just at the planning stage.
9. What is the proper audit procedure to ensure:
a. completeness of liabiliCes in the Bnancial statements?
b. that all related parCes have been included or disclosed in the consolidated Bnancial statements?
Completeness is the most diZcult asserCon to prove in audiCng Bnancial statements. Looking
for missing liabiliCes or operaCons with related parCes might be very challenging. The Brst
procedure to ensure completeness of such items is to interview management and take their
signed statements of representaCons wherein they declare that the accounts are correct
and/or disclose problems such as related party transacCons, related companies, and company
commitments, whether recorded or not. AddiConal procedures are necessary, such as review
of the minutes of the Board meeCngs, review of subsequent events, and the performance of
analyCcal procedures. Discussions may reveal other related interests and/or acCviCes that are
worthy of addiConal scruCny. Audit professionals who are knowledgeable about the industry
and client aPairs should apply their knowledge to idenCfy potenCal risks. Law Brms used by
the company and the Rigas family should be asked to disclose potenCal problems that could
aPect Adelphia or its assets where loans or advances have been made to Rigas family
members.
10. Do you think analyCcal procedures would aid the detecCon of fraud? What is the responsibility of
the auditor applying analyCcal procedures?
Applicable analyCcal procedures include comparisons to industry raCos and reasonability tests.
Auditors have to be aware of business trends and relevant staCsCcs. This is the reason why audit
partners and audit teams specialize by industry. In this case, for example, the number of
subscribers is a key staCsCc for the analysts following the cable industry. An unreasonable
increase of the number of subscribers should be a red gag for the auditor.
11. What should the 450 lending insCtuCons have done to protect themselves from subsequent lawsuit?
Lending insCtuCons would be well-advised to create a due-diligence protocol/process for new
and exisCng clients wishing Bnancing that covers the full ethical culture and governance system
of the enterprise and the ethics of the transacCon proposed.
Useful Ar:cles, Links, and Videos
“Rigas Family: Times Topics.” (December 7, 2010). New York Times,
h_p://topics.nyCmes.com/topics/reference/Cmestopics/people/r/rigas_family/index.html.
News about Rigas family, including commentary and archival arCcles.
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C-Span and U.S. Department of JusCce (Jul. 24, 2002). “Adelphia ExecuCves Arrests [video]”
h_p://www.c-spanvideo.org/program/171459-1
Discusses the arrest of several members of Rigas family who were accused of stealing hundreds
of millions and causing investor losses of $60 billion while in control of Adelphia
CommunicaCons.
NYSE (2017). Listed Company Manual, SecCon 303A.00 Corporate Governance Standards.
h_p://nysemanual.nyse.com/LCMTools/PlaˆormViewer.asp?selectednode=ch p
%5F1%5F4%5F3%5F6&manual=%2Flcm%2FsecCons%2Flcm%2DsecCon s%2F
[The website’s search feature can be used if the link is not direct. The rules from the year of the
case are no longer available.]
U.S. SecuriCes & Exchange Commission (July 24, 2002). “SEC Charges Adelphia and Rigas Family with
Massive Financial Fraud [Press Release]”, h_p://www.sec.gov/news/press/2002-110.htm
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18. Tyco – Loo6ng Execu6ve Style (Chapter 5, pages 333-337)
What this case has to oKer
Tyco InternaConal is one of the most widely known cases of pervasive fraud perpetrated by top
execuCves. Millions in company funds were misallocated, unreported and/or misrepresented by former
CEO L. Dennis Kozlowski, CFO Mark Swartz, and General Counsel Mark Belnick. Their personal misuse of
funds, lavish expenses, appeCte for excesses, and gagrant denial of any wrong-doing are examples of the
worst consequences of leaving management without adequate monitoring and restraint. EssenCally,
Kozlowski, Swartz and Belnick treated Tyco as their private bank, taking out hundreds of millions of
dollars of loans and compensaCon, but not telling the directors.
This case is interesCng because it points out that extreme weaknesses in governance processes in an
environment of deceit, too much trust by directors, and/or low ethical awareness, might open the door
for unscrupulous execuCves to commit and conceal fraud. As such, the case provides a means for
exploring governance structure and process, and the roles of the players involved. These players include
directors, execuCves, external and internal auditors, whistleblowers, as well as others.
Teaching sugges:ons
In order to lay the groundwork on governance and the issues involved in the case and the quesCons
listed at the end, I ask the following quesCons, in order:
1. How closely should the acCons of execuCves be monitored by the board of directors – very
closely, or with a great deal of trust? [Discussion of the role of the Board]
2. How and through what mechanisms and/or individuals should directors get the monitoring
informaCon they desire? [Discussion of governance mechanisms and players]
3. How can directors assure that they are gewng all the informaCon they need and are not being
misled? [Discussion of internal controls, checks, whistleblower schemes…]
4. Could any of the reported self-interested acCons of Kozlowski, Swartz, and Belnick be
considered reasonable given their posiCon and the size of the company? [Discussion of
reasonability of remuneraCon, perquisites]
Discussion of important issues/ques:ons
1. The pa_ern of illegal and improper conduct described above took place for at least 5 years prior to
June 3, 2002. What red gags or governance mechanisms should have alerted the following people to
this pa_ern:
a. Tyco management accountants?
b. Tyco internal auditors?
c. Tyco external auditors?
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d. Tyco board of directors?
In public companies, there is separaCon of ownership from management. This creates need for a
third party monitoring management in behalf of shareholders (i.e., the principal- agent problem)
and society. The core mandate of the board of directors is to be this third party overseeing
management, and engaging other mechanisms and people to facilitate this funcCon.
The board of directors, as part of their stewardship role, should demand from management a
complete picture of the company's performance, including Bnancial results, and of the acCons of
its execuCves and employees. In order to ensure that such informaCon fairly presents the
company's Bnancial situaCon and acCons, the board of directors receives reports from the
company's internal auditors on its policies and adherence to them, and hires external auditors to
review the company's Bnancial statements and speciBc other acCviCes.
The corporate governance mechanism relies upon policies to guide expectaCons for behavior,
and if these expectaCons are not met, the independence, objecCvity, vigilance, skepCcism, and
ethical behavior of accountants, auditors and directors should lead to Bnding and correcCng the
problem. Therefore:
a. Management accountants should have raised their concerns about waste of resources
(no value for the company's money) in lavish parCes, unreasonable loans to execuCves
and excessive compensaCon. However, Tyco's accountants might not raise any issues
because of fear to their bosses or because some of them were also involved at more
senior levels.
b. Internal auditors should have detected unusual expenses in the same way as
accountants when reviewing the company's operaCons, execuCve oZces expenditures
and management compensaCon programs, as well as compensaCon commi_ee minutes
and authoriCes.
c. External auditors should have detected very high (i.e., over material) execuCve
expenditures or uncollected loans through their audit procedures, including a review of
authorizaCon of material expenses and loans by the company's board of directors. The
partner in charge of the engagement may not have exercised proper due care or might
have decided not to disturb a good relaConship with the client.
d. Directors should have monitored more closely managements' compensaCon, opening
independent communicaCon channels with internal and external auditors. They should
have avoided potenCal congicts of interest prohibiCng management to receive loans
from the company over a certain threshold, and requiring them to ask for preauthorizaCon of certain expenses, and post-expenditure reporCng.
2. IdenCfy and discuss the most important weaknesses in Tyco's internal controls and governance
systems.
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Internal controls should provide reasonable assurance that fraud will be prevented or detected.
A strong control environment consCtutes the most pervasive element to deter fraud. Control
environment includes integrity, ethical values and competence, management's philosophy and
operaCng style, and the a_enCon and direcCon provided by the board of directors. In Tyco's
control environment, integrity, independence and separaCon of duCes were seriously
compromised.
Tyco’s policy and/or compliance reinforcement were insuZcient to encourage employees who
must have witnessed excessive transacCons to blow the whistle. Either they didn’t know what
was right, or didn’t know what to do about it, or didn’t have the courage to come forward. Highlevel execuCve collusion went on unreported. The legal department, or oZce of the general
counsel, typically plays a key role in reviewing disclosure documents for compliance with
applicable laws and regulaCons. The legal department also assists management in establishing
and maintaining internal controls to prevent and detect noncompliance with other laws and
regulaCons. The General Counsel was also involved in Tyco's fraud with the CEO and CFO.
The internal audit funcCon should examine, analyze, and make recommendaCons on ma_ers
aPecCng the company's policies and internal controls. Internal auditors did not raise any issue
regarding anC fraud controls or management illegal acCons.
The board of directors has a responsibility to the company's shareholders to oversee
management's performance, and relate it to compensaCon and beneBt plans – but they did not
do so. At least one of Tyco's directors was receiving addiConal pay as consultant.
3.
Would a post-Sarbanes-Oxley Act whistleblowing program to the Audit Commi_ee of the board
have eliminated the improper and illegal acCons? Why or why not?
Whistleblowing is one of the most common ways by which fraud is uncovered. EPecCve
whistleblowing programs should be:

Independent

Strictly conBdenCal

Direct-line reporCng to the board of directors' audit commi_ee

Timely in responding to issues raised

Available and known to all employees

Supported by a companywide ethics awareness program.
However, these programs themselves are no guarantee that all improper and illegal acCons will
be stopped. There is no subsCtute control for a solid ethical culture within an organizaCon.
4.
If you had been a professional accountant employed by Tyco during this Cme, and you wanted to
blow the whistle, who would you have gone to with your story?
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The Brst step is to discuss the accuracy of facts with your supervisor and try to escalate the issue
using the regular chain of command. If this does not work, you should consider talking to the
ethics oZcer, ombudsman or company's general counsel. However, if this is not possible or not
ePecCve, you should then use the company's whistleblower program. If the company does not
have an internal whistleblower program, you may use external whistleblower programs including
regulators' hotlines or the ethics oZce of your professional accounCng body. The important step
is to make sure that the company’s audit commi_ee Bnds out what is going wrong. Finally, if
there is no useful reacCon, as a last resort you could talk with your lawyer and consider going
public.
5.
Why were so many Tyco employees willing to go along quietly with the looCng by senior
execuCves?
There was a combinaCon of factors: lack of clear communicaCon that unethical behavior will not
be tolerated (ethical awareness), bad example set by senior management (tone at the top), lack
of ePecCve whistleblower programs, and fear of retaliaCon from their bosses.
6.
How many years in jail do you think Kozlowski should have received for his white-collar crimes?
Discussions on this topic are extensive and oTen involve contradictory ethical and legal
arguments. For Tyco's former bosses, their frauds were clear and huge. A signiBcant penalty
was important to show that such management misconduct will not be tolerated in public
companies, and thus deter fraudsters in similar cases, and to restore investors' conBdence that is
at its lowest level in years aTer several fraud scandals involving execuCves’ opportunisCc
behavior.
Addi:onal Events
April 17, 2006. Drawbaugh, Kevin (April 18, 2006). “Tyco to pay $50 million to se_le SEC fraud charges.”
Toronto Star, page C6.
Tyco to pay $50 million to se_le SEC fraud charges related to the looCng of the company.
May 13, 2006. Bloomberg News (May 13, 2006). “Tyco’s Kozlowski to pay millions to resolve tax case.”
Globe and Mail Report on Business, page B7.
This included $3.2 million in back sales tax, interest and penalCes, plus $18 million in back
income taxes. The original invesCgaCon into Kozlowski’s cheaCng on the 8.25% sales tax on $14
million in painCngs triggered further SEC invesCgaCons that led to his ulCmate downfall.
Useful Ar:cles, Links, and Videos
“The Rise and Fall of Dennis Kozlowski Cover Story].” (December 23, 2002). Business Week,
h_p://www.businessweek.com/magazine/content/02_51/b3813001.htm?chan=search
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Tyco Fraud Info-Center [website]. (May 9, 2006). h_p://www.tycofraudinfocenter.com/
“Tyco to pay 50 mil usd to se_le SEC accounCng fraud charges.” (April 18, 2006). Forbes,
h_p://www.forbes.com/feeds/afx/2006/04/17/afx2675905.html
“Timeline of the Tyco InternaConal scandal.” (June 17, 2005). USA Today,
h_p://www.usatoday.com/money/industries/manufacturing/2005-06-17-tyco-Cmeline_x.htm
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19. HealthSouth – Can 5 CFOs Be Wrong? (Chapter 5, pages 338-343)
What this case has to oKer
The HealthSouth case points out how key weaknesses in the corporate governance structure may allow
accounCng fraud pass without detecCon, highlighCng how diZcult is to make CEOs and Directors
accountable for such fraud and for the ulCmate loss of shareholder value. In spite of the apparently
overwhelming evidence of his involvement in the fraud, Richard Scrushy was acqui_ed, while the former
CFOs were subject to penalCes between 15 and 30 years in jail and Bnes totalling $11.2 million. This is a
good case to discuss the ePecCveness of the penalCes involved in the enforcement of the SarbanesOxley Act of 2002.
In 2002, looking forward to lower Wall Street expectaCons, the company’s revenue decreased, blaming a
one-Cme item; however, earnings kept going down progressively thereaTer. A year later, the SEC's
invesCgaCon uncovered serious accounCng irregulariCes. The company overstated revenues for the
years 1996-2002 by $2.74 million. Former CEO Richard Scrushy, together with 5 former CFO's and other
accounCng employees, was charged with accounCng fraud under Sarbanes-Oxley Act provisions.
Crucial accounCng lessons from this case include the signiBcant potenCal role of accruals and adjusCng
entries in accounCng fraud, and the risk of management’s override of internal controls. The accounCng
manipulaCon happened right aTer preliminary end-of-period results were reviewed in management
meeCngs during the “oP books” adjusCng period. Also, the case provides elements to discuss on what
the involvement of CEOs and directors should be in preparing Bnancial statements, as well as what their
degree of Bnancial experCse should be. Needless to say, the ethical awareness and sensiCvity of
parCcipants was severely lacking, as was their ethical courage to say no when asked to undertake
unethical and illegal acts.
Teaching sugges:ons
I start by asking the students what is the nature and purpose of corporate governance – this is about
who controls corporaCons and why. Then I ask what are the beneBts of separaCon between
management and ownership. Thirdly, I ask about management’s responsibility in taking accounCng
decisions, i.e., who in the company is responsible for accounCng choices, what should be the
involvement of CEOs and directors in the process of preparing a company's Bnancial statements, and
what should be an appropriate degree of accounCng experCse for CEOs and directors.
The central issue for discussion, given the Bnding of the court, is how could accounCng fraud have
happened without the CEO knowing about it, since there is evidence that he told senior accounCng
oZcers to “Bx” the problem when earnings did not match analysts’ expectaCons. I link this point with
the moral character of the former CEO, since there is evidence that “Earlier frauds, bankruptcies, or
quesConable business dealings are part of the history of several companies owned at least in part by
Scrushy and/or HealthSouth, and controlled by Scrushy with interlocking boards of directors to
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HealthSouth” (from the Case, page 340). Also it is important to bring out the diZcult proBt environment
for the U.S. Healthcare industry in which HealthSouth stood out.
Finally, I discuss the accounCng entries used to perpetrate and conceal the fraud: reducing a contra
revenue account, called “contractual adjustment,” and/or decreasing expenses (either of which
increased earnings), and correspondingly increasing assets or decreasing liabiliCes.
Discussion of important issues
1.
What were the major gaws in HealthSouth’s corporate governance?

Overall weak ethics environment/culture, and low ethical awareness and/or low moral
courage to report problems

Inadequate understanding of professional duty by professional accountants and lawyers

Inadequate whistleblower process to uninvolved person reporCng to the Board

InsuZcient oversight of related party transacCons

Lack of independence of the board of directors

Inadequate understanding of accounCng issues by members of the board of directors

Failure of probing Board Audit Commi_ee

DeBcient audit risk assessment and audit procedures
2 & 5. What should HealthSouth’s auditors, Ernst & Young, have done if they had perceived these gaws?
What is the auditor’s responsibility in case of fraud?
Auditors should use a systemaCc approach to idenCfy events or condiCons that could be root
causes of a potenCal fraudulent acCon. Fraud is diZcult to detect because it is generally
concealed by the perpetrators by withholding evidence, misrepresenCng informaCon or
inquiries, falsifying documentaCon and collusion. Even though it is not expected that normal
audit procedures will detect these irregulariCes, auditors should assess if fraud risk is suZciently
controlled by a combinaCon of prevenCon, deterrence and detecCon measures. The auditors’
assessment should include understanding and evaluaCng the risk factors that indicate incenCves
and pressures to perpetrate fraud, opportuniCes to carry it out, and awtudes or raConalizaCons
to jusCfy a fraudulent acCon. If the fraud risk is considered high, auditors should perform
addiConal procedures to ensure appropriate revenue recogniCon, existence and ownership of
assets, validity of sales, and completeness of expenses and liabiliCes. In this process, auditors
should pay special a_enCon to client’s accruals and audit’s materiality assessment.
3.
How – in accounCng terms – did the manipulaCon of HealthSouth’s Bnancial statements take
place?
On a quarterly basis, the company’s senior oZcers presented Scrushy with an analysis of
HealthSouth’s actual earnings compared with the analysts’ expected earnings. At these
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meeCngs, referred as “family meeCngs”, senior accounCng personnel discussed what false
accounCng entries could be made to meet the expected earnings. The entries primarily
consisted of reducing a contra revenue account, called contractual adjustment or decreasing
expenses, and correspondingly increasing assets or decreasing liabiliCes.
The contractual adjustment account was a revenue allowance account that esCmated the
diPerence between the gross amount billed to the paCent and the amount that various
healthcare insurers would pay for speciBc treatments. A $800 million overstatement, equal to 10
percent of the total company’s assets, was book in a BcCCous asset line called AP Summary,
under Property, Plan and Equipment. HealthSouth accounCng personnel designed the false
journal entries to avoid detecCon by the external auditors. For example, instead of increasing
revenues directly, the entries decreased the contractual adjustment account; this account had a
limited paper trail based on esCmates. HealthSouth also knew that the auditors only quesConed
addiCons of Bxed assets at any parCcular facility if the addiCons exceeded a parCcular threshold.
By increasing the AP Summary account, the entries never exceeded that threshold. False
documents and altered invoices supported addiCons of BcCCous assets.
4.
Why did all the people who knew about the irregulariCes keep quiet?
There was a combinaCon of factors, including: lack of clear communicaCon of wholesome
company values and expectaCons respecCng shareholders and other stakeholders and that
unethical behavior will not be tolerated (ethical awareness); bad example set by senior
management (tone at the top); lack of ePecCve whistleblower programs; fear of retaliaCon from
their bosses. There was an unethical culture culCvated by ‘group-think’ about decepCon.
5. (See #2, above)
6.
What are the proper audit procedures to ensure existence of assets in the Bnancial statements?
What are the proper audit procedures to validate esCmates?
Physical inspecCon is the basic audit procedure to ensure existence of assets such as property,
plant and equipment. This procedure may be used together with inspecCon of other
corroboraCve evidence, such as invoices or cheques paid to vendors. Auditors must ensure,
subject to a comprehensive materiality threshold, that all assets in the balance sheet exist and
also belong to the client. Furthermore, through regular business acCviCes, assets increase as a
result of contracCng liabiliCes or from the revenue generaCng process. Existence and ownership
of asset tests also conBrm the completeness of liabiliCes and validity of sales (i.e. pertain to the
enCty and have occurred in the accounCng period).
Making an accounCng esCmate oTen requires management to develop models and assumpCons
regarding possible outcomes, including Cming, transacCons or events that are uncertain at the
Cme of the esCmaCon. Guidance on audit procedures for validaCng accounCng esCmates,
including materiality and restatements, remains somewhat unclear and dispersed throughout
diPerent secCons of the AudiCng Standards. However, auditors should ensure that the client is
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using an appropriate esCmaCon model and is considering reasonably accurate assumpCons. In
some cases auditors may opt for consulCng with an actuarial expert when reviewing very
material esCmates.
7 & 8.What areas of risk can you idenCfy in HealthSouth’s control environment before 2003? What areas
of risk can you idenCfy in HealthSouth’s strategy before 2002?

Business risk: An increased business risk gives rise to a higher probability that management
will overstate revenue or conceal losses by using incorrect or inappropriate accounCng
pracCces. HealthSouth – while trying to meet analysts’ targets – reported proBtability and
growth that were far be_er than the industry average, while operaCng in a very compeCCve
industry on a path towards consolidaCon. Under pressure to maintain good Bnancial
performance, others in the industry were involved in fraud at diPerent levels, providing
inadequate services, billing in excess and cuwng costs beyond reasonable standards.

Control risk: an increased control risk results in a higher chance that management’s
manipulaCon of earnings may occur without detecCon. The company recruited enthusiasCc
impressionable young and relaCvely inexperienced staP from the local community in
Birmingham, Alabama. They were malleable and apparently easily induced into unethical
and fraudulent corporate pracCces. The CEO’s authority was thus unchallenged.
The company lacked ePecCve whistleblower and ethics’ awareness programs. Some parCcipants
in the fraud admi_ed to the U.S. A_orney that they feared physical or psychological retribuCon if
they came forward with details of the fraudulent accounCng pracCces.
Over the years, some shareholders complained that HealthSouth was run like a personal
company of Mr. Scrushy, with many investments in ventures that stood to be proBtable for
Scrushy and other execuCves and directors. Few directors appeared to quesCon Mr. Scrushy or
any of his decisions.
9. What changes could be made in HeathSouth’s control system and corporate governance structure to
miCgate the risk of accounCng fraud in future years?
In 2005, the company released restated results for the period from 2000 to 2003. HealthSouth
President and CEO, Jay Grinney, esCmated that the restatement of the company’s Bnancial
statements required more than 1,000,000 of outside consultant hours incurring costs over $250
million. With 3.8 m shares, Richard Scrushy was sCll member of the company’s board of
directors.
The following measures may help to improve the company’s governance structure:

Board of directors with more members

A majority of independent directors

More audit commi_ee meeCngs
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
Financial experts on the audit commi_ee

Separate CEO and Chairman of the Board roles

Auditor’s and execuCves’ appointment by recommendaCon of the Audit Commi_ee

Internal audit funcCon reporCng to the board’s Audit Commi_ee

Company-wide ethics awareness programs

ConBdenCal whistleblower programs for accounCng and ethics concerns

see other Sarbanes-Oxley reforms
10. Was Scrushy’s defense ethical?
Scrushy alleged he lacked accounCng knowledge to understand the fraud and the implicaCon of
the proposed journal entries. His defence used several potenCally unethical tacCcs to convince a
local court that Scrushy, previously an investment banker, was unaware of the accounCng
manipulaCons. These included his religious inclinaCons and folksy character, his support to local
causes, and the apparently “dubious moral character” of the CFOs tesCfying against him. The
trial took place in Alabama, and the defendant’s lawyers successfully manoeuvred to have seven
blacks on the jury and Bve whites, all from working-class backgrounds. The jurors apparently
believed that a CEO could be unaware of manipulaCons arranged by his company’s accountants,
at his direcCon. On the other hand, a person is enCtled to a trial by his peers and their emoCons
may be appealed to. The court process provides that the opponent’s interests are to be
protected, in part by his/her lawyer, as well as by the rules of the court. Consequently, it can be
argued that unethical tacCcs, if any, should have been exposed (i.e., rendered impotent) by the
opposing lawyer. SomeCmes, however, this is not possible, and in this case there may have been
other a_empts to inguence the jurors inside and outside of the courtroom; for example, by
threats or inCmidaCon implied by the set of black Bible class members who sat behind Mr.
Scrushy throughout the trial.
Useful Ar:cles, Links, and Videos
Weidlich, Thom (April 23, 2010). “UBS to Pay $217 Million to Se_le HealthSouth Case.” Bloomberg,
h_p://www.businessweek.com/news/2010-04-23/ubs-to-pay-217-million-to-se_le-healthsouthcase-update2-.html
U.S. SecuriCes and Exchange Commission (March 20, 2003). “SEC Charges HealthSouth Corp., CEO
Richard Scrushy with $1.4 Billion AccounCng Fraud [LiCgaCon Release].”
h_p://www.sec.gov/liCgaCon/litreleases/lr18044.htm
“HealthSouth Whistleblower Lectures UAB Students on Company Fraud” [2010]. uabnews [University of
Alabama News], h_p://vimeo.com/7710751
“Special Report: Richard Scrushy Trial” Birmingham News
h_p://www.al.com/specialreport/birminghamnews/healthsouth/
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This site provided the Scrushy indictment, trial details, press releases and SEC Blings. [Link no
longer valid in 2017.]
“Timeline of AccounCng Scandal at HealthSouth.” (Sept. 30, 2004). Washington Post,
h_p://www.washingtonpost.com/wp-dyn/arCcles/A24671-2003Oct14.html
“Topics: HealthSouth CorporaCon.” (2017). New York Times,
h_p://topics.nyCmes.com/topics/news/business/companies/healthsouthcorporaCon/index.html
This website provides “News about HealthSouth CorporaCon, including commentary and archival
arCcles published in The New York Times.” ArCcles range from 1996 to 2011.
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20. Royal Ahold – A Dutch Company with U.S.-Style Incen6ves (Chapter 5, pages 343-346)
What this case has to oKer
This case is interesCng because it Ces stock opCon compensaCon and accounCng irregulariCes in a
European-based mulCnaConal company. Nevertheless, granCng management stock opCons is a common
pracCce in North American companies and some research suggests it is a good mechanism to align
managers' and shareholders' interests.
The case points out the risks derived from aggressive expansions--and joining companies with diPerent
control cultures--under pressure to meet analyst expectaCons. It presents interesCng accounCng issues,
including revenue recogniCon for vendors' rebates and full control versus joint venture control in
consolidaCon of subsidiaries.
Teaching sugges:ons
I start the class with a brief discussion about performance-based management compensaCon, and the
advantages and disadvantages of granCng management stock as a way to improve a company's Bnancial
results.


Key advantages of stock opCon compensaCon:
o
MoCvates managers to improve Bnancial performance, aligned with the personal gain
derived from exercising stock opCons over the company's shares
o
Reduces the company's cash needs, given that the opCons granted are not paid in cash, thus
making cash available for pursuing growth opportuniCes
o
Links rewards with performance in an way easy to understand and control, potenCally
reducing or eliminaCng the cost of tracking metrics for performance measurement
Key disadvantages of stock opCon compensaCon:
o
MoCvates managers to produce short-term gains, disregarding long-term results
o
Causes a diluCon ePect, reducing shareholders' parCcipaCon in the company
o
Poses a threat for the shareholders, as it might be tempCng for managers to manipulate
public Bnancial results in the absence of ePecCve internal control mechanisms
I then introduce the case, explain the background of the company, and ask the class to idenCfy the risk
elements present before the fraud was uncovered.
I also ask about the two accounCng issues, and depending upon the accounCng foundaCons of the
students, tease out the proper accounCng treatment for revenue recogniCon for vendors' rebates (no
recording of unearned rebates (see below), veriBcaCon of sales beyond representaCon le_ers, and
comparison to past results), and consolidaCon of subsidiaries with full control versus joint venture
parCcipaCon (100% proBt pick-up versus percentage pick-up).
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Next, I ask students about their opinion of the auditor's role in the case. Some interesCng points are: the
auditor's responsibility in case of fraud, the auditor's acCons aTer some irregulariCes were uncovered-including the decision of not making them public--and the appropriateness of relevant audit procedures
(i.e., preliminary risk assessment and conBrmaCon of receivables).
Finally, I wrap up by discussing the appropriateness of the changes made by Royal Ahold in its corporate
governance structure in prevenCng future manipulaCon of Bnancial results.
Discussion of important issues/ques:ons
1.
A vendor may oPer a customer a rebate of a speciBed amount of cash or
other consideraCon that is payable only if the customer completes a speciBed cumulaCve level of
purchases or remains a customer for a speciBed period of Cme. When should the rebate be
recognized as revenue? At what value should the rebate be recorded as revenue?
Cash consideraCon received from a vendor is presumed to be a reducCon in the prices of the
vendor's products or services and should be accounted for as a reducCon in cost of sales and
related inventory, when recognized in the customer's income statement and balance sheet.
Amendment to EIC-144 issued in January 2005 requires disclosure of the amount of any vendor
allowances that have been recognized in income but for which the full requirements for
enCtlement have not yet been met.
2. The SEC invesCgaCon found the individuals involved in the fraud “aided and abe_ed the fraud by
signing and sending to the company’s independent auditors conBrmaCon le_ers that they knew
materially overstated the amounts of promoConal allowance income paid or owed to U.S.
Foodservice.” Is the conBrmaCon procedure enough to validate the vendor’s allowance amount in
the Bnancial statements?
No. The conBrmaCon process, if properly controlled by the auditor, can be a useful tool, but
there should also be a veriBcaCon check of some of the actual transacCons in which amounts are
signiBcant in order to avoid the problem of falsiBed or misunderstood conBrmaCons.
3. The SEC invesCgaCon also revealed “a signiBcant porCon of U.S. Food Service operaCng income was
based on vendor payments known as promoConal allowances.” How might irregulariCes have been
discovered through speciBc external audit procedures?
InteresCngly, Ahold’s auditors, Deloi_e & Touche insisted that they warned the Brm about
problems in its U.S. unit. The auditors also pointed out that Ahold did not supply them with full
informaCon. These problems were never disclosed to the public. Deloi_e said during the
inquiries that they idenCBed the problems during the 2002 audit, and gave the details to Ahold’s
Board immediately before the audit was concluded in 2003. Royal Ahold revealed the accounCng
irregulariCes voluntarily. Ahold blamed a group of execuCves of fraud and the company did not
face any penalCes.
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See the answer to quesCon 2. IrregulariCes may generally be discovered by detailed review of
transacCons, parCcularly when fraud is suspected or the risk is considered high.
There are three common elements present in cases of fraud: moCvaCon, opportunity, and lack
of ethics or raConalizaCon of conduct. In this case, probable moCves were a stock opCon
compensaCon program and the conCnuance of a period of aggressive expansion. Opportunity
was present because the company did not update its reporCng lines, and did not strengthen its
internal controls following its high growth period. Also, the culture of the US subsidiary was
probably not the same as the culture of the European parent. Finally, lack of a company-wide
integrity and ethics program leT awareness of ethical issues at the level of the individual.
The presence of some of these elements should cause the auditors to set inherent and control
risks as high, and therefore compensate with addiConal detailed tesCng.
4. Royal Ahold made several changes in its corporate governance structure. Discuss how those changes
will miCgate the risk of accounCng fraud in future years.
Ahold undertook several corporate governance changes to prevent future accounCng
irregulariCes:

RotaCon of the members of the Board of Directors, paying special a_enCon to
succession issues, targeCng improving their overall independence, objecCvity and skills
set required to oversee a complex organizaCon;

Thirty-nine execuCves and managers were terminated, and an addiConal sixty
employees faced disciplinary acCons of diPerent degrees, showing that unethical
behavior would not be tolerated;

Developed a one-company system with central reporCng lines, facilitaCng division of
duCes and authorizaCon of non-rouCne transacCons.

IniCated a company-wide Bnancial integrity program aimed at 15,000 managers, raising
overall ethical awareness.
However, other measures might also be appropriate including an accounCng concerns hotline
and ongoing approval of performance based compensaCon programs by the board of directors.
Related Events
May 22, 2006. Sterling, Toby (Associated Press) (May 23, 2006). “Ex-Ahold execuCves Bned for fraud.”
Toronto Star, page C4.
In a very disappoinCng ruling, the CEO and the CFO were each Bned 225,000 euros (approx.
$300,000) and given nine-month suspended sentences for falsely asserCng that companies in
Brazil, ArgenCna, and Scandinavia should be consolidated because they were fully controlled,
when only 50% of them were owned. According to the judge, neither of the men beneBted
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personally as a result of the resulCng overstatement of proBts. The CEO is esCmated to have
been worth 43 million euros.
Useful Ar:cles, Links, and Videos
Mui, Yian (November 7, 2006). “Royal Ahold to Sell US Foodservice Unit.” Washington Post,
h_p://www.washingtonpost.com/wp-dyn/content/arCcle/2006/11/06/AR2006110600290.html
Crouch, Gregory & Jennifer Bayot (February 26, 2003). “Market Place; Royal Ahold AccounCng Scandal
Leaves Dutch Employees with Heavy Debts.” New York Times,
h_p://www.nyCmes.com/2003/02/26/business/market-place-royal-ahold-accounCng-scandalleaves-dutch-employees-with-heavy.html?scp=11&sq=Royal%20Ahold&st=cse
U.S. SecuriCes and Exchange Commission (Oct. 13, 2004). “SEC Charges Royal Ahold and Three Former
Top ExecuCves with Fraud; Former Audit Commi_ee Member Charged with Causing ViolaCons of
the SecuriCes Law [Press Release].” h_p://www.sec.gov/news/press/2004-144.htm
“Ahold Europe’s Enron.” (February 27, 2003). Economist, h_p://www.economist.com/node/1610552
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21.The Ethics of Bankruptcy: Jetsgo Corpora6on (Chapter 5, pages 346-348)
What this case has to oKer
This case presents a true story of Brm that used decepCon and lies, called ‘white lies’ by the owner of
the airline, to minimize the cost of bankruptcy. It allows students to discuss the concept of lying,
understand its consequences, and determine if there are any situaCons in which lying is an acceptable
business alternaCve.
Teaching sugges:ons
Before discussing the details of the case, there should be two general discussions: the Brst on the nature
of bankruptcy and purpose of bankruptcy laws, and the second on the ethical aspects of lying.
Darwinian economics argues that bankruptcy is a natural event. Firms that cannot ePecCvely compete
are forced out of the marketplace. In the struggle for survival, only eZcient and ePecCve Brms survive.
Because of the high cost of going bankrupt, Brms will strive to ensure that they provide the goods and
services that people need and want, in an ePecCve and eZcient manner, in order to generate suZcient
posiCve cash ingows to remain economically viable.
Bankruptcy protecCon laws are intended to allow a period of Cme for Brms to reorganize. Firms are
provided protecCon from creditor claims under laws such as Chapter 11 of the United States Bankruptcy
Code or the Companies’ Creditors Arrangement Act in Canada. The purpose of these laws is not to help
Brms avoid their economic obligaCons. Instead, they remove some of the Bnancial pressure, thereby
allowing the Brm to rearrange certain aspects of its operaCons and structures so that it can resume its
place as an on-going business.
Lying is a lapse from moral idealism. Bok (1978) argues that when wrongdoing, such as lying, is excused
(for example, as in “Nobody is gewng hurt and I can’t aPord to do otherwise”), trivialized with a
euphemism (such as, “Everybody does it. It’s just the way the business world works”) or denied (as in,
“Nobody cares about this anyway”), then it may be an example of succumbing to pressure. The liar must
idenCfy the pressures that are causing the person to be hypocriCcal. Bok also notes that what the liar
perceives to be harmless, a white lie, may not be so in the eyes of the one who is being deceived.
Discussion of ethical issues
1. For many organizaCons, bankruptcy protecCon is just another operaConal and Bnancial strategy.
Discuss the ethical aspects of intenConally remaining silent, collecCng money and then suddenly
announcing that the company is bankrupt?
Bankruptcy protecCon laws can be abused when solvent Brms enter bankruptcy as a cost
ePecCve strategy. The Brm may use bankruptcy protecCon to:

avoid making legiCmate payments,
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
adjust pension plans without consolaCon or renegoCaCon with employees,

break union agreements, and /or

circumvent terms of contracts.
Bankruptcy laws are not intended to help Brms to enCrely avoid their obligaCons. As such, a key
ethical aspect is to invesCgate whether all stakeholders are being treated fairly. These aspects
can be addressed by asking the following quesCons.

Is the Brm using the bankruptcy laws in ways in which they were not intended? Are
solvent Brms using them as a cost-ePecCve means to avoid honoring their legiCmate
liabiliCes?

If bankruptcy is just another cost-ePecCve Bnancial stratagem, then does this encourage
Brms to take unnecessary risks? If the risky venture succeeds, then the Brm beneBts.
But if the venture does not succeed, then the Brms can easily move in and out of
bankruptcy, with only the creditors suPering as their claims are not fully honored.
2. Do you accept that the li_le ‘white lie’ told to the pilots was jusCBable?
A white lie is oTen used to protect the feeling of another. ComplimenCng someone’s hat or
awre is a social nicety. The problem with the white lie is that the recipient of the lie does not
know that the comment is untrue. In the Jetsgo case, LeBlanc feared that the pilots would not
gy the planes to Quebec City if they were told the truth. So, this is not a white lie in which the
truth was altered as a polite social gesture. Instead, it is a decepCon intended to beneBt only
the liar. The central problem with decepCon is that it tends to erode trust, which is a key
element in the economic system.
3. Was it operaConally wise for Jetsgo to keep the online reservaCon system open unCl the company
oZcially declared bankruptcy? Was it an ethically correct or incorrect decision?
Keeping the on-line reservaCon system open all day on March 20, when Leblanc knew it would
be permanently closed at midnight that evening was a decepCon and very unfair to many
passengers. These people made their reservaCons in good faith were misled and deluded into
thinking that their reservaCons would be honored and that their gights would occur as
scheduled.
DecepCon is considered to be unethical because the people who are lied to are not allowed to
make an informed decision. They are being treated as means to achieve the liar’s objecCve. As
result, when the subterfuge is discovered, they normally feel wronged and manipulated.
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4. Should Leblanc have waited unCl the busy spring-break holiday period was over to then close down
operaCons?
Nash (1990) notes that unethical behavior and acCons oTen occur because managers ask the
wrong quesCons.

Instead of asking whether this will reduce costs, or achieve a personal objecCve, ask
whether this is consistent with the values the Brm. Will this decision result in value
creaCon?

How will this decision aPect the quality of the Brm’s relaConship with its customers?
If the manager cannot answer these quesCons posiCvely, then the manager may be in the wrong
line of business. Perhaps Jetsgo should not have been in the discount airline business. Perhaps
the Bnancial and ethical obstacles were too great. If a manager feels that decepCon, lying and
subterfuge are the only means to staving oP bankruptcy, then perhaps the manager should
admit that operaCng the business successfully is beyond his or her capabiliCes. In such
situaCons, the ethical alternaCve is to hire good talent to run the Brm or rearrange the business
model so that lying, decepCon and subterfuge are not part of the operaCng strategy of the Brm.
Useful Ar:cles, Links, and Videos
Bok, Sissela. 1978. Lying: Moral Choice in Public and Private Life (Random House)
Nash, Laura. 1991. Good Inten-ons Aside: A Manager’s Guide to Resolving Ethical Problems (Harvard
Business School Press).
“Jetsgo lost $55 million in 8 months, court told.” (March 11, 2005). CBC News,
h_p://www.cbc.ca/canada/story/2005/03/11/jetsgo-lapierre050311.html
Alexander, Doug (March 11, 2005). “Canada’s Jetsgo Ceases OperaCons, Stranding 17,000.” Bloomberg,
h_p://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLSjmZ0MF7lM&refer=canada
Austen, Ian (March 12, 2005). “Canada Suddenly Grounds All Flights.” New York Times,
h_p://query.nyCmes.com/gst/fullpage.html?res=9F0CE1DA143CF931A25750C0A9639C8B63
“Jetsgo’s founder Leblanc says he is sorry [video].” (March 18, 2005). CTV News,
h_p://www.ctv.ca/CTVNews/TopStories/20050318/Jetsgo_apology_050317/
“Discount airline Jetsgo declares bankruptcy [video].” (May 14, 2005). CTV News,
h_p://www.ctv.ca/CTVNews/Canada/20050514/jetsgo_bankruptcy_20050513/
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Stock Market Cases
22.Société Générale Rogue Trader (Chapter 5, pages 348-350)
What this case has to oKer
Rogue traders, such as Jérôme Kerviel, can severely damage an organizaCon, such as Société Générale
(SocGen), or even bankrupt a Brm, as did Nick Leeson’s rogue trades that brought down Barings Bank. It
is important that students remember that

no internal system can prevent all rogue trades from occurring,

there is a cost-beneBt trade-oP when installing internal controls, and

it is important to have a posiCve organizaConal culture that does not encourage rogue acCviCes.
Teaching sugges:ons
The class can begin with a discussion of the key elements of corporate governance and accountability.
They can discuss

how an organizaCon could unintenConally install a negaCve organizaConal culture, and

how that negaCve organizaConal culture could be re-enforced.
Then the students can discuss the opposite.

the elements that would go into developing a posiCve organizaConal culture, and

how the organizaCon could reinforce that posiCve organizaConal culture.
ATerwards, the quesCons at the end of the case could be taken up.
Discussion of ethical issues
1.
Did Jérôme Kerviel perpetrate a fraud? Why or why not?
Fraud is a legal concept. EssenCally it means that an individual or organizaCon intenConally deceived
another for personal gain. In this case, Kerviel did not personally gain from his unauthorized trades
nor was he convicted in a court of law of having perpetrated a fraud on anyone. However, he was
guilty of a breach of trust. His employer, SocGen, was relying on him to stay within his proscribed
trading limits, which he failed to do. As such, he did violate the trust that SocGen had placed in him.
2. When such mammoth unauthorized trades occur, and the bank is bankrupted or severely damaged
Bnancially, should the board of directors, who have the ulCmate responsibility for the bank’s
acCviCes, or its execuCves whose job it is to protect the bank, go to jail rather than the rogue trader?
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The board of directors has the responsibility of overseeing management, and management has
the responsibility of ensuring that the organizaCon operates in an eZcient and ePecCve manner
within the law and in accordance with standards of normal ethical business behavior. If people
fail to live up to their responsibiliCes, they should be held accountable for their shorˆalls. This
means that management should be held accountable for the acCviCes of its employees if those
employees are not properly trained and supervised. The report of the special commi_ee of the
board highlighted numerous failures of management to install ePecCve internal controls. As
such, management is parCally responsible for the loss and therefore should be disciplined. The
degree of the disciplinary acCons would be a funcCon of management’s degree of culpability in
not installing adequate controls to supervise employees. Jail for directors or management would
be unlikely unless it could be shown that the individuals involved recognized that a problem
existed and purposely failed to take acCon to prevent it. Fines would be a more normal sancCon
to be applied.
3. Where the bank’s acCons in liquidaCng Kerviel’s posiCons ethical?
Unfairness in Bnancial markets can occur when there is volaClity, i.e., when there is a mismatch
between buyers and sellers. Although the market will eventually correct for any mismatch,
during the mismatch period, investors may be harmed by either paying to too much or selling
too low. The size of SocGen’s liquidaCng trades was equal to eight percent of all trades that
were conducted on the various exchanges in that three-day period. Eight percent of all trades
may be enough to move the marketplace. The bank was concerned that if they revealed the
magnitude of the anCcipated trades that this informaCon might adversely aPect the price the
bank would receive. This, in turn, might increase the size of the bank’s losses. On the other
hand, by gooding the market over a three-day period, the bank may also have been creaCng an
unfair marketplace in which prices did not regect all available informaCon. In other words,
investors could have sold at prices that were too low, and investors purchased without knowing
all of the market risks.
4. Did the French oZcials who authorized the liquidaCon behave ethically?
In the U.S., the SecuriCes Exchange Act of 1934 authorizes the SEC to intervene in the
marketplace to correct any volaClity or excess price swings thereby ensuring ‘fair and orderly’
markets. This suggests that the French oZcials who authorized the liquidaCon were acCng in an
ethical fashion, but that they should have intervened if they thought that the size of the Bank’s
trades was unfairly moving the marketplace.
5. There is considerable debate about whether be_er controls can ever stop a rogue trader. What is
your opinion, and why?
There is a trade-oP to be considered for all internal prevenCon costs between their costs and
their beneBts. It would be cost-prohibiCve to install a control system that completely prevented
rogue trades from occurring. That is why it is important to develop a much more cost-ePecCve,
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posiCve organizaConal culture that will discourage rogue acCviCes. It is important that
organizaCons carefully screen their employees to ensure that they do not put into a posiCon of
trust a person who lacks the moral Bber to not abuse that trust. It is also important that
employees see that the organizaCon is monitoring and supervising them. This shows employees
that if they engage in rogue trades their acCviCes were will be caught. A rogue trader would also
be dissuaded by the prospect of heavy sancCons.
6. If enhanced controls really can’t stop all rogue traders, how are companies to be protected from
them?
Companies can protect themselves from rogue traders by installing the key elements of
corporate governance and accountability that are outlined in Chapter 5, especially those
elements that are summarized in Figure 5.9 on page 268.
7. Was the court’s verdict jusCBed? Could it have been improved?
It seems like the court decided to impose a very harsh penalty on Mr. Kerviel, possibly to serve
as an example and deter other people from doing something similar. Nevertheless, it seems like
the economic sancCon of 4.9 billion euros is excessive aTer three years in jail. There is almost no
possibility that Mr. Kerviel could ever pay this amount.
A possible improvement for this sentence would be a strong recommendaCon by the court for
Société Générale to strengthen its internal controls. Arguably, the company is parCally
responsible for what happened.
Useful Ar:cles, Links, and Videos
Nicholson, Chris (November 17, 2010) “Kerviel: Bosses Never Said a Thing.” New York Times,
h_p://dealbook.nyCmes.com/2010/11/17/kerviels-comeback-they-never-said-a-thing/
Clark, Nicola (October 5, 2010). “Rogue Trader at Societe Generale Gets 3 Years.” New York Times,
h_p://www.nyCmes.com/2010/10/06/business/global/06bank.html?
_r=1&partner=rss&emc=rss
“Societe Generale trader Kerviel says risks ‘encouraged.’” (June 8, 2010). BBC News,
h_p://www.bbc.co.uk/news/10259720
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23. Galleon’s Insider Trading Network (Chapter 5, pages 350-352)
What this case has to oKer
This case is the story of an apparently successful hedge fund manager who based his trading strategies
on inside informaCon from Cpsters and not on sound market research. Billionaire Raj Rajaratnam used a
vast network of contacts to proBt from Cps on nonpublic informaCon from a number of companies such
as IBM, Google, Hilton Hotels, and Intel. This is a very good case to discuss what consCtutes inside
informaCon and insider trading. It represents the Brst Cme that wiretap informaCon was allowed as
evidence in insider trading cases, and therefore liTs the veil of secrecy that prevented earlier a_empts at
prosecuCon.
Teaching sugges:ons
I start the discussion asking students how a trader, or hedge fund manager, can gather informaCon to
develop a successful trading strategy. I then ask for an explanaCon of the concept of illegal insider
trading and discuss the apparent Bne line between gathering informaCon and obtaining conBdenCal
informaCon from insiders. ATer discussing some of the key case facts, I ask students whether or not
Galleon’s trading was illegal and/or unethical.
Finally, I highlight two takeaways from this case, Brst, that given that insider trading is illegal it should be
prosecuted as any other form of fraud; and second, that the liability for insider trading violaCons cannot
be avoided by passing on the informaCon, as long as the person receiving the informaCon knew or
should have known that the informaCon was conBdenCal to the company (i.e., was its property) and its
insiders. I also point to the potenCal change for prosecuCon that wiretap evidence will bring in the
future.
Discussion of ethical issues
1. Should inside traders, who are non-violent, white collar criminals, be subject to MaBa-style
invesCgaCon tools?
Insider trading is a crime equivalent to theT. The U.S. Supreme Court explicitly adopted the
misappropriaCon theory of insider trading in the case United States v. O'Hagan (q.v.). The U.S.
SEC guidance (U.S. SecuriCes and Exchange Commission 2011) on insider trading cites the
Supreme Court’s decision as a legal landmark in making insider trading a crime:
“In the course of its opinion, the Court idenCBed two discrete arguments for prohibiCng
insider trading.
First, the Court (United States v. O'Hagan) stressed that prohibiCng insider trading is:
“…well-tuned to an animaCng purpose of the Exchange Act: to insure honest securiCes
markets and thereby promote investor conBdence…Although informaConal disparity is
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inevitable in the securiCes markets, investors likely would hesitate to venture their capital in
a market where trading based on misappropriated nonpublic informaCon is unchecked by
law. An investor's informaConal disadvantage vis-à-vis a misappropriator with material, nonpublic informaCon stems from contrivance, not luck; it is a disadvantage that cannot be
overcome with research or skill.”
Second, the Court acknowledged the "informaCon as property" raConale underlying insider
trading prohibiCons:
“A company's conBdenCal informaCon…qualiBes as property to which the company has a
right of exclusive use. The undisclosed misappropria:on of such informa:on in viola:on of
a Sduciary duty…cons:tutes fraud akin to embezzlement – the fraudulent appropria:on to
one's own use of the money or goods entrusted to one's care by another.” [Emphasis
added.]
Given the criminal nature of insider trading, regulatory agencies can and should use any legal
means to collect evidence to prosecute insider trading. The consequences of insider trading can
be very severe for those who suPer loss.
2. How can a stock trader know when she or he is receiving inside informaCon that would be illegal to
act upon?
It is not always easy to decide whether or not trading on certain informaCon can be deemed
insider trading. The SEC guidance on insider trading (U.S. SecuriCes and Exchange Commission
2011) explains that;
“Illegal insider trading refers generally to buying or selling a security, in breach of a Bduciary
duty or other relaConship of trust and conBdence, while in possession of material, nonpublic
informaCon about the security.”
Furthermore, a fundamental component of illegal insider trading is being aware that certain
informaCon is nonpublic:
“Rule 10b5-1 provides that a person trades on the basis of material nonpublic informaCon if
a trader is "aware" of the material nonpublic informaCon when making the purchase or sale.
The rule also sets forth several aZrmaCve defenses or excepCons to liability. The rule
permits persons to trade in certain speciBed circumstances where it is clear that the
informaCon they are aware of is not a factor in the decision to trade, such as pursuant to a
pre-exisCng plan, contract, or instrucCon that was made in good faith.”
As a way to avoid illegal insider trading, Rule 10b5 establishes that:
“A person other than a natural person also may demonstrate that a purchase or sale of
securiCes is not "on the basis of" material nonpublic informaCon if the person demonstrates
that:
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The individual making the investment decision on behalf of the person to purchase or
sell the securiCes was not aware of the informaCon; and
The person had implemented reasonable policies and procedures, taking into
consideraCon the nature of the person's business, to ensure that individuals making
investment decisions would not violate the laws prohibiCng trading on the basis of
material nonpublic informaCon. These policies and procedures may include those that
restrict any purchase, sale, and causing any purchase or sale of any security as to
which the person has material nonpublic informa:on, or those that prevent such
individuals from becoming aware of such informa:on.” [Emphasis added.}
Based on the above guidance, if a trader receives or seeks to obtain direct informaCon from an
insider and that informaCon is believed to be nonpublic, it is the trader’s personal responsibility
as well as his Brm’s responsibility to avoid trading on such informaCon. In such cases, the trader
or his Brm could seek addiConal legal counsel if it is not a straight forward case to determine if
the informaCon received could be considered insider informaCon.
3. How can a stock trader avoid using insider informaCon?
The answer to this quesCon is related to the answer of the previous quesCon. Using insider
informaCon is directly linked to the means by which a trader obtains informaCon. If direct
informaCon is obtained from a person with a Bduciary duty and that informaCon cannot be found or
directly inferred from publicly available informaCon, that informaCon should not be used by a trader.
Most cases of insider trading involve not only one instance but several instances where traders used
nonpublic informaCon. Furthermore, illegal insider trading cases may be detected through market
surveillance systems. Regulators can use computer programs to Bnd changes in volume and price
that are outside normal pa_erns. Trading just before a major corporate event is a red gag for illegal
insider trading.
4. Would a private investor be subject to the same rules against using insider informaCon as a stock
trader?
The same rules apply for private investors as for stock traders. In fact, the SEC has enforced
insider trading rules against:

Corporate oZcers, directors, and employees who traded the corporaCon's securiCes
aTer learning of signiBcant, conBdenCal corporate developments;

Friends, business associates, family members, and other "Cppees" of such oZcers,
directors, and employees, who traded the securiCes aTer receiving such informaCon;

Employees of law, banking, brokerage and prinCng Brms who were given such
informaCon to provide services to the corporaCon whose securiCes they traded;

Government employees who learned of such informaCon because of their employment
by the government; and,
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
Other persons who misappropriated, and took advantage of, conBdenCal informaCon
from their employers.
5. Should a person giving a Cp (the Cpper) be subject to the same penalCes as the user (the Cppee)?
The liability for insider trading violaCons cannot be avoided by passing on the informaCon as
long as the person receiving the informaCon knew or should have known that the informaCon
was company property. Insider trading violaCons also include Cpping informaCon. A person
giving a Cp is an accomplice of the person using the informaCon. All parCes that may have been
involved are at risk of being found guilty of insider trading.
Useful Ar:cles, Links, and Videos
United States v. O'Hagan, 521 U.S. 642 (1997); 117 S.Ct. 2199, 138 L.Ed.2d 724 , 65 USLW 4650, available
at h_ps://www.law.cornell.edu/supct/html/96-842.ZO.html ...
U.S. SecuriCes and Exchange Commission. 2011. Insider Trading.
h_p://www.sec.gov/answers/insider.htm
U.S. SecuriCes and Exchange Commission. (September 19, 1998). “Speech by SEC StaP: Insider Trading –
A U.S. PerspecCve.” h_p://www.sec.gov/news/speech/speecharchive/1998/spch221.htm
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24.Conhicts of Interest on Wall Street (Chapter 5, pages 353-355)
What this case has to oKer
This case illustrates some of the complex set of congicts of interest that exist in the investment
community, and oPers the opportunity to discuss some of the means available to manage them. It
represents the Brst occasion where an enterprising district a_orney (DA) took the lead on a securiCes
case when the SEC and other agencies run by friends of Wall Street were slow to act. Eliot Spitzer, the
DA involved, made things happen that should signal changes on the Street.
Teaching sugges:ons
I start oP by asking why Eliot Spitzer acted when the Sec and other agencies did not. This sets the stage
for a discussion of congicts of interest, and those shown in the case (quesCon 1). Then I turn to the
penalCes assessed, and their adequacy. QuesCon 2 about the adequacy of the rule changes comes next,
followed by quesCons 3 and 4.
Discussion of ethical issues
1. IdenCfy and explain the congicts of interest referred to in this case.
The following congicts are idenCBed in the case:

Self-interest of brokers vs. the interest of investors:


Self-interest of analysts vs. investors:


Brokers and brokerages have investments on which they speculate and do not
disclose their own interests fully, but upon which they also advise investors who
expect the brokers to act only in the investors’ interest,
Analysts tout investments that they believe are poor because:

They are remunerated from proBts for IPOs or trading in those investments

They are inguenced to do so to beneBt others – children in a private school

Their bosses tell them to

They want to curry favor with repeat issuers of IPOs, or excellent prospect for
future investment banking business
Self-interest of retail brokers gewng early informaCon on IPOs vs. the public who cannot
and therefore invest in an unfair market.
2. What addiConal rules should the SEC make?
The SEC should consider insCtuCng addiConal rules such as:

Investment Brms should disclose their investment posiCons to their clients whenever
they are buying or selling a stock, bond or commodity they have a posiCon in for that
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client

A code of behavior should be developed covering analysts, brokers and so on, and
compliance programs should be developed and monitored, with appropriate sancCons

And so on.
3. What should be included in the investor educaCon that the se_lement funds are earmarked for?
The objecCve here is to encourage discussion and thinking in the class about the knowledge
required by investors, and the investment community. The investor educaCon program should
contain such programs as web-based, easy-to-access, self-training for investment assessment in
various levels from elementary to advanced, potenCal congicts of interest to be aware of, risks to
be aware of in investments, ongoing Cmely commentaries by leading knowledgeable analysts,
and so on. It is too bad some money cannot be spent on ethics programs for investment
analysts and brokers, and on compliance programs for them.
4. Was it appropriate for the New York A_orney General’s OZce to have become involved in securiCes
regulaCon, or should this have been leT to securiCes regulators?
Yes, Eliot Spitzer’s iniCaCve was Cmely and had a beneBcial impact. The problem arose in his
geographic jurisdicCon, and it was not so arcane that it was beyond the capacity of his oZce to
correctly consider and arrive at a just result. The SEC does not have exclusive jurisdicCon over
malfeasance in the securiCes Beld.
Useful Ar:cles, Links, and Videos
Berenson, Alex & Andrew Ross Sorkin (December 22, 2002). “How Wall Street Was Tamed.” New York
Times, h_p://www.nyCmes.com/2002/12/22/business/how-wall-street-was-tamed.html
Valdmanis, Thor (April 29, 2003). “Few believe $1.4B deal will change Wall St.” USA Today,
h_p://www.usatoday.com/money/industries/brokerage/2003-04-29-se_le-cover_x.htm
“Eliot Spitzer Talks to Fareed Zakaria about Wall Street Bonuses [Video].” (January 17, 2010). Hucngton
Post, h_p://www.huZngtonpost.com/2010/01/17/eliot-spitzer-talks-to-fa_n_426422.html
IgnaCus, Adi (December 30, 2002). “Eliot Spitzer: Wall Street’s Top Cop.” Time,
h_p://www.Cme.com/Cme/magazine/arCcle/0,9171,1003960,00.html
Cullen, Ann (October 18, 2004). “The Bias of Wall Street Analysts.” Harvard Business School,
h_p://hbswk.hbs.edu/item/4430.html
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25. Loyalty, But to Whom? (Chapter 5, pages 355-357)
What this case has to oKer
Too oTen, employees are misguided by thinking too narrowly and/or too short-term about the beneBts
and costs of their acCons. Many employees act to saCsfy interests that congict with the legiCmate,
ethical strategic objecCves of their employer, or of their profession, or even of themselves in the longer
term. This is a case that illustrates how a well-intenConed but short-sighted acCon caused a lot of
trouble for the actors and the employer. This sub-opCmal decision making is one of the problems that
trouble governance systems, and underscore the need for a strongly supported, well-developed ethical
corporate culture to provide the necessary guidance for employees.
Glen Grossmith told me that he was just trying to help a team-mate – a guy with whom they had worked
for quite a while. At the Cme, he didn’t see signiBcant harm in doing what he did.
As noted at the conclusion of this note - this case illustrates that a consequen-alist or u-litarian
approach needs to be supplemented with both deontological and virtue expecta-ons approaches to yield
a sound, defensible, and ethical decision.
Teaching sugges:ons
This case idenCBes a common occurrence that students should be able to idenCfy with. The reasoning
behind “take one for the team” or “help the team” “group think” is what keeps police and unions from
whistleblowing on each other, and for other employees to raConalize not behaving according to
company goals. Referring to the police and the union mores will bring the problem into focus, but the
instructor may not want to do this at the outset – preferring instead to introduce the extra examples
when the class has deBned the problems and issues inherent in the case. I would suggest asking for the
class to deBne the problems and issues inherent in the case, introduce the extra examples, and then take
up the quesCons posed at the end of the case, followed by a summary of the material in the ‘What this
case has to oPer’ secCon above.
Discussion of ethical issues through the case ques:ons
1. Loyalty is a highly desirable ethical value, and disloyalty is serious unethical and oTen illegal acCvity.
Explain how and to whom Grossmith, Horcsok, and Webb (G, H, and W) were disloyal.
G, H, and W were disloyal to UBS because they did not follow its ethical guidelines, which were
intended to protect the integrity of clients and hence the market. They were disloyal to the U.S.
client and perhaps to a professional body they might be members of that speciBed a code of
conduct. Loyalty involves respecCng the interests of others and not acCng contrary to the best
interests of clients, their employer, and the market regulators.
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2. Although Grossmith’s acCons did not negaCvely aPect the wealth of any client, why did UBS Bre
him?
Glen was probably Bred because he knowingly falsiBed documents, and in so doing broke
company policy, and market regulaCons. He was a two-Cme oPender. Also the company needed
to show an example of their vigilance so that the rest of their employees would get the message
as well as the regulators. In the end, if regulators had not been saCsBed that UBS was enforcing
the company code and ethical culture, the company, its execuCves and directors could have
been vulnerable to charges of failure to maintain proper governance oversight and procedures.
Finally, the company may have seen the Bring as a chance to save the bonus money, but this is
probable too cynical.
3. How should an employer like UBS encourage employee loyalty?
An employer needs to mount a comprehensive ethics program that includes clear guidance to
employees, with appropriate training, monitoring, rewards and sancCons. Above all, employees
need to understand why loyalty is important to themselves, to their clients, the employer, and to
the market. Most importantly, top management must ‘walk the talk’.
Because they do not see any harm from unethical and someCmes illegal acCons does not make
them OK or permissible. A consequenCalist argument (the end jusCBes the means) would lead
the employee astray in these cases. This case illustrates that a consequen-alist or u-litarian
approach needs to be supplemented with both deontological and virtue expecta-ons approaches
to yield a sound, defensible and ethical decision.
Useful Ar:cles, Links, and Videos
“Former UBS traders Bned, suspended.” (July 18, 2005). CBC News,
h_p://www.cbc.ca/money/story/2005/07/18/ubs-050718.html
“Former Senior Traders of UBS Bned by RS for ViolaCng Trading Rules.” (July 18, 2005). Market Wire,
h_p://www.marketwire.com/press-release/Former-Senior-Traders-of-UBS-Fined-by-RS-forViolaCng-Trading-Rules-548820.htm
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26.Bankers Trust: Learning from Deriva6ves (Chapter 5, pages 358-361)
What this case has to oKer
Bankers Trust is the story of a company that emphasized maximizing proBt at almost at any cost.
Certainly, its employees placed earning commissions before the interests of their clients. Therefore the
case illustrates the operaCng value diPerences between “buyer beware” and “seller beware”, and it
shows that Bankers Trust (BT) did not have high interest in the Bduciary responsibiliCes that have
moCvated the brokerage community to insCtute “know your client rules” etc. Congicts of interest
abound, and unfair sales pracCces, non-compliance with company policies, taped conversaCons
(privacy), and charges of using RICO as a blackmail tacCc are issues well worth discussing with your class.
Teaching sugges:ons/Discussion of ethical issues
I would suggest beginning the case by having someone in the class give a recap of it.
I would then ask what the class understood by the term deriva-ves, and how they think the derivaCves
that BT was selling worked, in general. In this case, although the details of the contracts are not known
precisely, it would appear, since P & G would make money if interest rates went down and lose if rates
went up, that the derivaCve contracts cost $195.5 million more than P & G expected due to interest rate
increases. This loss is high, in part, because P & G leveraged their contracts, so a small investment could
give rise to a big win or a big loss.
The next ma_er to deal with is whether BT was ac-ng as a principal or an agent when selling the
derivaCve contracts to P & G. What did BT think, and what did P & G think? What does the class think?
If BT was acCng as an agent, then P & G has the right to expect BT to act in P & G’s best interests. If BT
was acCng as a principal, and P & G ought reasonably to have known this, then P & G would not expect
BT to be acCng in P & G’s best interests and presumably should/would have insCtuted defense
mechanisms to guard against being taken advantage of. Modern stockbrokers are in much the same
posiCon in that they sell some securiCes (bonds) from their own inventory for proBt and some they
arrange for the client to purchase with a commission to the broker. Modern stockbrokers are expected
to discharge their kduciary responsibili-es to their clients by assessing their knowledge level, risk
preferences and ability to sustain losses etc., under “know your client guidelines.” If the stockbroker
advises a client to invest in a security beyond a reasonable risk level for that client, the stockbroker is
liable to receive a Bne and is subject to lawsuit for failing to discharge their Bduciary duCes. Also, if a
modern stockbroker fails to noCfy his/her client that a sale is being made as a principal rather than as an
agent, the sale can be overturned and the broker Bned. Modern laws have made it dangerous for a
broker to ignore these connicts of interest.
For normal clients of stockbrokers, the operaCng policy of seller beware is now in force rather than that
of buyer beware as it had been up unCl about 1990 or so. However, the quesCon is: Was P & G a normal
client? The answer is no because it was a big mulCnaConal and had a massive porˆolio including
derivaCves that it had managed for years.
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I then ask: Did the BT salesman take unfair advantage of P & G even though P & G was an expert client,
and does that make any dioerence? Unfortunately for BT, according to the tapes, the BT salesman knew
that P & G did not understand the leverage aspect of the transacCon he had sold them. Therefore he
knew he was taking advantage of P & G. Moreover, since the loss could be astronomical, it could be
argued that he was taking unfair advantage of P & G. What does the class think?
At this stage you have the answers to quesCons 2, 3, and 4, and I would recap them or ask the class their
views, and I would then press on with quesCon 1. The se_lement has never been publicly released so
we don’t know the speciBcs as yet.
QuesCon 5 is intended to bring together the other issues of the case, including:

Unethical corporate culture of BT
The buyer beware/proBt at the expense of our clients’ awtude that was fostered at BT got BT
into great diZculty and threatened its reputaCon worldwide. It was a policy that did not foster
the conCnued support of its clients who are a most important stakeholder support group for any
company. As such it was an unsustainable strategic building block.

Was P & G responsible?
No. Its internal policies were not followed, and its personnel did not understand the risk
involved in the contracts. They tried to get P & G to explain, but P & G refused to show its
proprietary risk model, and knew that the client had not grasped the explanaCon. P & G could
have been more responsible and so should probably share some of the loss.

Privacy of taped conversaCons
Usually this is unethical. However, conversaCons are usually taped in the brokerage industry in
order to verify who said what at a later date. Moreover, the parCes are told that the taping is
occurring and tacitly agree to it.

RICO blackmail
By adding RICO charges to the lawsuit, P & G was upping the risk of loss from the lawsuit
substanCally. Presumably, if the RICO charge was frivolous, the cost to get it dismissed would
have involved legal and invesCgaCve Cme, but not a triple pay out. Therefore it would not have
increased the se_lement much unless the charge had some merit. The claim of “blackmail” was
probably a counter-ploy to relieve the stress on BT’s reputaCon and put P & G somewhat on the
defensive. The RICO issue probably hastened a se_lement. You might ask the class: Does the
end jus-fy the means?
Useful Ar:cles, Links, and Videos
Holland, Kelley et. al. (June 13, 1997). “Cover Story: The Bankers Trust Tapes.” Business Week,
h_p://www.businessweek.com/1995/42/b34461.htm
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[Reprint available from h_ps://www.bloomberg.com/news/arCcles/1995-10-15/the-bankerstrust-tapes ]
Andrews, Edmund (December 1, 1998). “BANK GIANT: THE OVERVIEW; Deutsche Gets Bankers Trust for
$10 Billion.” New York Times, h_p://www.nyCmes.com/1998/12/01/business/bank-giant-theoverview-deutsche-gets-bankers-trust-for-10-billion.html
“DerivaCves: Alive, but oh so Boring.” (January 30, 1995). Business Week,
h_p://www.businessweek.com/archives/1995/b340981.arc.htm
[Reprint available from h_ps://www.bloomberg.com/news/arCcles/1995-01-29/derivaCvesalive-but-oh-so-boring ]
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27.Barings Bank: Rogue Trader (Chapter 5, pages 361-363)
What this case has to oKer
Nick Leeson was deBnitely a rogue trader, but he didn’t get into trouble on his own – he had help. The
story of how he did so involves congicts of interest, a poor corporate ethical culture and compliance
system, misguided moCvaConal systems, poor control reports, and unwiwng advice from senior
management.
Congicts of Interest, Cultural Aspects, Relevance of Controls
This case oPers interesCng insights into typical problems in the three areas noted. Students can readily
see the common congicts faced by employees, management and owners, and how these groups can be
blinded by tradiCon, habit and the erroneous assumpCon that everyone is honest – or at least they
won’t bite the hand that feeds them. The experience of forensic invesCgaCons experts given in the text
at page 262 provides an interesCng insight on this as it suggests that as many as 60% of employees will
commit a fraud if given the chance, and a further 20% will do so without any opportunity. Therefore
only 20% of employees can be relied upon not to commit a fraud under any circumstances. The theory is
based on expert observer experience and not on rigorous scienCBc tesCng, but it is probably not far oP.
Would you gamble on a 20% chance of winning? That’s what managements do that work on faith
without adequate controls.
Teaching sugges:ons
I would begin by having a class member or two recap the salient points of the case. This should show
that Nick was operaCng on his own. He had evidently decided to make unhedged investments on his
own to increase his proBts to recoup his losses that had been hidden in the Error Account No. 88888. He
was in control of the investment operaCon and the record-keeping back oZce that should have provided
informaCon that would have brought quesCons on his increasing losses and need for cash. The Head
OZce of Barings had warnings in term of reports of potenCal lack of control and of the need of lots of
cash, but did nothing because they thought Leeson was making a lot of money, and they were needy and
greedy. I would also ask for a clariBcaCon of how Leeson was making his deals to see that the class
understood derivaCve investments. I would then ask the quesCons posed at the end of the case.
Discussion of ethical issues
1. How would you deal with a star trader who would be extremely sensiCve to addiConal controls that
implied he or she wasn’t trusted or would generate more Cme on paperwork and explanaCons?
Unfortunately, excepCons to compliance or control systems usually end up badly. The star gets
into trouble because s/he is unaware of problem areas, or thinks that rules are not for her/him
to observe. Therefore, the star must be convinced or cajoled into accepCng the ethical culture
and compliance system. Top management must set a strong, commi_ed example, and be
convinced what they are doing is important or else the star may not accept the overture. The
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star may well respond to a self-interest argument – that the system will protect the reputaCon
and Bnancial health of the organizaCon, and thereby protect him from other employee acCons.
He or she, as a leader, should serve as a good example to others. ATer all, he or she wouldn’t
want to see another case like Barings Bank, or…
2. What ethical and accounCng controls would you advise ING to insCtute at Baring’s?
I would recommend insCtuCng the following in order to move the Brm away from reliance on
faith in the “old boy” or “old school Ce” networks:

a full ethical culture program, including: a code of conduct, training, iniCal and annual
sign-oP, reinforcement and encouragement mechanisms, whistleblower protecCon plan,
generic reporCng to a board commi_ee, etc.

daily (on-line if possible) report of hedged and exposed securiCes posiCons sent to
upper line management and top management,

daily, or online if possible, report of cash gows of over $50 million (10% of equity) to be
sent to upper line management and top management.

separate supervision of trading (front) and record-keeping (back) oZces,

have internal audit check that all company policies are followed, and report to an Audit
Commi_ee with non-employee Directors from the Board on it (who are supposed to be
protecCng the public interest) so that acCons are not ignored without outside directors
knowing about it.
3. Who was more at fault – top management or Nick Leeson?
Management was more at fault than Nick Leeson. They had early warning of inadequate
controls and did not do their job as stewards of the company assets to protect them. They could
have moved much earlier and have prevented the bankruptcy and takeover. Leeson is not
blameless, of course, but it is the old story of someone leaving something of value open to
misuse (a pie on the window sill) thus tempCng someone else to steal or misuse it. Leeson went
to jail for about two years and is now in poor health, and the Barings lost their Bank. Is this fair?
Useful Ar:cles, Links, and Videos
CurCs, Adam (Producer) (1996). 25 Million Pounds [video], available at
h_p://www.bing.com/videos/search?
q=documentary+25+Million+Pounds+&view=detail&mid=59894AAFFDAFFED6FB3E59894AAFFD
AFFED6FB3E&FORM=VIRE
Documentary video about Nick Leeson and The Barings Bank Collapse.
Leeson, Nick (1996). Rogue Trader: How I Brought Down Barings Bank and Shook the Financial World.
London: Li_le, Brown & Co.
Business & Professional Ethics for Directors, Execu-ves & Accountants, 8e
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Autobiography of Nick Leeson wri_en while in prison
Norris, Floyd (March 31, 1996). “Upper-Class Twists Made Me Do It.” New York Times,
h_p://query.nyCmes.com/gst/fullpage.html?res=9C03EFDF1239F932A05750C0A960958260
Dearden, James (Director) (1999) Rouge Trader [Film].
Movie about Nick Leeson.
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Cases on Product Safety
28.Dow Corning Silicone Breast Implants (Chapter 5, pages 364-365)
What this case has to oKer
This case oPers the chance to examine why an excellent code of conduct, and an excellent ethics audit or
ethical assurance program may prove to be inePecCve. Dow Corning Inc. had a celebrated ethics control
system which did not surface the problem of health risk associated with their silicone breast implants,
which were prone to rupture. The invesCgaCon of why involves looking at the following ethical issues:

What are the criCcal success factors involved in making a code of conduct and an ethical
assurance program ePecCve?

How to insCll the desire to comply with the company’s ethical guidelines.

How to apply ethical principles to crisis decisions and announcements.

The need to balance legal risk with ethical performance.

Should products used for purposes of vanity be subject to the same ethical/safety concerns as
one which is used for purposes of uClity or health improvement?
Teaching sugges:ons
The case builds upon a Harvard Case which provides the details of the company’s code of conduct, the
process of preparaCon of that code and of the audit process used to examine compliance with the code.
This is a very useful discussion of background details, which can be very instrucCve for those facing the
reBnement of less developed systems. I have the students come to class having read the full case, and
begin the discussion with a short statement covering the issues laid out above.
SomeCmes the class wants to discuss whether the company is at fault because the purpose of the
product is viewed (usually by men) to be purchased to saCsfy female vanity. I facilitate this because it
serves to raise the awareness of the men in the audience about the problem from a women’s
perspecCve and gets into the relaConship of appearance to mental health.
I then get the class to describe the code of conduct and the related compliance process in their own
words. When we are all at the same level of understanding, I use the quesCons at the end of the case to
shape the discussion, covering the issues described below.
I use the Dow Corning Breast Implant Case, either to start oP the discussion of codes of conduct, or to
reinforce the discussion on codes. The case induces strong discussion, and takes about 30-35 minutes.
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Discussion of ethical issues
Vanity vs. u-lity: Although men usually see the breast implant as just a response to female vanity, the
women in the class are quick to point out that many breast implants are installed as part of the aTertreatment for breast cancer involving mastectomy. Consequently, these implants are not considered to
result from frivolous whimsy. In addiCon, and more importantly, the women will make the connecCon
between physical appearance and mental health. The men can then see that poor mental health can
have an impact on health costs and job performance, so the breast implant issue suddenly becomes
important to the men in the class for reasons other than avoiding legal risks. OTen a woman or I, who
am balding, playfully raise the issue of hair transplants for men, and this seems to se_le the vanity issue.
This discussion is useful in sewng up the need to include both sexes in ethical audit/assurance programs
in order to have the best chance to surface single-sex issues – those which have special signiBcance for
one sex but which may not appreciated by the other.
1. Why didn’t the Dow Corning ethics audit program reveal any concerns about the silicone-gel breast
implant line?
Usually the class suggests several reasons for the failure of the ethics audit program to surface
the breast implant issue at an early stage so that it could be acted upon and resolved as early as
possible, including the following:

the audit team may not have been tuned in to women’s problems (a single sex issue),

the audit team may have not have included a manager grounded in the science or health
disciplines,

the audit focus may have been internal rather than external, so that the press reports on
the problem were not surfaced,

the group input sessions with local personnel involved up to 35 people, so some
a_endees may have been too shy to speak, or may have considered whistle blowing in
such a large group to be too risky,

whistleblowing without anonymity, when a lot of jobs are at stake was too much to
expect,

original memos had been wri_en by a person who had “leT” the company, and this may
have dissuaded further discussion,

the issue of cause of leakage (installaCon, accident) and culpability was not suZciently
clear from the company’s or employee’s perspecCve,

some personnel apparently believed the problem to be already under review in a tesCng
program and therefore not worth raising again.
These faults can be summarized under the following topics some of which relate to the code and
culture of the company:

audit team: experCse and sensiCvity
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
audit focus

audit processes

whistleblowing processes

trust

understanding of the intent and scope of the process.
2. What are the criCcal factors necessary to make such an ethics audit program work ePecCvely?
This case oPers an opportunity to reinforce the issues discussed in the text on pages 104-108. In
parCcular, the following are germane to the case:

conCnued endorsement of the process by top execuCves,

clear communicaCon of performance guidelines, and idenCBcaCon of an ombudsman or
other person for clariBcaCon of problems,

conCnued training/sensiCvity sessions to insure that parCcipants understand the need
for, scope of, and relevant issues to the process,

creaCon of a condiCon of trust or whistleblower protecCon, so people will come forward
and report wrongdoing,

comprehensive compliance processes, including scans of the internal and external
environments,

formal, periodic reports to compliance oZcers on problems discovered earlier and under
invesCgaCon,

knowledgeable, sensiCve assessors of problems,

performance measures, linked to reward and discipline systems,

internal and external reports of performance.

governance of the process by a senior oZcer reporCng, at least annually, to a commi_ee
of the Board.
3. Was the March 20th announcement well-advised and ethical?
The short answer is no on both counts. The spokesman did not convey much empathy for the
women who had suPered from the leakages. He would have been be_er advised to
acknowledge the possibility of a problem and indicate that further invesCgaCons were under
consideraCon or underway. Instead he came across as non-caring and legalisCc, which is not
appropriate for a company in the health-products Beld. The stance taken would weaken the
image of the company with potenCal customers for all products of the company even though
this parCcular product is relaCvely low in revenue contribuCon.
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In addiCon, the stance taken with regard to paying for some excisions, where health insurance is
not available, is unethical. It is unfair for the other fee-paying members of the plan to have to
pick up the cost of a problem caused by Dow Corning, and the company is trying to shiT the cost
of remediaCon from their shareholders to the fee-payers. Where a naConal or government
health plan exists, such an acCon would shiT the cost to the taxpayers.
4. Are there any other ethical dilemmas raised by the case?
This case opens up the chance to discuss the need to keep ethics in mind when handling a crisis.
Crisis management, which is discussed in Chapter 5, oPers approaches minimize the harm from
crises, including the early recogniCon and acceptance of the reality of a crisis, and the
recogniCon that ethical reacCons can provide the best long-run soluCons. For further discussion,
please see Chapter 5.
One of the interesCng aspects in this case is that Dow Corning Inc. was a joint venture of Dow
Chemical Co. and Corning, Inc. and they had to seek protecCon from the courts to prevent the
liability arising from breast implants to impact on the parent company resources other than their
investment in the joint venture. This they were able to do, based on the argument that they had
no knowledge of the concern, and were not the controlling mind involved in dealing with the
problem.
Subsequent Events
For a chronology of events see Frontline (1995-2014). “Breast Implants on Trial: Chronology of Silicone
Breast Implants.” PBS, h_p://www.pbs.org/wgbh/pages/frontline/implants/cron.html.
For details of the payment as of June 1, 2004 pursuant to a second se_lement (the Brst, which was
negoCated in May 1995, collapsed) see Claimants’ Advisory Commi_ee (2016). “Final Plan Documents.”
h_p://www.tortcomm.org/plandocs.shtml
Useful Ar:cles, Links, and Videos
Kolata, Gina (June 21, 1999). “Panel ConBrms No Major Illness Tied to Implants.” New York Times,
h_p://query.nyCmes.com/gst/fullpage.html?
sec=health&res=9B03E6D9103BF932A15755C0A96F958260&n=Top%2fReference%2fTimes
%20Topics%2fOrganizaCons%2fI%2fInsCtute%20of%20Medicine
Feder, Barnaby (May 16, 1995). “Dow Corning In Bankruptcy Over Lawsuits.” New York Times,
h_p://select.nyCmes.com/gst/abstract.html?res=F60613FB3E5A0C758DDDAC0894DD494D81
Tabor, Mary (September 23, 1995). “Ex-Dow Corning ExecuCve Faults Company’s Ethics on Implants.”
New York Times, h_p://www.nyCmes.com/1995/09/23/us/ex-dow-corning-execuCve-faultscompany-s-ethics-on-implants.html
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29.Ford/Firestone Tire Recall (Chapter 5, pages 366-376)
What this case has to oKer
The Ford/Firestone Tire Recall is a classic in many ways. Here are two companies that have had a history
of damaging recalls, but they did not learn or retain enough to avoid a repeat the errors of handling
earlier damaging crises. The companies suPered because they had not developed an ethical corporate
culture that provided formal and informal guidance when problem arose. The case shows illustrates
many of the problems developed in the crisis management material in Chapter 5 – denial rather than
early acCon to control damage, belief that the world is too large for domesCc consumer and capital
market to take noCce of foreign acCviCes, no ongoing system of data collecCon and review, and so on.
The case also illustrates that the biggest cost to the companies involved in a product liability case is not
the Bnes – it is the cost of lost reputaCon and of lost trust by consumers that translates into future lost
sales.
Teaching sugges:ons
This is a case that students Bnd most interesCng. ATer asking several students to recap the case, I deal
with the quesCons at the end of the case. I frequently use this case as an assignment, and have
developed the materials that are presented below. In addiCon, I deal with the 3 quesCons located at the
end of the material located below.
Discussion of ethical issues
Since I have used this case as an assignment, I have developed for feedback “Overview Comments” and a
“Full Set of Comments” that contain the issues raised by my classes in regard to each of the 7 quesCons
at the end of the case. I have reproduced each below as a way of conveying what I think is relevant for
the ethical issues involved.
Overview Comments on Ford/Firestone Case
I have returned a “Full Set of Comments” that were raised about the Case, and another page that shows
(by underlining) the comments raised by your group and my overall comments and mark. In general …
My take on the Ford/Firestone Tire disaster is that they failed to recognize and develop an ePecCve
response because their corporate cultures had not embraced a risk assessment dimension focused on
safety-related, consumer interests. Neither company was alert to or looking for safety-related problems,
nor did they have systems in place to collect and analyze relevant data, and report against acceptable
standards. Neither company could be considered a “learning company” due to these shortcomings.
This failure, and the slow reporCng to NHTSA, was due to many factors - short-term focus based on legal
advice craTed in view of very low legal penalCes, incorrect projecCon of consumer outrage, lost sales
and new legal consequences, and so on, as noted in the “Full Set of Comments”. Clearly F & F did not
foresee the largest cost – lost reputaCon/future revenue – involved.
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The ethical risks involved in this disaster are many. They would be discovered from an assessment of
where the expectaCons of all stakeholders were not saCsBed or likely to be saCsBed. These ethical risks
have a signiBcant potenCal impact on reputaConal risk and the corporate value chain. This leads to the
ethics risk management advice noted in the ExecuCve MBA 20 …“Full Set of Comments”.
EMBA 20 Ford/Firestone Tire Grading Answer/Comments – Full Set of
Comments
______________________________________________
Ethics Issues/Case Ques:ons:
1.
Why no learning from earlier disasters: no culture/philosophy change, no training,
short-term focus, concealment vs. disclosure, past evasion success – low cost & no
personal cost, no legal imperaCve, poor risk management procedures, data analysis
funcCon lacking, no ethics oZcer/monitor, no personal memories, denial, Firestone’s
problem not Ford’s, Ditlow’s statement useful
2.
Why not earlier discovery: No safety related data bank, insuZcient analysis and
awareness of downside, lax employees, inspectors, labor unrest and poor risk
management in Decatur, decision to not report Saudi problem to NHTSA, blamed
someone else, no F & F cooperaCon, no organizaConal accountability established, no
stakeholder dialog, NHTSA slow to invesCgate
3.
Why no report earlier to NHTSA: Not technically/legally required if case by case
treatment, could wait out 8 year limit, $1,000 per document withheld cap on Bnes if
discovered – defense strategy dominates acCon, poor risk assessment of downside costs,
short-term focus, lack of F & F collaboraCon
4.
Largest cost: Lost reputaCon: revenue and costs esCmates made – note that previous
Bne cost only 5 cents per car
5.
CBA Correc6ons – most depend upon assump6ons: Lost reputaCon esCmate
clariBed/corrected – Cre costs & numbers, present value, loss of share value to investors,
higher costs of capital, intangible costs of dead, loss to each stakeholder, Cme and ePort
of F & F, producCvity lost, insurance costs, diPerence in perspecCve/costs if nylon cap
used, environmental impact, drop in market cap = lost reputaCon cost, job losses,
ongoing liCgaCon costs too low, possible criminal charges, U.S. market only so should
expand to internaConal
6.
Ethical risks involved: DeBniCon of ethical risk – see text, To each stakeholder group –
safety, rate of return, employment, deceit – “customer noCBcaCon enhancement
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acCon”, reputaCon risk and place in value chain viability/success/reputaCon/values/hypernorms - honesty, fairness, compassion,
integrity, predictability, responsibility; global perspecCve, lack of trust, more regulaCon
7.
Ethics Risk Management Advice: Create or enhance Culture, Code, CooperaCon with
NHTSA, Stakeholder Analysis, Decision Analysis, Cost BeneBt Analysis, Public RelaCons,
more proacCvity, strategic issue management team, factor in reputaCon losses, more
early warning/detecCon and prevenCon ePort, be accountable and transparent with
problems, ensure that suppliers follow similar appropriate risk management pracCces,
risk management strategy linking org. values, customer commitment and compliance, 6step issues management, whistleblowers rewards & protecCon plan, complaint review,
involvement and reporCng to top management, domesCc-internaConal linkage,
eliminaCon of unreasonable risks, appropriate internal controls
8.
Other Ques:ons Raised:
a) Was recall ethical? No, it was unfair (slow) to many warm weather customers
b) Lessons for Crisis Management? See commentary above
c) Whose was the responsibility for the warrantee issues? Both Ford and Firestone, as
well as the NHTSA. GM does not leave this to their suppliers and have developed a
group that tests and monitors Cres. Also, how can a regulator do their job without
any (independent) data source?
Other Factors Considered:

Thoroughness/Depth of Analysis/Exhibits

CreaCvity
Overall Grade
Subsequent Events
From: Easton, Pam (March 16, 2004). “Judge approves $149 million Bridgestone-Firestone se_lement.”
Associated Press, h_p://cjonline.com/stories/031604/bus_bridgeBre.shtml
On March 15, 2004, a judge approved “..a $149 million se_lement of 30 class-acCon lawsuits on
behalf of [some owners of the 14.4 million potenCally defecCve Bridgestone-Firestone Cres that
were recalled in 2000.”
“At least 271 U.S. traZc deaths [and over 800 injuries] have been blamed on the Cres, most of
which were sold with the Ford Explorer… but the se_lement [pertains only to those who had
not] suPered any injury or property damage.
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“The se_lement calls for Bridgestone … to pay an esCmated $70 million to replace Cres, $41
million to manufacture be_er Cres, $15.5 million on a consumer educaCon campaign, and $19
million for a_orney’s fees. The company has also paid #3.5 million to noCfy owners of the
se_lement.
“The se_lement could aPect up to 15 million people. The 45 named plainCPs each could receive
up to $2,500.” Others could have their Cres replaced.
A Firestone spokesman said the company was pleased with the se_lement. One of the PlainCPs
a_orneys, however, said that it was “really no se_lement at all. Everything in the se_lement was
already being done by Firestone.”
October 13, 2005
[Reuters and Bloomberg] (October 13, 2005). “Bridgestone and Ford se_le Cre recall feud”, Toronto Star,
D16.
Bridgestone agreed to pay $240 million to Ford covering about 11 percent of Ford’s cost of
replacing up to an esCmated 13 million Cres in 2001.
Useful Videos, Films & Links
Greenwald, John (2001) “Inside the Ford/Firestone Fight” Time, May 29 th
h_p://www.Cme.com/Cme/business/arCcle/0,8599,128198,00.html
C-Span and Senate Commerce, Science and TransportaCon Commi_ee (September 12, 2000). “Firestone
Tire Recall: Senate Commerce Commi_ee [video].” h_p://www.cspanvideo.org/program/159191-1
Witnesses tesCfy about the recall of Firestone Cres while Ford and Firestone oZcials insist on
each other’s culpability.
ShaPer, Marc and Goodman, Barak (February 21, 2002). “Rollover: The Hidden History of the SUV
[Transcript ].” PBS Frontline,
h_p://www.pbs.org/wgbh/pages/frontline/shows/rollover/etc/script.html
Business & Professional Ethics for Directors, Execu-ves & Accountants, 8e
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