Article 10: Soltani: American and European Corporate Scandals

Ethical dilemmas of corporate scandal have been coupled with...

-Ineffective boards -Inefficient corporate governance and control mechanisms -Distorted incentive schemes -Accounting irregularities -Failure of auditors -Dominant CEOs -Dysfunctional management behavior -Lack of sound ethical tone at the top

major criticisms of current control mechanisms

-Widespread corporate management abuse -Lack of efficient internal control mechanisms within corporations -Lack of sufficient independence, integrity, and objectivity among external auditors - Insufficient oversight exercised by regulatory agencies -Ineffective corporate governance structure and non-executive directors

Environmental context of fraud:

1. Coverage in media and academic literature 2. Regulatory and corporate governance frameworks

six areas of ethical climate:

1. Ethical climate 2. Tone at the top 3. Bubble economy and market pressure 4. Fraudulent financial reporting 5. Accountability: Control, Audit and Governance 6. Management compensation/personal interess

Types of Control instruments:

1. Internal: Internal control & Internal audit 2.External: Outside auditors

major deficiencies of fraud triangle framework:

1. analysis of this framework should be performed by taking into account the characteristics of control environment in a broader sense 2. imperative to consider the fraud triangle analysis in the regulatory context due to strong impact of laws and regulations on corporate functioning / management decision-making 3. analysis of corporate fraud should be made in conjunction with organizational ethical climate

WorldCom Origins

1983: partners led by former basketball coach Bernard Ebbers, sketched out their idea for a long distance company LDDS (Long Distance Discount Service) began providing long distance reseller services in 1984 company went public in August, 1989 $40 billion merger with MCI in 1998 was the largest in history October 1999, WorldCom attempted to purchase Sprint in a stock buyout for $129 billion in stock and debt: deal was vetoed by the U.S. Department of Justice firm began to unravel with an accumulation of debt and expenses, the fall of the stock market and of long distance rates and revenue

PricewaterhouseCoopers

Ahold's appointed auditor after the fraud detection forensic audit documented lax internal controls and poor financial and accounting practices by Ahold

Deloitte Touche Tohmatsu

Ahold's auditor at the time of fraud warned the company about problems in its U.S. unit and said Ahold did not supply it with full information Response: firm had suspended its 2002 audit pending completion of investigation by Ahold's supervisory board.

HealthSouth Corporate Fraud

Before its collapse in 2003, largest provider of outpatient surgery, diagnostic and rehabilitative healthcare services in the U.S revenues came substantially from Medicare so, changing policy of Medicare in the late 1990s had significant impact on revenues huge financial difficulties in 2002, temporarily resignation of the CEO, was considered warning signal in financial market so stock price plunged subsequently 2003: charged with Medicare fraud and SEC also accused the company's management of falsifying the earnings, cooking the books, internal control violations and fraud SEC accused HealthSouth Corporation for overstating its earnings by at least $1.4 billion since 1999.

major differences between common law and civil law systems:

Common law and civil law countries differ markedly in their regulatory intensity with the common law expending vastly greater resources on enforcement by a measurement standard;

What makes European corporate governance different/worse?

Compared to the U.S. and based on the above four criteria, the European legal system is much less broader and vigorous even in the case of 'core' offenses (eg. market abuse & insider trading) European context: problem also comes from corporate governance codes: mainly based on the concept of 'comply or explain' implies that a company which chooses to depart from a corporate governance code recommendation must give detailed, specific and concrete reasons for the departure provides flexibility but also has serious shortcomings because it: reduces the efficiency of EU's corporate governance frameworks & limits the system's usefulness. Also, no sanction for those who do not comply

Royal Ahold

Dutch Corporate Fraud Before its 2003 collapse, one of the world's largest international retail grocery and food service companies 2002, Ahold was the world's third-largest group in its sector with: • Net sales of €62.7 billion (€1.2 billion loss) • 5,606 stores in 27 countries. following year, Ahold revealed more than $880 million in accounting irregularities at its Columbia-based U.S. Foodservices unit.

Which company(s) had Insider trading?

Enron HealthSouth

Which company(s) used company money to indulge the personal whims of CEO and his family?

Enron Vivendi HealthSouth Parmalat Royal Ahold

Which firm(s) had dispersed shareholder structure?

Enron WorldCom

Which company(s) benefited from a generous contract including salary, bonus, option-based incentive schemes?

Enron WorldCom HealthSouth Parmalat Royal Ahold

Key American Corporate Failures

Enron(energy), WorldCom(telecommunications), HealthSouth(healthcare services) selected groups are relatively comparable in terms of capitalization, assets, and revenues

ECT

Ethical Climate Theory examined in studies which provide evidence of the relationship between ethical climate perceptions, individual ethical behavior, and individual-level work outcome.

What makes US corporate governance different/better?

In terms of actual enforcement actions brought and sanctions levied, the U.S. is an outlier even on a market-adjusted basis, imposes heavy financial penalties Public enforcement of law is supplemented by a vigorous, arguably even hyperactive, system of private enforcement in the form of class actions: no true analog U.S. prosecutes securities offenses criminally- and does so systematically U.S. has a much more deeper, liquid, and sophisticated financial market so still has high # of cases of market abuse and insider trading

Parmalat

Italian Corporate Scandal SEC: ''one of largest and most brazen corporate financial frauds in history'' overstated assets and understed liabilities by approximately €14.5 billion: fraud bigger than the combined financial frauds at Enron AND WorldCom TOTAL 1990-2003: Parmalat Group borrowed money from global banks and justified those loans by inflating its revenues through fictitious sales to retailers problems came into the open on December 2003, when it had difficulty in making a bond payment amounting to €150 million.

Vivendi

Media and environmental services conglomerate based in Paris, France. Traded on the NYSE 1999: employed 275,000 people around the world with consolidated net sales of €41.6 billion & €2.3 billion operating income Grown almost entirely through buyouts Announced it would pay a dividend in May 2002 of €1 per share. end of 2001 and during the first half of 2002: produced negative cash flows from core holdings such as its entertainment businesses, indicating that it would not be able to meet its debt obligations. July 2002: Admitted it was in critical condition: value of the firm's shares fell by 70 % and trading in them was suspended on the Paris Stock Exchange. board unanimously asked the CEO to quit, and in July 2002 he stepped down

Chewco

One of Enron's SPEs Enron announced that the company and its auditor had determined that certain off-balance sheet entities, primarily CHEWCO, should have been consolidated in accordance with GAAP.

Firm-specific characteristics of fraud

Ownership Structure

Key European Corporate Failures

Parlamat(dairy/food), Royal Ahold(supermarket chain), Vivendi Universal(media group) selected groups are relatively comparable in terms of capitalization, assets, and revenues have significant commercial operations and a strong presence in the U.S European groups (Ahold and Vivendi) were also listed on the NYSE so subject to similar rules and regulations and accounting standards

Which company CEO(s) maintained an extravagant lifestyle using company's money?

Parmalat Vivendi

Parmalat and Royal Ahold disciplinary measures

SEC and U.S. Department of Justice pursued these groups under national jurisdictions rather than U.S. law to avoid problem of double jeopardy most severe penalties were imposed in the case of Parmalat. Parmalat's CEO was found guilty of fraudulent bankruptcy and criminal association and sentenced to 18 years in prison, with several other executives also condemned Parlamat ordered to pay the amount of €2 billion to the group and compensate the other shareholders for 5 % of the share values Ahold and Vivendi penalties were mainly monetary

Corporate Governance Rules in the U.S. Compared to Europe

Stronger Public and Private Enforcements Major differences with regard toL legal environment, enforcement efforts by securities regulators, and the level of disclosure & corporate governance codes not only limited to the number of legislations and regulations (higher in US), also include enforcement intensity and its content Despite having a common law system, there is a highenforcement legal regime in the U.S

For which company was money used to buy an apartment in New York for more than $17 million?

Vivendi

Which companies benefited from a golden parachute?

Vivendi

Which firm(s) had concentrated shareholdings?

Vivendi

Tone at the top

manner in which the company's board of directors, senior management and CEO perceive their responsibilities in setting the tone of an organization in turn influences the control consciousness of the employees CEOs set by their words and deeds the ethical tone for the organizations & all those who are involved in the firm look to the top for guidance positive tone setting essential for maintaining an efficient internal control system. result: failure, was due to the lack of willingness of CEOs in defining the core values in ethics and management code of conduct: "too big to fail"

Fraud can range from...

minor employee theft & unproductive behavior to misappropriation of assets, company's funds and fraudulent financial reporting

determinant factors in providing an extensive public discussion on financial scandals

more apparent in the US than Europe Why: strong media coverage of the financial matters and the significant size of the U.S. financial market

Accountability

perceived need to justify or defend a decision or action to some audience which has potential reward and sanction power rewards and sanctions are perceived as contingent on accountability conditions corporate level accountability: -management perception, the performance -effectiveness of formal & informal mechanisms that implemented within an organization to respond to shareholders. high profile lapses of accountability have been observed in recent financial scandals.

There are major differences between Europe and the U.S. in terms of...

political institutions, laws & regulations, managerial practices.

Executive Personal Interest, Compensation Package, and Bonus

relationship exists between executive compensation, earnings management, and fraud recent corporate financial failures show that despite huge falls in companies' share values, certain board members have attributed a large part of corporate funds to themselves in the form of salary, bonus, and stock options

Control Mechanisms, Auditing, and Governance

separation of owners from managers reinforces the need for a number of control instruments which comprise mechanisms Why: to ensure efficient decision-making, and maximizing the value of the company. recent financial crisis caused... lack of public confidence in the usefulness and the quality of financial reporting and efficiency of control mechanisms Why: significant 'expectation gap' between various groups of stakeholders and management.

auditors' failures in corporate scandals

show that auditor performance and audit quality is sensitive to management earnings behavior which is, in turn, affected by financial market conditions.

Bubble Economy / Market Pressure

significant gap between the performance of the real economy and the capital market economy causes corporate earnings to move upwards in a straight line while the drivers of those results— consumer demand, stock markets, interest rates foreign exchange rates—bump around unevenly as share prices soared in the bubble economy, people pointed to the growing gap between the book value of companies and their market capitalization as evidence of the irrelevance of accounts. driven by strong effect of market pressure tied to the desire of management of publicly listed companies to satisfy the unrealistic expectation of investors and analysts. CEOs and senior executives largely benefited from bubble economy because they used financial markets-based compensations since their performance was evaluated on the basis of high-powered incentive contracts

Overarching conclusion

significant similarities exist between the six high profile corporate failures

Kaptein (2010)

survey study that raises question of whether the ethics of organizations has improved in recent years claimed that the ethical culture of organizations improved in the period between 1999 and 2004. Between 2004 and 2008, however, unethical behavior and its consequences declined, while scope of ethics programs expanded

What are the major differences between the six American and European corporate scandals particularly with regard to the specific characteristics of the firm and the environmental factors?

• Ownership structure. • Coverage in media and academic literature. • Legal and regulatory frameworks. • Corporate governance codes.

Viewpoints of corporate fraud analysis

• company-specific characteristics (ownership structure). • environmental factors (coverage in media and academic literature, legal/regulatory framework and corporate governance codes).

'black hole' in Parlamat accounts

€3.9 billion cash that simply did not exist

WorldCom Collapse & Disciplinary Action

WorldCom went from being one of the biggest stock market stars of the 1990s to being the largest corporate accounting scandal in the U.S. (estimated at $11 billion as of March 2004) WorldCom improperly booked $3.8 billion as capital expenditure, boosting cash flow and profit over the 5 previous five quarters. series of stunning disclosures in early 2002 that lead to a Chapter 11 filing in July of that year SEC filed a civil action charging WorldCom with a massive accounting fraud totaling more than $3.8 billion. SEC imposed a fine of $2.25 billion on the company which was later reduced by bankruptcy court to $750 million. 4 of WorldCom's executives were prohibited from serving as officer, director or accountant of a publicly held company CEO, its CFO, and 4 others fined/jailed: resulting ultimately in combined sentences of 32.4 years and $49.2 million in restitution 2005: parallel private class action settled in for $6.8 billion, mainly paid by banks and financial institutions that worked with WorldCom

Moriarty (2009)

argued that CEOs have a moral obligation to reject excessive compensation from the corporation they are in charge of even as outcome of an entirely arm's length negotiation and even when it is freely offered by the corporation

Coffee (2005)

asked whether European managers are more ethical or if European shareholders are better off than in US? rejected this idea on the grounds that concentrated ownership encourages a different type of financial overreaching: extraction of private benefits of control stated that different kinds of scandals characterize different systems of corporate governance. dispersed ownership system of governance is prone to the forms of earnings management that erupted in the U.S. But concentrated ownership economies (the European system) are much less vulnerable, may mitigate agency problem as a substitute for legal protections.

Wimbush and Shepard (1994) & Bulutlar and Oz (2009)

attempted to show the conceptual relationship between ethical climate and ethical (or unethical) behavior in organizations particularly with regard to supervisory influence and the behavior of subordinates

Arthur Andersen

auditor of Enron 5th largest auditing firm in the world, employing 85,000 people in 84 countries. January 10, 2002: notified the SEC and the U.S. Department of Justice that Andersen personnel involved with the Enron engagement had disposed of a significant # of electronic/ paper documents as well as correspondence related to the Enron engagement.

Cohen et al. (2010)

combined the theory of planned behavior with fraud triangle in order to analyze corporate fraud cases released in the press. emphasized the importance of personality traits in corporate fraud: suggested that auditors should take a strong interest in the behavior/attitudes of managers when assessing risk and detecting fraud.

Fraud triangle analysis

credited to Edwin Sutherland (1939) and Donald Cressey (1973) 1. Incentives/Pressures: provides a reason to commit fraud: eg. excessive pressure on management to meet financial targets regarding sales or profitability,; overly optimistic press releases/annual report messages 2. Opportunities: absence of controls, ineffective controls, or the ability of management to override controls Can be directly related to: ineffective monitoring of management (due to dominant position), ineffective board of directors, audit committee oversight of financial reporting & internal control 3.Attitudes/ Rationalizations:set of ethical values that allow individuals to knowingly and intentionally commit a dishonest act the greater the incentive or pressure, the more likely an individual will be able to rationalize fraud

Trevino and Weaver (2003)

defined ethical culture as those aspects that stimulate ethical conduct

Brown et al. (2005)

ethical leadership=1. demonstration of normatively appropriate conduct through personal actions and interpersonal relationships 2. promotion of such conduct to followers through two-way communication, reinforcement, and decision-making

Victor and Cullen (1988)

ethical work climate= prevailing perceptions of typical organizational practices and procedures that have ethical content

Interrelationship of bubble economy with...

financial-incentive bubble and the use of financial markets-based compensation (esp. at large corporations and investment banks)

Shin (2012)

firm-level analyses regarding the relationship between CEO ethical leadership and ethical climate result: CEOs' self rated ethical leadership was positively associated with employees' aggregated perceptions of the ethical climate of the firm

When & what type of corporate deviances occurred?

from late 2001-2003 high profile financial scandals, management misconduct, frauds and scams fraudulent financial reporting and audit failure within several large multinational groups

capital market economy

good performance and successful outcome of corporations depends, on achieving earnings targets. executives' compensation & personal interests may also have a significant impact on corporate reporting and the likelihood of fraudulent financial reporting

Parlamat letter to Bank of America

heart of corporate scandal confirmed that Bonlat, a Parmalat subsidiary based in the Cayman Islands, had "deposited" close to €4 billion with the bank

Enron and Arthur Andersen Affair

ignited the issue of corporate accountability in the United States Enron: seventh largest company by revenues in the U.S. & innovative marketer of natural gas and electricity December 31, 2000: MV= $75.2 billion, while its BV=$11.5 billion. October 16, 2001: Enron produced figures that revealed glaring accounting malpractices November 8, 2001: Form 8-K filing reported that it intended to restate previously issued financial statements that dated back as far as 1997 & disclosed that Enron should have consolidated 3 previously unconsolidated 'Special Purpose Entities', (SPEs) not included in its consolidated financial tstatements. questionable accounting transaction: improper recording of a note receivable from Enron's equity partners in various limited partnerships

Duh et al. (2010)

importance of core values, culture and ethical climate in the context of family versus non-family businesses. concluded that family as well as nonfamily enterprises maintain positive attitudes towards the core values with ethical content. with respect to the type of enterprise culture, the results of this study demonstrated a stronger presence of clan culture characteristics in family than in non-family enterprises (e.g., Parmalat, Royal Ahold, and HealthSouth)

When was the issue of tone at the top was initially discussed?

in the context of financial reporting in 1987 by the U.S. National Commission on Fraudulent Financial Reporting stated that ''tone set by top management...is the most important factor contributing to the integrity of the financial reporting process.''

Benediktsson (2010)

investigated the cases of several large U.S. accounting scandals from the viewpoint of the information coverage in media many corporate boards severed their connections to malfeasant executives, forcing them to stand trial alone. redirected public attention away from organizational wrongdoing and toward individual wrongdoing.