Fraud, Corruption and Bribery

Handout 02 – Managerial Ethics - Module – 01A: The Ethics of Market Abuse: Fraud, Corruption and Bribery

Fr. Oswald A. J. Mascarenhas S.J., Ph.D. JRD Tata Chair Professor of Executive Ethics, XLRI, Jamshedpur July 10, 2014

Case 2.1: The Enron Corporate Fraud

Incorporated in 1930 and re-incorporated in 1997, Enron, a multinational company that specializes in electricity, natural gas and energy markets and other physical commodities, was re-established in 1985 from the merger of Houston Natural Gas and Inter North of Omaha, Nebraska. In the year 2000, Enron employed 61,000, operated in over 40 countries, and reported revenues of $101 billion, thus wining the seventh rank among Fortune 500 that year.

By October 2000, however, Enron became the pioneer and trendsetter of energy sector corporate aggressive accounting and insider trading irregularities. Among accounting scandals were the numerous “round-trips” it engaged in, and which soon became the industry “norm” for similar scams. For instance, Denver-based Qwest Communications used bandwidth to manufacture illusory revenue streams in its recent deal with Enron. According to investigators, Qwest agreed to pay Enron $308 million for the use of “dark fiber” (or unused fiber optic) capacity. In exchange, Enron agreed to pay Qwest between $86-195 million for access to active sections of Qwest’s network. Both deals turned out to be fake allowing both companies to record fat revenues for the period, and particularly helping Enron avoid reporting a loss for that period (Pizzo, 2002).

Andrew Fastow, a Harvard Business School graduate and chief financial officer (CFO) at Enron, wore two hats. As CFO, he negotiated and set up outside partnerships to conduct Enron business. As the principal in these partnerships, however, Fastow also negotiated with Enron on behalf of the partnerships. This is obviously conflict of interest: which entity did Fastow favor in these deals? Enron’s policies prohibited employees from wearing two hats, but Enron’s Board of Directors exempted Fastow from this rule. The result was a series of money-losing transactions for Enron, and consequently, Enron’s stockholders, creditors and employees all emerged as heavy losers.

A series of fake transactions between Enron and investment partnerships executed by Andrew Fastow, led to its filing for Chapter 11 bankruptcy protection in June 2001. In October 2001 Enron was suspected of a massive financial statement fraud. Chairman Kenneth Lay, former President Jeffrey Skilling, and former Chief Financial Officer Andrew Fastow, among others, were accused of shielding debt from public view, and overstating revenues and earnings, thus giving the impression of rapid profit growth. The same year, Enron declared bankruptcy, then the largest corporate failure in U. S. history. Its stock price plummeted from $90 in 2000 to $ 0.26 per share, just a few days before fling the bankruptcy petition.

Enron had such a strong following on Wall Street that its CEO Jeffrey Skilling could bluff his way around tough questions about the company’s operations. Yet what happened to force this giant icon to come down in 2001 when its stock plummeted to $0.26 and the company faced almost extinction?

The Company boosted profits and hid debts totaling over $1 billion by improperly using off-the-books partnerships, it bribed foreign governments to win contracts abroad, and it manipulated the California energy market. Ex-Enron executive, Michael Kopper, pled guilty to two felony charges; acting CEO Stephen Cooper said Enron might face $100 billion in claims and liabilities. Enron’s former energy trader, Timothy Belden, pleaded guilty on Thursday, October 17, 2002, to criminal fraud charges admitting he was part of a conspiracy to artificially boost power prices during California’s devastating power crisis (Anderson, 2002). Belden is the first member of the company’s trading team to face such charges. Enron, ranked 7 on the Fortune 500 list two years ago, filed Chapter

11 protection on December 2, 2002 after revealing a $618 million loss and eliminating $1.2 billion of shareholder equity (Hays, 2002). Its auditor, Arthur Andersen, was convicted of obstruction of justice for destroying Enron’s documents.

One of the reasons that Enron's implosion was so destructive was that it had managed to hide its problems through complex “round trip” transactions, a scale that even WorldCom couldn't match. By co-opting Arthur Anderson, formerly one of the world's top five accounting firms, Enron was able to spin out shell companies and special purpose vehicles/entities (SPVs) to hide its fatally wounded core.

Later in October-November 2001, Enron’s Board of Directors scrutinized these transactions. Among the securities scams investigated were associated with Enron’s former Division Head, former CEO, and two former Division Heads, each cashed in stock to mint $270 million, $108 million, $80 million and $74 million respectively; two other directors each cashed in $68 million worth of Enron stock. The company’s stock once peaked at $65; by November 2001 it traded for less than 50 cents. The retirement funds (401K) of more than 45,000 of its American employees forced invested in Enron stock have virtually evaporated since (Fortune 2002; Forbes 2002).

The meltdown of Enron Corporation was one of the largest corporate bankruptcies in history, and certainly represented the biggest accounting scandal ever, and possibly, the largest cash crisis in corporate business. Once a stodgy focused gas pipeline company, Enron redefined itself into the nation’s leading marketer of natural gas, electric power, and bandwidth capacity. It struck hundreds of joint venture deals with domestic and foreign partners alike in projects that diffused its original focus. Revenues soared from $20 billion in 1997 to $31 billion in 1998 to $40 billion in 1999 until it jumped to $100 billion in 2000. Its NYSE annual-high stock price rose from $22.5625 in 1997 to $29.375 in 1998 to $44.875 in 1999, until it peaked at $90.5626 in 2000. Profits increased almost tenfold from $105 million in 1997 to $979 million in 2000. Its total assets expanded from $22.5 billion in 1997 to $65.50 billion in 2000.

Investors have sued Enron ever since, with the accumulated damage to them estimated at over $25 billion. New York-based Amalgamated Bank, which lost millions in the Enron fraud, sued 29 top Enron executives. Enron restated its financial statements, citing accounting errors, and cut profitability for the past three years by about 20 percent, or by around $586 million. Lawsuits against Enron claimed that its top executives reaped enormous personal gains from “off-the-book” partnerships. Meanwhile, Enron’s auditor, Arthur Andersen, allegedly instructed employees to shred critical documents involving fraud. Enron fired Fastow; he was later prosecuted, and later (September 26, 2006) served a six-year prison sentence. Kenneth Lay is dead, and Jeffrey Skilling is currently serving a two-year prison sentence. This tragedy of enormous human, social, economic and monetary losses could have been prevented had Enron applied strict internal cash and accounting controls (Harrison and Horngren 2004).

Vice president Sherron Watkins, CPA at Enron, understood what was going on in the company. She had three alternatives each loaded with high risk: a) report her concerns about Fastow’s deals to Kenneth Lay, CEO of Enron; b) discuss these concerns with her boss, Andrew Fastow, CFO of Enron, or c) do nothing. Under (a) and (b), there was a high chance that Watkins could be ignored or resisted and penalized for blowing the whistle, but there was also a small chance that she could be heard and corrective action taken immediately. Under (c), Watkins would avoid confrontation with Lay or Fastow, but the public (investors, creditors, employees, customers) would suffer if they relied on faulty data. Watkins blew the whistle, reported the matter to the CEO and was severely penalized, but enough damage had already been done to Enron that the company filed for Chapter 11 bankruptcy protection from its creditors in September 2001.

Ethical Questions:

1. Andy Fastow masterminded the Enron fraud. How would you identify and assess the economics and ethics of this fraud? 2. Among accounting scandals, Fastow was known to pioneer “round-trip” sales that apparently did not violate the GAAP codes of those days. Today, it violates the Sarbanes-Oxley Act of 2002 that USA promulgated to prevent such scams. Explain the unethicality and immorality of round-trip sales, and their dangerous economic harm. 3. The retirement funds (401K) of more than 45,000 of Enron’s American employees that were forced to be invested in Enron’s stock have been wiped away. Explore the ethics of injustice in this deal.

4. Among other things, Andy Fastow wore two executive hats that implied serious conflict of interest. Explain the ethical implications of such conflict situations. 5. Insider trading irregularities date from the origin of stock markets. But they took a dangerous scale at Enron. Explain the unethicality and immorality of such irregularities, and their dangerous economic harm. 6. By co-opting Arthur Anderson, an accounting firm that also provided consulting services, an obvious of conflict of interests, Enron was able to spin out shell companies and special purpose vehicles (SPVs) to hide its fatally positioned business. Argue the economic, financial and ethical violations of Arthur Anderson, and the shell companies and SPVs that it spun for Enron. 7. Was Sharron Watkins right in whistle blowing? Even though whistle blowing is legal in the USA, and now in India, when and how is it ethically and morally justified and imperative?

Case 2.3: Satyam Computer Services Ltd

Satyam Computer Services Ltd (popularly called as Satyam) proposed on December 16, 2008 that the 20-year old company would spread risk by diversifying into the infrastructure and real estate business by acquiring two family-run firms: a) a listed Maytas Infra Ltd where the Raju brothers had a stake of 35%, and b) an unlisted Maytas Properties Ltd where the family ownership was about 36% (Maytas is Satyam spelt backwards!). Surprisingly, such a proposal to acquire two totally unrelated companies was readily approved by its eminent board. However, the spontaneous and immediate uproar of Satyam investors against the merger proposal led the board to call it off by December 17, 2009. Subsequently, B. Ramalinga Raju, Satyam Chairman, revealed that, especially in the wake of the dot.com bubble bust and subsequent loss of IT business from several Fortune 500 companies, the company had been reporting inflated profits, understating debts, and doctoring other financial parameters to fight its market share erosion vis a vis domestic competitors such as Infosys, Wipro and Tata IT Services. Such self-motivated whistle blowing stunned investors, perplexed government regulators such as SEBI and the CII (Confederation of Indian Industry), intrigued accounting companies, leading to the dismissal of the Satyam board and installing a board of government nominees. The board of directors of Satyam as of December 16, 2008 was as follows:

Name Designation B. Ramalinga Raju Chairman B. Rama Raju Managing Director Ram Mynampadi Whole-time director Mangalam Srinivasan Non-executive independent director Krishna Palepu Non-executive director Vinod Dham Non-executive independent director M. Ram Mohan Rao Non-executive independent director T. R. Prasad Non-executive independent director V. S. Raju Non-executive independent director

Satyam is a watershed event for the institution of independent directors, wrote Prithvi Haldea (2009), chairman and managing director, Prime Database, in Economic Times. It has demonstrated that even highly credible, qualified, and educated persons are no insurance for corporate governance, that they are no watchdogs of the minority shareholders whose interests they are supposed to serve. In fact boards can serve a negative purpose, that of providing a false sense of security to the minority shareholders. In general, promoters want to enrich themselves and their institutions; the independent directors, on the contrary, should be preventing this from happening. But this is the core of the problem: what if promoters also seek positions of independent directors on boards? When this happens, the promoters as directors may not even recognize or resolve conflict – they could exploit it, as it happened with Satyam. Often, several independent directors may not be aware of some promoter-driven initiatives as they attend only a few meetings a year.

Ethical Questions: a) To what extent did the Satyam episode bring to light the deficiencies in the corporate governance system in India? b) To restore investor confidence in corporate governance systems in India, an ethical mandate, how would you redefine the role of the board, the independent directors, the internal auditors, the external auditors, the audit committees, and government regulatory bodies?

3 c) To what extent can corporate governance failures be attributed to factors such as short-term quick fix solutions? d) To what extent can corporate governance ethical failures be attributed to factors such as corporate greed of managers, chief executives, and even of boards and investors? e) To what extent can corporate governance and ethical failures be attributed to more critical factors such as the lack of a questioning culture and critical thinking in corporate boardrooms? f) To what extent can corporate governance ethical failures be attributed to lack of effective separation between governance and management, especially given the fact that several corporations have the CEO (management) as also Chairman (governance) of the board?

Case 2.3: Sherron Watkins and Whistle Blowing at Enron

In summer of 2001, Sherron Watkins switched jobs within Enron to work for Andy Fastow, CFO. In this new back office role, a non-commercial one, Watkins examined assets that Enron had for sale. Basically she examined a spread sheet that had book values with estimated gains or losses on sales. It is here that she stumbled upon what she thought was an accounting fraud. Fastow hedged a number of assets with several entities called the raptors, apparently fraudulent structures or shell companies. Millions of dollars of losses that should have been borne by the raptors were fed back to Enron instead. The interesting part of the story is not the pseudo raptors but the real person behind this game plan.

In 1999, the BOD of Enron made an unprecedented move of waiving the company’s Code of Conduct to allow Fastow to start his own investment partnership, named LJM (named after his wife and children, Lea, Jeffrey and Mathew). Fastow raised $600 million from Enron for this limited partnership. This entity worked exclusively with Enron – to buy assets, and on hedging contracts. All losses of LJM came back to Enron but not its profits. The CEO, Jeff Skilling, concurred with Watkins that LJM was a shady deal; he resigned on August 14, 2001, barely six months on the job. Meanwhile, Enron’s cash flow had dried up by May 2001 as the government regulators stepped in and put price caps. Also, Enron Broadband tanked and the telecom sector was in real trouble. Watkins wrote an anonymous letter to Ken Lay, the new CEO of Enron. Ken, however, did not hire independent inspectors to investigate the allegations of Watkins about LJM and other creative accounting structures at Enron. Instead, Ken began to unwind these structures and forced a write down (non-recurring expenditures) of a billion dollars in the third quarter of 2001, completely wiping previous year’s net income of $979 million.

Much of this loss could be attributed to Enron’s foray into unrelated businesses, especially water business, and broadband business. Moreover, the trading customers got very skittish. Enron had about $18 billion of energy contracts as receivables and $16 billion as trade payables. Within 6 weeks, Enron lost $4 billion in receivables as some of its trading customers went in for closures. On the other hand, most of its $16 billion dollar creditors demanded to be paid during the same time. Enron had no option but to file for bankruptcy by September 2001. [For more details, see Singh 2005: 239-47].

Ethical Questions:

1. What is whistle blowing? Is it legally, ethically and morally justified? 2. When is whistle blowing ethical and ethically mandating, and why? 3. When is it moral and a moral imperative, and why? 4. Will business in general, and young entrepreneurs in particular, be discouraged by whistle blowing? 5. How is whistle blowing different from one’s fiduciary duty to the company, and why? 6. Why is whistle blowing legal and legally protected in the USA or in India, and with what results? 7. How does whistle blowing help society, especially, shareholders, employees, customers and local communities? 8. Hence, was Sherron Watkins justified in whistle blowing at Enron?

The Ethics of Fraud as Market Abuse

Fraud has existed since the dawn of humanity and will continue until the end of times. Given human nature and its weaknesses, one’s avarice and greed for money, power and popularity has been the major stimulus for fraudulent crime. The landmark case of fraud is McKesson Robinson, a corporation involved in a 1937 financial statement balance fraud that reported $10 million of non-existent inventories and accounts receivable. This case marked the beginning of required generally accepted auditing standards

(GAAS) for independent public auditors.

Fraud exists even today and can occur anytime in an organization. At the same time, there is no special recipe or checklist for detecting and preventing corporate or personal fraud at all times. No such thing exists and no such thing is truly capable of being developed to monitor and control all forms of fraud (Silverstone and Davis 2005: 5-6). Managers should be aware of fraud, deal with the human factors that generate fraud by hiring honest people and keep them honest by instituting strong deterrents of fraud, and deal with the environmental factors that cause crime by enforcing adequate monitors, controls, policies and procedures.

The corporate world is failing in its fiduciary duty and loyalty to its stakeholders. During the last decade, the media has been reporting hundreds of corporate frauds either in the form of accounting misdeeds or insider trading security scandals. Led by Enron in 2001, the list of giant corporate malfeasance grew steadily in 2002 and thereafter. In fact, there is a great fear that we have just scraped the tip of corporate deviant behavioral iceberg.

In the wake of these extraordinary scandals, discussions about the executive virtues of honesty and integrity are no longer academic or esoteric, but critically urgent and challenging. As representatives of the corporation, its products and services, corporate executives in general, and production, accounting, finance, and marketing executives in particular, must be the frontline public relations and good will ambassadors for their firms, products and services. As academicians of business education, we must analyze these corporate wrongdoings as objectively and ethically as possible. What is wrong must be declared and condemned as wrong, what is right must be affirmed and acknowledged as right. We owe it to our students, our profession, and to the business world. This chapter deals with corporate fraud, particularly in terms of its origination and proliferation. Detecting fraudulent accounting practices and insider securities trading irregularities in time, and preventing or forestalling them is an important duty of managers and corporate executives today.

Losing investors’ confidence in the securities market can be disastrous. Thousands of shareholders were shell-shocked and numbed when premium blue chip stock prices trading at the $100 and more levels suddenly plummeted to a few cents a share within a year. What happened? Did the stock market crash? Was it rigged? Neither. In reality, creative accountants fooled the markets – they cleverly inflated reported cash flow from operations by reclassifying items among the operating, investing and financing sections of the statement of cash flows – all this, presumably, well within the boundaries of the then generally accepted accounting principles (GAAP). For instance, in acquisitions, cash paid for working capital could be shifted to the investment section rather than shown as a reduction in cash flow from operations (Mulford and Comiskey 2005: xi).

In an era of questionable and fraudulent accounting, cash flow is the only trustworthy measure of financial performance available. It is almost impossible for accountants to manipulate cash flow. The balance in cash and the total change in cash from one period to the next are generally not prone to misstatement. The balance in cash is readily verifiable from banks and other institutions holding reported balances. Hence, cash is a fact, while profit (which accountants can easily manipulate) is an opinion. Cash flow is real and is not easily subject to the vagaries of GAAP. Most investors rely more on cash flow statements than on reported annual statements such as the balance sheet and the profit and loss statements.

Regardless of whether corporate scams have peaked or not, their intensity, frequency, and magnitude over the last eight to twelve years since 2000, should be a moral and ethical wake-up call for all and must be seriously scrutinized, objectively analyzed, effectively monitored, and expeditiously controlled. This Chapter is a step in this direction. For all practical purposes, corporate scandals represent the level of

5 corporate greed that left unchecked will destroy firms, industries, markets and our business system in general.

The Incidence of Corporate Fraud and Corporate Damages

The top giant five fraudulent companies, Enron, WorldCom, Tyco, Qwest, and Global Crossings, destroyed a combined capital of $460 billion in shareholder value while moving inexorably toward bankruptcy (Stoller 2002; USA Today, October 10, 2002). The cascade of corporate accounting and securities scandals has rocked major security markets of the world, especially the New York Stock Exchange (NYSE) and the NASDAQ markets. The United States of America is the economic engine of world commerce and the cornerstone of the world economy, and therefore, American corporate frauds and scams have affected the stock markets around the world. However, not all of the stock associated with the offending companies has suffered in other markets the way it has in the United States.

According to the 2002 Report of the Association of Certified Fraud Examiners (ACFE) on Occupational Fraud and Abuse, on average, U. S. organizations lose about six percent of revenues owing to dishonesty from within. When adjusted to U. S. Gross Domestic Product, the cost of occupational fraud and abuse amounts to over $600 billion annually. The ACFE had conducted a similar study in the mid-1990s based on voluntary reports of over 2,600 frauds, estimating losses to $400 billion annually, or about $9 per day per employee (ACFE 1996). Such abuses may include everything from disorders in the mailroom to the boardroom, from employee theft, purchasing managers’ kickbacks to corporate embezzlement, but corporate fraud takes the lion’s share of organizational fraud and abuse (Albrecht and Albrecht (2004: viii). These numbers understate the real damage, as it is impossible to know what percentage of fraud is really discovered, and what percentage of fraud perpetrators are eventually caught and brought to justice. In addition, many frauds that are discovered are handled out of court and clandestinely and never made public (Albrecht and Albrecht (2004: 3).

Each dollar lost in fraud is a dollar loss of net income, and hence, it takes significantly more sales revenue to recover the effect of fraud loss on net income. For example, a fraud loss of $100 million to an automobile manufacturer whose profit margin (i.e., net income divided by revenues) is ten percent would necessitate the manufacturer to generate additionally ten times the fraud loss, that is, $1billion in revenue to recover the effect on the net income. If the average ticket price of a car were $20,000, this would imply that the auto manufacturer would have to make and sell an additional 50,000 cars ($1 billion/$20,000) to counterbalance the fraud loss. Meanwhile, this loss could be easily passed on to the consumer via higher ticket prices. Alternately, if that amount is deducted from R&D, the opportunity loss of $1 billion could affect the quality of cars.

Whereas most employee crimes in the past were theft of physical goods (e.g., stationery, money, commodities) that were either in small amounts or infrequent, owing to fear of being caught, modern crime is much more sophisticated and electronic in nature. Telecommunications, particularly the computers and the Internet, have facilitated and stimulated corporate fraud. Employees now need only to make a telephone call, misdirect purchase invoices, bribe a supplier, manipulate a computer program, misplace company assets, and other fraudulent transactions by a mere push of a key on computer, PDA or Blackberry keyboards. Most of them take years to be detected.1

1 Corporate fraud is a growing problem. The FBI (USA) has labeled fraud the fastest growing crime and hence, has committed almost 24 percent of its resources to fighting fraud. At any given time, the FBI is investigating several hundreds of cases of fraud and embezzlement, each averaging to over $100,000 in damages. These cases, however, relate just to FBI jurisdiction. Secondly, insurance companies, that provide fidelity bonding or other types of coverage against employee and other fraud, undertake regular investigations within their jurisdiction of employee bonding or similar insurance. Occasionally, researchers conduct studies about particular types of fraud in specific industrial sectors. Fourthly, victims of fraud report crime. All four sources of fraud, however, are incomplete, jurisdiction-specific, and periodical. They fail to provide a comprehensive

Basic Definitions regarding Fraud

A fraud, in general, means deliberate misrepresentation. It implies a deliberate or willed and planned misrepresentation of subjects, objects, properties, and/or events (SOPE) in a deviant behavior situation.

The Association of Corporate Fraud Examiners (ACFE) in 1996 defined an occupational fraud as “The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets” (ACFE 1996: 4). This definition has remained more or less the same in 2004: an occupational fraud is “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s services or assets” (ACFE Report 2004).

The ACFE defines occupational fraud against one’s organization. ACFE also defines fraud as an activity that is: a) clandestine, b) which violates the employee’s fiduciary duties to the organization, c) is committed for the purpose of direct or indirect financial benefit to the employee and d) which costs the employing organization assets, revenues or reserves (ACFE 1996: 9). The term “employee” in this definition includes employees of all categories: blue- and white-collar labor, managers, corporate executives, including CEOs, CFOs, and presidents. Fraud can encompass any crime that uses deception as its primary method or modus operandi.

Based on the Webster’s Dictionary (4th edition, 2002) we may identify the following fraud synonyms or equivalents:

. Deception: The act or practice of deceiving. The fact or condition of being deceived. Something that deceives, as an illusion, or is meant to deceive, as a fraud. In marketing, the word deception has been defined as those instances in which consumers change their behavior for reasons not grounded on “fact” or “reality” but on beliefs and impressions made on them by the influencer (such as advertising, marketers, sales representatives) (Gardner 1975). Often, consumers are influenced by non-substantial attributes and features of a product (such as style, appearance, color, sheen, display) at the expense of disregarding the intrinsic aspects of the product” (Gardner 1975: 43). . Fraud: Deliberate deception in dishonestly depriving a person of property, rights, etc. . Mislead: To lead in a wrong direction, error of judgment or into wrongdoing. This may or may not be intentional. . Subterfuge: An artifice or stratagem used to deceive others in order to evade something or gain some end. . Trickery: Implies the use of tricks or ruses in deceiving others. . Chicanery: Implies the use of petty trickery and subterfuge, especially, in legal actions. . Beguile: To mislead people by one’s charm or persuasion of cheating or tricking. . Seduction: (In a marketing context) “means interactions between marketer and consumer that transform the consumer’s initial resistance to a course of action into willing, even avid, compliance” (Deighton and Grayson 1995: 660). It is “the enticement of a consumer into an exchange where ambiguity is resolved by a private (non-institutionalized) social consensus that the consumer plays a part in constructing” (Ibid 668). Seduction is a strategy whereby consumers are induced to tolerate overlook unsustainability, or even to connive in denying it. In this sense, seduction is more voluntary than fraud and more collaborative than entertainment - a playful, game-like social form (Ibid 661).

Thus, deception is a broader term that applies to anything that deceives, whether by design (fraud), by delusion (trickery or illusion) or by device (subterfuge and chicanery). A fraud is a deliberate misrepresentation or nondisclosure of a material fact made with the intent that the other party will rely and up-to-date picture of organizational fraud at the national level.

7 upon it. If the party did in fact rely upon such a misrepresented statement, and if this causes injury, then the person may bring an action to rescind the contract. Statements of opinion, however, may not be usually used as a basis for fraud or misrepresentation. If the seller says, "This car is the best buy in town," such a claim is treated as a statement of opinion or puffery, but not a statement of fact. However, if the person making such a claim has "superior knowledge" having specific expertise in the field, and the buyer relies on this expertise in the actual purchase, then such a claim may be equivalent to a misrepresentation. 2 The misrepresentation must be of a present or a past fact. False statements regarding the future are not actionable. In addition, in general, silence or nondisclosure is not fraudulent, unless nondisclosure relates to “material” facts regarding an inherently dangerous product. If the manufacturers/sellers, however, choose to speak, they must tell the whole truth. Deceptive partial disclosures often amount to fraudulence.

Corporate Frauds as Deceptive Trade Practices

Corporate frauds are deceptive trade practices. Traditionally, the concept of deceptive trade practices included all transactions that have a "tendency or capacity" to mislead consumers. One did not have to prove actual harm to any specific group of consumers. The courts have not changed the "tendency or capacity standard". However, the Federal Trade Commission (FTC) of USA came with new guidelines for deception. In the early 1970s, in the context of deceptive ads, the FTC used three tests to determine whether to take action against trade practices: 1) the FTC must conclude that the ad is "likely to mislead consumers"; 2) the misleading ad must be “material” to subsequent purchase, and 3) misled consumers must be "acting reasonably in the circumstances." All three criteria apply to corporate frauds as deceptive trade practices.

A lie is not the same as deception or fraud. The Oxford English Dictionary defines: "A lie is a deliberate false statement that is intended to deceive others". Deception does not always need a false statement to deceive. A lie is a deliberate false statement that is either intended to deceive others or foreseen to be likely to deceive others (Brandt and Preston 1977; Carney 1972). Most frauds in the form of creative accounting practices are “lies” in this sense. From a legal perspective a lie is (a) a deliberate withdrawal of (b) material information from (c) a person who has (d) a right for that information (e) at the time of the withdrawal. The “deliberate withdrawal” of rightful information is a deliberate false statement. Thus, lie is a form and subset of deception.

Embezzlement means to take willfully, or convert to one’s own use, another’s money or property of which the wrongdoer acquired possession lawfully, because of some office or employment or position of trust. Embezzlement, therefore, implies three elements: a) fraudulent appropriation or conversion of money, b) that the wrongdoer acquired because of his office or position, and c) that the said money belongs to the employer or employing company. Thus, embezzlement is a special type of fraud.

Fraud is different from robbery. The latter uses physical force on someone to give the robber what he wants. Fraud deceives or tricks you out of your assets. Robbery often involves force and violence. Fraud involves surprise, cunning, deception and trickery by which one violates someone’s confidence, and gets an advantage by false misrepresentation. Fraud betrays trust of one’s customers or clients.

2 The "Recovery Theory" in the U. S. Law is also based on the definitions of "fraud" and "misrepresentation." A misrepresentation occurs when a person, by words or acts, creates in the mind of another person an impression not in accordance with the facts. Example: If the seller of a passenger car expressly states that the auto has been rebuilt to meet tougher road conditions, when it has not been, and if the buyer relies heavily upon this statement (hence a "material fact") in deciding the purchase, then the latter’s decision was not freely and voluntarily made, but triggered by misrepresentation. A fact is "material" if the person trying to avoid the contract will not have entered into it had he/she known of the misrepresentation. The buyer may ask a court to free him/her of the contractual obligations of the purchase contract.

Fraud is different from larceny, which is a form of stealing. The legal term for stealing is larceny. According to Black’s Law Dictionary, larceny is felonious stealing, taking and carrying, leading, riding, or driving way another person’s personal property, with the intent to convert it or to deprive the owner thereof (Black 1979: 792). Thus, the essential elements of a larceny are a) an actual or constructive taking away of the goods of another, b) without the consent or against the will of the owner, and c) with a felonious intent. Obtaining possession of property by fraud, trick or devise with preconceived design or intent to appropriate, convert or steal is larceny. Thus, fraud is a subset of larceny.

Fraud is different from bribery or corruption. Bribery in the USA is giving or receiving of anything of value by a subcontractor to a prime contractor. Black’s Law Dictionary (1979: 311) defines bribery or corruption as “an act done with intent to give some advantage inconsistent with official duty and the rights of others. It is an act of an official or fiduciary person who unlawfully and wrongfully uses his station or character to procure some benefit for himself or for another person, contrary to duty and rights of others.” 3

Fraud differs from skimming: a subtle practice of stealing a small portion of a resource (e.g., money, commodity) that presumably will not be noticed. Skimming is a subset of larceny. [See Business Executive Exercises 2.1].

Summarizing and synthesizing most of the above definitions of deviant behaviors, Table 2.1 characterizes major physical transactional abuses – these include coercion, con games, theft by stealth, theft by fraud and theft by force. Table 2.2 characterizes non-physical transactional abuses such as verbal pressures via exaggerated financial statements, aggressive ads and other deceptive promotional tools. Exhibit 2.1 is a simpler taxonomy of a wide variety of deviant behaviors. Exhibit 2.2 distinguishes between fraud, corruption and bribery. This Exhibit assumes that corruption and bribery are subset of frauds as deliberate misrepresentation.

Exhibit 2.1: A Simple Taxonomy of Business Deviant Behaviors

Task Execution Task Ambiguity Low High Non-Physical: Discrimination Trickery, Beguile Corruption Chicanery, Conning, Persuasion, Bribery Seduction, Deception Forced Fraud Money-laundering; consensus Theft by Fraud Racketeering; Theft by Stealth Physical: Much Larceny Terrorism Stealing Ethnic Cleansing Force and Robbery Genocide Undue Power- Theft by Force Preemptive Wars pressure Aggressive wars

3 Bribery violates Title 18, US Code # 201; punishable by up to 15 years in prison + fines of 3 times the value of the bribe + bribing officer is disqualified. Bribery also violates Foreign Corrupt Practices ACT (FCPA), Title 15, US Code # 78. Bribery in the form of kickbacks violates Title 41, US Code #s 51-58; up to 10 years in prison.

Exhibit 2.2: Distinguishing between Fraud, Corruption, and Bribery

Fraud as Deliberate Misrepresentation as: Deliberate Conspiracy-Abuse Factual-Abuse Misrepresentation Regarding:

Past and Current Corruption as Deception: Corruption as Accounting Bribery: Facts, Figures and Deceptive accounting; Kickbacks; Income smoothing; Wash Trading or Round Trip sales; History Ghost or shell companies; Accounting abuses (e.g., over-invoicing, under- Ghost employees or accounts; invoicing, dumping) Restating annual financial statements Hostile Takeovers;

Past, Current and Corruption as Deceptive Corruption as Financial Bribery: Future Advertising: Insider Trading; Active or passive bribery; Decisions, Lies, Cheating, Subterfuge; Under- disclosure or Over-disclosure; Excessive executive compensation; Strategies and Planned buyer-seller information Seduction; Actions asymmetry; Market dominance; Promoting non-existent patents or Undue market entry barriers; products/services; Exorbitant pricing or price wars; Hyping IPOs; Dishonoring warranties and guarantees Covering or disguising product/service defects Corporate Corruption as Deceptive Corruption as Abusive Reporting: Financial Reporting: Over-borrowing based on inflated collateral; Tax Evasion gimmicks; Statements and Understating Debt; Overstating revenues; Inflating bad debts, theft, wastage and other Annual Reports Overvaluing tangibles/intangibles; damages for tax exemptions and insurance Massive write-downs claims

Types of Corporate Fraud

Albrecht and Albrecht (2004) define and classify occupational frauds as using one’s occupation to cheat ones organization or for the benefit of one’s organization. Table 2.3 lists commonest frauds by type, perpetrators, and methods, victims, and costs of deception. The fraud types listed in Table 2.3 are in the descending order of the magnitude of fraud losses in relation to money, market valuation, brand equity, supplier goodwill and customer loyalty, cash crisis, insolvency and bankruptcy. Hence, our list heads with management fraud followed by securities scams or insider trading, investment scams, tax fraud, racketeering, vendor fraud, employee fraud, computer fraud, bribery, and customer fraud. Other things being equal, historically, the magnitude of money and non-monetary damages of frauds could be estimated along the rank order suggested in Table 2.3.

The most common occupational frauds on behalf of one’s organization are those of the top management that result in false financial reporting. Financial statement frauds occur in companies that are experiencing net losses or have profits much less than forecasts or expectations. Such frauds make corporate earnings look better and thus, increase the stock’s price. Often, executives misstate corporate earnings in order to draw larger year-end bonuses. [See Business Executive Exercise 2.2].

Basic Instruments of Corporate Frauds

Several types or patterns of corporate financial scandals are reported (e.g., See Yahoo! Finance, various reports):

1. Unscrupulous brokers: sale of fictitious limited partnerships to boost revenues. 2. Wash Trades: sale of a product to another company with a simultaneous repurchase of the same product at the same price; these swindles uniquely inflate sales by units and dollar volume without recording any profits. 3. Oil and gas schemes (scammers speculate on oil shortages or a rise of natural gas prices). 4. Equipment leasing (scammers sell interest in pay phones, cash machines or Internet kiosks to seduce thousands of investors). 5. Affinity frauds (scammers use their victims’ religious or ethnic identity to buy or gain their trust and then steal their life savings). 6. Promissory notes (e.g., short-term debt instruments sold by independent insurance agents and issued by little-known or non-existent companies promising no-risk high returns). 7. Prime-bank schemes (e.g., scammers promise investors triple-digit returns through access to the investment portfolios of world’s elite banks such as Rothschild banking family or Saudi Royalty). 8. Aggressive accounting (e.g., converting long-term debts to assets, purchase intentions to actual purchases, future orders to current ones). 9. Analyst research conflicts (e.g., Merrill Lynch issued misleading research reports, and had to pay $100 million fine in May 2002, in New York, and had to institute several significant changes in the way it does business). (See Berkenbilt 2002)

All nine corporate scam-types involve selling or buying under fraudulent conditions, and hence, fall well within the domain of fraudulent marketing.

The U. S. Federal Energy Regulatory Commission (FERC) defines “wash trading,” also known as “round trip” trading or “sell/buyback” trading, as the sale of a product to another company with a simultaneous purchase of the same product at the same price. Essentially, wash trading is a false trading because it boosts the companies' trading volume, or even sets benchmark prices, but shows no gains or losses on the balance sheets. While this kind of trading may not be strictly illegal, (possibly, they are too recent frauds to receive federal scrutiny), it can manipulate the power market, which is illegal and it is downright unethical. An inflated balance sheet from round-trip trading misleads investors about the true value and volume of the company's business. Misled investors may tend to invest more, thus jacking up the corresponding stock price. Large volumes of "wash trades” raise the revenues but have no effect on earnings. For example, in the energy industry, round-trip trades involved the simultaneous purchases and sales of energy at the same quantity between the same parties; they inflated revenues in both companies but added no profit. For instance, in the energy trading market controlled by fraudulent energy companies such as Enron, CMS Energy, Duke Energy, Dynergy, and Reliant Energy, each company indulged in the same basic type of wash trading and thereby seriously affected market prices and shortages (see Forbes.com’s accounting tracker Internet service).

Wash trading also affects final consumers. For instance, wash energy trading created false congestions and the perception of energy shortage in the Californian market in 2001, and the price of electricity paid both by the industrial and home users skyrocketed (USA Today April 4, 12, 2002). Also, on September 23, 2002, Allegheny Energy, a Maryland electric utility company, sued Merrill Lynch for $605 million and more unspecified punitive damages in a New York state court. The charge stated that Merrill inflated revenues of Global Energy Markets (GEM) through a series of “round-trip trades” with former industry giant Enron, before selling it to Allegheny for $490 million in 2001. The lawsuit also accused Merrill for misrepresenting the qualifications (e.g., age, experience) of Daniel Gordon, GEM’s

11 head (Yahoo! News, Thursday, September 26, 2002, 9:25 am, EST).

Fraud versus Occupational Abuse

Occupational abuse is a form of fraud, presumably of smaller proportions. Nevertheless, abuses imply some form of cheating and cost to the employers. Consider the following typical employee abuses:

1. Use sick leave when not sick. 2. Come to work late or leave work early. 3. Take a long lunch break without approval. 4. Indulge in slow and sloppy work. 5. Declare or punch more hours than worked for and get paid. 6. Work under the influence of alcohol or drugs. 7. Take products or stationery belonging to the organization (pilferage). 8. Pad your expense accounts. That is, collect more money than due on business expense reimbursements. 9. Use employee discounts to purchase goods for relatives or friends. 10. Use company’s computers during office hours to engage in personal email or securities exchange.

All of these behaviors are examples of occupational fraud. According to the Association of Corporate Fraud Examiners (ACFE), an occupational fraud is “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s services or assets” (ACFE Report 2004). This definition is broad enough to include fraud schemes as simple as pilferage to complex financial statement frauds. Each of these abuses implies: a) some clandestine behavior, b) violation of perpetrator’s duties to the victim organization, c) some form of cheating the employer, d) which costs the employer some money, revenues or assets, and e) some direct or indirect financial benefit to the perpetrator.

The first five examples relate to cheating on time spent on work for which the employer must pay extra. The sixth case of alcohol or drugs cheats on the quality of work that you owe to the company. The next three abuses cheat on products and/or money. The tenth abuse cheats the company on everything: time spent on work, quality of work and using company’s products/services for one’s private business. All ten examples involve a corrupt practice, deception, and improper use of one’s fiduciary trust. Fiduciary duty implies that you are employed (entrusted with responsibilities) on the condition that you are trustworthy and that you do not betray the trust your employer has in you.

In practice, how do you distinguish fraud from abuse? The difference is a matter of perspective. Fraud implies more conspiracy and conspirators, more scheming, affects more people, involves greater losses, and negatively affects large assets of the company. In contrast, abuses are often single-handed actions that are ordinary and routine deceptions, which mostly benefit just the abuser, and involve smaller corporate losses. [See Turnaround Executive Exercises 2.3].

Let us illustrate the difference between corporate fraud and corporate abuse by an example. Jane is a bank-teller, and steals $100.00 each day for five different days of a quarter from her cash drawer. John is also a teller who earns $500.00 a week, and calls in sick (when he was healthy) five different days during the same period. Normally, the former crime would be called a fraud, and the latter action an abuse, even though the damage to the bank in both cases is the same amount, namely $500.00. Each offense implies a dishonest intent to benefit oneself at the expense of the company. Both violate their fiduciary duties to the employer and betray the trust the employer had in them. Yet the punishment meted out in each will be different. Jane would be fired for embezzlement and possibly prosecuted while John will be gently reprimanded, and for repeated offense, his pay may be docked for a day or two. Jane stole money, but

John stole time (which is equivalent in money to Jane’s damage to the company). Jane’s action, however, will be treated as a crime of embezzlement or stealing, while that of John would be treated as misconduct or inappropriate behavior. It is a matter of perspective (Wells 2004: 4).

Based on Wells (2004: 46), Table 2.4 presents a detailed taxonomy of occupational fraud and abuse. Table 2.4 traces occupational fraud to three major action-sources: a) corruption practices, b) misappropriation of assets, and c) falsifying financial statements. Table 2.4 also includes several major types and sub-types of occupational fraud under each of these three heads. Vigilant managers could use this exhaustive list to check and identify occupational frauds in their companies.

Corporate Financial Irregularities

Corporate financial irregularities include several deviant behaviors and data manipulations. Some of these are: overselling shares to depress stock prices, overstating financial worth to boost stock prices, overstating revenues by “round-trip” sales, understating debts, or, in general, “cooking” the books to influence better SEC ratings. In general, financial irregularities are classified under two major heads: a) Accounting Irregularities and b) Insider Trading Irregularities.

Most corporate accounting irregularities come under two heads: a) Fake transactions like “round- trip” sales, and b) manipulation of debts and assets to overstate the value of the company. The U. S. Federal Energy Regulatory Commission (FERC) defines wash trading, also known as "round trip" or "sell/buyback" trading, as the sale of a product, e.g. electricity, to another company with a simultaneous purchase of the same product at the same price.

Essentially, wash trading is false trading because it boosts the companies' trading volume, or even sets benchmark prices, but shows no gains or losses on the balance sheets. While this kind of trading may not be illegal as per then GAAP, it can manipulate the power market, which is illegal. Most of the large scams recently uncovered were in the utility business (See Forbes 2002, July 25; Fortune 2002, September 2). Several wholesale power traders revealed that they participated in the so called "round trip" or "wash trading." For instance, wash-trading practices among some energy companies created false congestion and generated the perception of an energy shortage in the troubled California energy market in 2001-2002. Some would even argue that this practice contributed to the bankruptcy of the two largest California electric utilities and forced subsequent government support to keep power flowing there. The price of electricity skyrocketed and in the end, it was the consumer who had to pay the price for corporate accounting frauds. An inflated balance sheet from round-trip trading misleads investors about the true

nature and volume of the company's business. Large volumes of "wash" trades raise the revenues but have no effect on earnings.

Recent Corporate Accounting Irregularities

Round-trip Sales:

1. Enron and Qwest Communications: Denver-based Qwest Communications used bandwidth to manufacture illusory revenue streams in its recent deal with Enron. According to investigators, Qwest agreed to pay Enron $308 million for the use of “dark fiber” (or unused fiber optic) capacity. In exchange, Enron agreed to pay Qwest between $86- 195 million for access to active sections of Qwest’s network. Both deals turned out to be fake allowing both companies to record fat revenues for the period, and particularly helped Enron avoid reporting a loss for that period (Pizzo 2002). Qwest admitted that an internal review found that it incorrectly accounted for $1.6 billion in sales. It restated results for 2000, 2001, and 2002. It was planning to sell its phone director unity for $7.05 billion in order to raise funds.

2. CMS Energy (May 2002): It executed several “round-trip” trades with Reliant Energy artificially to boost energy- trading volume. Thomas Webb, former CFO of Kellogg, has been appointed as its new CFO since August 2002. These companies have admitted that they have wash traded close to $6 Billion in sales revenues, either between these two companies, or involving other energy companies involved in the fraud.

3. Dynergy (May 2002): also executed “round-trip” trades artificially to raise its energy trading volume and cash flow. S&P cut Dynegy’s rating to “junk,” even though the company is conducting a re-audit.

4. El Paso (May 2002): Also executed “round-trip” trades artificially to enhance energy-trading volume. Oscar Wyatt, a major shareholder and renowned wildcatter, may be engineering a management shake-up.

5. Duke Energy (July 2002): Duke engaged in 23 “round-trip” trades to boost trading volumes and revenue. Duke claims that its round trip trades had no “material” impact on current or prior financial periods.

6. Global Crossing: February 2002, the company engaged in network capacity “swaps” with other carriers to inflate revenue and shredded documents related to securities practices. Company filed Chapter 11 bankruptcy protection. The Congress is investigating the role of its securities firms in its bankruptcy.

7. Homestore.com (January 2002): Inflated sales by booking barter transactions as revenue. The California State Teachers’ pension fund, which lost $9 million on a Homestore investment, has filed suit against the company.

8. Merck (July 2002): Recorded $12.4 billion in consumer-to-pharmacy co-payments that Merck never collected. Even though SEC approved Medco’s IPO registration that would raise $1 billion, the company has withdrawn from it.

Thus far, the FERC has demanded disclosure on wash trading from almost 150 energy companies from all over the United Sates. Only when the investigation is complete and other wash trading information is uncovered will we be able to assess how widespread this trading actually was.

Inflating or Restating Revenues:

9. Halliburton (May 2002): Improperly booked $100 million in annual cost overruns before customers agreed to pay for them. The legal watchdog group Judicial Watch filed a securities fraud against Halliburton.

10. WorldCom: (March 2002): It overstated cash flow by booking $3.8 billion in operating expenses as capital expenses. It gave founder, Bernard Ebbers, $400 million in off-the-book loans. By the end of 2002, the WorldCom scam totaled $16 billion. The company found another $3.3 billion in bogus securities, and may have to take a goodwill charge of $50 billion to write-off its debts. Former CFO Scott Sullivan and ex-controller

David Myers have been arrested and criminally charged. David Myers agreed to be guilty on September 26, 2002.

11. Peregrine Systems (May 2002): It overstated $100 million in sales by improperly recognizing revenue from third-party resellers. It slashed nearly 50% of its workforce to cut costs. With a third auditor in 3 months, it has yet to file its 10K for 2001; hence, it may be soon de-listed from the NASDAQ. Currently, it is restating revenues from April 1999 to December 2001, during which John Moores, Chairman, dumped $530 million of stock (Fortune, September 2, 2002).

12. Adelphia Communications (nation’s 6th largest cable TV company): April 2002, the founding Rigas family collected $3.1 billion in off-balance sheet loans backed by Adelphia, and overstated results by inflating capital expenses and hiding debt. The company filed for Chapter 11 bankruptcy on June 25, 2002. Three Rigas family members and two other ex-executives were arrested for fraud on July 24, 2002. The company is suing the entire Rigas family for $1 billion for breach of fiduciary duties, among other things (Forbes, July 2002).

13. AOL Time Warner: As the media market faltered and AOL’s purchase of Time Warner loomed, AOL inflated sales by booking barter deals and advertisements it sold on behalf of others as revenue to keep its growth rate up and seal the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers. The Department of Justice (DOJ) has ordered AOL to preserve it documents. AOL confessed that it might have overstated revenue by $49 million. New concerns are that AOL may take another goodwill writedown, after it took a $54 billion charge in April (Forbes, July 2002). The scandal went public in July 2002.

14. Bristol-Myers Squibb: Inflated its 2001 revenue by $1.5 billion by “channel stuffing” (i.e., forcing wholesalers to accept more inventory than they can sell to get it off manufacturer’s books). Efforts to get inventory back to acceptable size will reduce Squibb’s earnings by 61 cents per share through 2003 (Forbes, July 2002). The scandal was disclosed in July 2002.

15. K-Mart (January 2002): Allegedly, its securities practices were intended to mislead investors about its financial health. The company, then in a bankruptcy situation, was undertaking a “stewardship” review to be completed by the end of 2002. February 26, 2003, two Kmart executives were indicted by a Detroit grand jury on federal charges of fraud, conspiracy and making false statements over their recording of a $42 million payment that resulted in an overstatement of Kmart’s results (Hays 2003).

Ethical Implications

Deliberate accounting irregularities are failures of corporate accountability. In the wake of these escalating corporate accounting scandals, several ethical and moral questions arise. As responsible ambassadors and representatives of the corporation, and of its mission, products and services, corporate executives in general, and accounting executives in particular, must represent integrity, honesty and corporate responsibility to customers, shareholders and other stakeholders.

The Enron bankruptcy raised questions about the validity of the independent audits and of the business practices of the accounting industry itself. It is clear that the auditors failed to pinpoint the accounting irregularity problems with companies involved in corporate scams. Given the fact that the accounting practices are relatively simple, it is hard to believe how easily the accounting firms disguised the truth, presumably in collusion with the audit and accounting branches of the implicated firms. It is just hard to accept that the accountants did not assess the magnitude of these frauds. Clearly, the accounting principles and rules were not followed.

There were systems level failures at several points that allowed many corporate frauds and scams to remain undetected until they were so large that they bankrupted large companies, with billions of dollars of loss in shareholder equity. Some of the biggest and most prestigious U. S. accounting firms (e.g., Arthur Anderson, Deloitte & Touché, Ernst & Young, KPMG, and Price Waterhouse & Coopers) offered

15 consulting services to the same companies they also audited. This is gross conflict of interest. These firms clearly compromised their credibility and independence when they had to audit their own work. The Securities and Exchange Commission (SEC) failed to bar accountants from also being consultants for the same company due to extensive pressure from the accounting lobbying groups. The same groups have contributed millions of dollars to individuals, political activity campaigns (PACs), and soft money contributions to fight any SEC rules change. Some of the largest scams recently uncovered were in the utility business (see Appendix 2.1 and 2.2). Several wholesale power traders revealed that they participated in the so-called "round trip" or "wash trading" practices.

Insider Trading Irregularities

Early 2000 marked the beginning of some of the worst corporate security irregularities in history. Rapidly rising stock prices followed by the eventual market collapse might have led these executives to unusual activities and practices in corporate transactions that were either questionable in terms of their ethical and moral implications, or were outright violations of the law. For instance, Forbes (July 25, 2002) listed top 25 securities irregularities among top management executives, and little later, Fortune (September 2, 2002) featured another list of 25 largest corporate irregularities in the form of corporate accounting frauds and security scandals. The latter list of securities irregularities involved a total haul of $23.074 billion dollars, averaging to $923 million per company. The list named 55 top executives laundering $14.147 billion with over 257 million dollars per person. Incidentally, the Fortune 2002 report resulted from a research conducted during 2001 in conjunction with the University of Chicago, School of Business. The current avalanche of security irregularities could represent just the tip of the iceberg. Each business week of the last two years (2000-2002), the media has been featuring at least one or other top corporate executives of the country confessing either accounting frauds or securities irregularities or both.

Definitions and Discussion of some Key Terms

 Insider Trader: The term insider is specially defined in Section 16b of the U. S, Securities Exchange Act of 1934 that limits short-term transactions by insider parties (Vagts 1979: 827). Section 16b of the 1934 SEC Act imposes express liability upon insiders - directors, officers, and any person owning more than ten percent of the stock of a corporation listed on a national stock exchange or registered with the SEC - for all profits resulting from their “short-swing” trading in such stock. The insiders are assumed to have special access to insider information concerning a corporation either because of financial interests and/or a managerial position. If any insider sells such stock within six months from the date of its purchase or purchases such stock within six months from the date of its sale, the corporation is entitled to recover any and all profit the insider realizes from these transactions. The “profit” recoverable is calculated by matching the highest sale price against the lowest purchase price within the relevant six-month period, and losses cannot be offset against profits (Mann and Roberts 2000: 961). Individuals classified as insiders are subject to special restrictions in using such data in trading in securities. Insider trading during a tender offer is prohibited by Rule 14e-3 of the 1934 SEC Act (Mann and Roberts 2000: 963). A tender offer is a general invitation to shareholders to purchase their shares at a specified price for a specified time. Section 14e imposes civil liability for false and material statements or omissions or fraudulent, deceptive, or manipulated practices in connection with any tender offer.

 Security: A security includes any note, stock, bond, pre-organization subscription, and investment contract. An investment contract is an investment of money or property made in expectation of receiving a financial return solely from the efforts of others. Securities not subject to the registration requirements of the 1933 SEC Act are “exempt securities” which include short-term commercial paper, municipal bonds, and certain insurance policies and annuity contracts. Non-exempt securities come under 1933 Act such as notes, stocks, bonds and some investment contracts. Similarly exempt transactions are issuance of securities that do not come under the registration requirements of the 1933 Act (e.g., limited offers, intrastate issues). Disclosure of accurate material information is required in all public offerings of non-exempt securities unless offering is an exempt transaction.

 Disclosure requirements: these are statements disclosing specified information that must be filed with the SEC and furnished to each client. Insiders are liable under Rule 10b-5 for failing to disclose material, nonpublic information to the SEC and each client before trading on the information.

 Antifraud Provision: Rule 10b-5 makes it unlawful to 1) employ any device, scheme, or artifice to defraud; 2) make any untrue statement of a material fact; 3) omit to state a material fact without which the information is misleading; 4) engage in act, practice, or course of business that operates or would operate as a fraud or deceit upon any person. Recovery of damages under Rule 10b-5 requires proof of: 1) a misstatement of omission; 2) materiality; 3) scienter (intentional and knowing conduct), and 4) relied upon 5) in connection with the purchase or sale of a security. In an action for damages under Rule 10b-5, it must be shown that the violation was committed with scienter or intentional misconduct. Negligence is not sufficient.

 Material: A misstatement or omission is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to purchase or sell a security. Examples of material facts include substantial changes in dividends or earnings, significant misstatements of asset value, and the fact that the issuer is about to become a target of a tender offer.

 Tippers – These pass on insider information that they had a legal obligation to keep secret even though they do not trade on it themselves. Correspondingly, a Tippee is someone who accepts insider information from a person who should not have revealed it, and trades on it.

 Insiders, for the purpose of SEC Rule 10b-5, include directors, officers, employees, and agents of the security issuer, as well as those with whom the issuer has entrusted information solely for corporate purposes, such as underwriters, accountants, lawyers, and consultants. In some instance, the rule also precludes persons (tippees) who receive material, nonpublic information from insiders (tippers) from trading on that information. A tippee who knows or should know that an insider has breached his fiduciary duty to the shareholders by disclosing inside information to the tippee is under a duty not to trade on such information (Mann and Roberts 2000, p. 962).

 Insider Trading: SEC Rule 10b-5 applies to sales or purchases of securities made by an “insider” who possesses material information that is not available to the public (Mann and Roberts 2000, p. 961). More specifically, it is the attempt to benefit from stock market fluctuations by using unpublicized information gained on the job (Mescon, Bovée and Thill 2002, p. 58). An insider who fails to disclose the material, nonpublic information before trading on the information will be liable under Rule 10b-5, unless he or she waits for the information to become public. The U. S. Supreme Court has upheld the misappropriation theory as an additional and complementary basis for imposing liability for insider trading. Under this theory, persons may be held liable for insider trading under Rule 10b-5 if they trade in securities for personal profit using confidential information misappropriated in breach of a fiduciary duty to the source of the information; this liability applies even though the source of information is not the issuer of the securities that were traded (Mann and Roberts 2000, p. 262).

 Insider Information: Insider information is data or news that has not been publicly released and that could affect a shareholder’s decision to buy or sell stock in a publicly traded company utilizing material, nonpublic information (Markon and Schmitt 2002). The law bars trading in a material nonpublic information. In terms of defining just what kind of information fits this category, prosecutors have some leeway. The most clear-cut examples include market-moving news such as an impending merger or bad earnings report before it is made public. But, gray areas abound. Numerous other issues abound. For example, many companies attend professional conferences each year and they may provide information about new products to attendees, while at the same time bar members of the general public from any of the above information (Business Week, April 26, 2002). The American Society of Oncology (ASCO) is a case in point. At each of their annual conferences a great deal of information is released to those attending these gatherings. This is akin to insider trading if the attendees begin trading on the information provided to them.

 Legal Insider Trading: Insiders need to follow certain procedures when they wish to sell some or all of their holdings. First, the potential inside trader needs to consult with legal consul so as to determine the appropriateness of an insider purchase and/or sale at a given point in time such as a pending merger. Then a Form 144 must be filed with the Securities Exchange Commission (SEC) indicating the number of as well as the precise timing of the desired sale. Finally, an opinion letter must be sent from the appropriate legal counsel and filed along with the above, to the Securities Exchange Commission (SEC). All these procedures are meant to ensure that the corporate insiders do not trade on or tip others with insider information thus negatively affecting the company and/or its shareholders.

Thus, although both Section 16b and Rule 10b-5 address the problem of insider trading and both apply to the same transaction (i.e., trading securities), yet these two legal sources differ in many aspects: 1) Section 16b applies only to transactions involving registered equity securities, whereas Rule 10b-5 applies to all securities. 2) The insiders by Section 16b are only directors, officers, and those who own more than 10% of the a company’s stock, while the insiders by Rule 15b-5 extends to other categories such as agents of the security issuer, underwriters, accountant, lawyers and consultants. 3) Section 16b does not require that the insider possess material, nonpublic information; the liability is strict; whereas Rule 10b-5 applies to insider trading only where such information is not disclosed. 4) Section 16b applies only to transactions occurring within six months of each other, while Rule 10b-5 has no such limitation. 5) Under Section 16b, although shareholders may bring suit, any recovery of damages is on behalf of the corporation; but under Rule 10b-5, injured investors may recover damages on their own behalf (Mann and Roberts 2000, p. 962).

In 1988, the US Congress amended the 1934 Act by adding Section 20A that imposes express civil liability upon any person who violates the Act by purchasing or selling a security while in possession of material, nonpublic information. Any person who contemporaneously sold or purchased securities of the same class as those improperly traded may bring a private action against the improper traders to recover damages for the violation. The action must be filed within five years after the date of the last transaction that is the subject of the violation. Tippers are jointly and severally liable with tippees who commit a violation by trading on the insider information (Mann and Roberts 2000, p. 963).

Further, any person who distributes a materially false or misleading proxy statement may be liable to a shareholder who relies upon the statement in purchasing or selling a security and thereby suffers a loss. A misstatement or omission is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote or buy/sell shares, even if this misstatement or omission occurred merely through negligence. Similarly, by Section 14e of the SEC Act of 1934, it is unlawful for any person to make any untrue statement of material fact, to omit to state any material fact, or to engage in any fraudulent, deceptive or manipulative practices in connection with any tender offer. This provision applies even if the target company is not subject to the 1934 Act’s reporting requirements. Some courts maintain civil liability for violations of Section 14e; however, the requirements for such an action are not entirely clear because relatively few cases have involved such violations. At present, the target company may seek an injunction, and a shareholder of the target company may be able to recover damages or obtain rescission (Mann and Roberts 2000, p. 963).

By legislations enacted in 1984 and 1988, the SEC is authorized to bring an action in a U. S. district court to have a civil penalty imposed upon: 1) any person who purchases or sells securities while in possession of material, nonpublic information; 2) any person who by communicating material, nonpublic information aids and abets another in committing such a violation; 3) any person who directly or indirectly controlled a person who ultimately committed a violation, even though the controlling person knew or recklessly disregarded the fact that the controlled person was likely to commit a violation and consequently failed to take appropriate steps to prevent the transgression. Violation in all three cases must be on or through the facilities of a national security exchange or from a broker or dealer. Purchases

18 that are part of a public offering by an issuer of securities are not subject to this provision (Mann and Roberts 2000, p. 963).

Corporate insiders for some time have been forbidden to trade while knowing about material, nonpublic information such as earnings announcements or a possible merger. Currently, insiders need only be aware of confidential market-moving information, as based on SEC Rule 10b-5. A second rule (105b-2) extends liability for illegal insider trading to family members and other non-business relationships that have agreed to keep secret the information they receive.

Further, as of August 2002, SEC has come up with newer rules requiring firms to report trades of company stock by officers, directors and majority shareholders within two (2) days (Kristof 2002). This is a vast improvement over past sales that allowed companies at least 10 days - and sometimes more than a year - to reveal whether the top officers within the firm were buying or selling their equity or portions thereof. Recently, the SEC is involved with more activities relative to insider trading cases: as a result, 57 insider trading related cases were filed in 1996, up from 38 in 1990 (Bryan-Low 2000).

Some Recent US Insider Trading Irregularities (See Fortune, September 2, 2002).

Qwest Communications: As part of BellSouth’s deal to buy some of Qwest, Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion.

Gateway: Tedd Waitt, founder and CEO of Gateway, spent $9.36 million in June to buy back 2 million Gateway trading around $4, when $82.5 was the stock peak price in November 1999: his haul was $1.00 billion.

Ariba.com: With an unusually short post-IPO lockup period, several corporate executives of Ariba.com began selling their stock barely 4 months after Ariba went public in June 1999. Ron DeSantis, former EVP made 222 million, Keith Krach, Chairman hauled 191 million, Paul Heagarty, Director, Edward Kinsley, former CFO, each laundered 127 million and 114 million, respectively.

I2Technologies: Founder, chairman and CEO of I2 Technologies, Sanjiv Siddhu, who still owns 27% of the company, sold most of these shares after the stock peaked at $110 in March 2000. I2 Technologies stock now trades at less than $1.0; his catch was 447 million; Ramesh Wadhwani, Vice-Chairman, and Sandeep Tungare, former Director each did the same and made 160 million and 140 million, respectively.

Enron: Enron’s Lou Pai, former Division Head, Ken Lay, former CEO, Rebecca Mark, former Division Head and Ken Rice, former Division Head, each cashed stock to mint 270 million, 108 million, 80 million and 74 million dollars respectively; Jeff Skilling and Andy Fastow cashed $68 million each worth of Enron stock, respectively.

Global Crossings: Gary Winnick, Chairman, Global Crossings, cashed stock worth $508 million; Winnick also sold another $227 before January 1, 1999.

Cisco Systems: John Chambers, President, CEO, Cisco Systems, and Judith Estrin, former CIO, each cashed stock to gain $239 million and $ 72 million respectively in 2000. Estrin also cashed $61 million of stock in February 2000, a month before it peaked at $80.06; she left Cisco that April.

Nextel Communications: Craig McCaw, Director, Nextel Communications, cashed stock to the tune of $343 million in 2000. He also cashed $115 million from XO Communications, the Telecom he founded that went belly-up June 2001.

Juniper Networks: Last May, with stock down 96% from its high of $243, executives of Juniper Networks, Scott Kriens, Chairman, CEO, Pradeep Sindhu, Vice-chairman, and Peter Wexler, VP exchanged their booming

options for ones priced at $10.31! They bagged each 148 million, 108 million and 87 million dollars, respectively.

Opportunism is rampant in every area of business, and corporate finance is no exception as the long list of corporate securities irregularities (e.g., Fortune September 2, 2002) demonstrates. The risk of opportunism can be very high, and considerable resources might have to be spent in controlling and monitoring it, resources that could have deployed more productively elsewhere in the company. Opportunism is hard to detect owing to information asymmetry between the party engaging in opportunistic behavior and the other exchange partner, even harder to control, and strategies for suppressing opportunistic behavior may undermine existing exchange relationships (Murry and Heide 1998) as well as forfeit valuable deals in the process. While several strategies of “external” control of opportunism have been devised, tried, and often failed (e.g. reduction of information asymmetry, closer monitoring, higher monetary incentives to discourage opportunism, higher contracted penalties for opportunistic behavior), very few “internal” control mechanisms have been tried. A major “internal” control such as selecting, contracting, and rewarding marketing or securities managers whose virtues of honesty, prudence, commitment, and fiduciary responsibility have been tested and proven may help control opportunism far more effectively than external monitors.

Corporate irregularities are bred by corporate greed that in turn is stimulated by the corporate “virtue” of selfishness (Rand 1964). What we need at this juncture is a real return to virtue, specifically the virtue of caring for others, specifically advocated by recent feminist ethical scholars (see Gilligan 1982; Noddings 1984). Unless corporate executives “aim higher” (see Bollier 1997), and incorporate virtue in their corporate strategies (see Morris 1997), they will never appreciate the “social contracts” they have implicitly signed with society by their corporate position (Donaldson and Dunfee 1995, 1999).

How do we Combat Corporate Fraud?

Our main argument is that ethics can combat corruption. Additionally, we believe that excessive regulation and its complex interpretation/enforcement process breeds corruption. We also theorize that there is a supply side versus demand side of corruption, especially in India.

However, how and under what circumstances can ethics reduce corruption? We suggest two approaches:

1. Much of corruption thrives on uncertainty or ambiguity of the law, licenses, and other excessive regulation and its enforcement mechanism. There is much information asymmetry between the buyer and the seller of excessive regulation services. Ethics should focus on reducing uncertainty, ambiguity and asymmetry in the entire corruption phenomenon wherever it occurs.

2. In order to do this, we breakdown the phenomenon of corruption into inputs, process, and outputs, and distinguish the supply side and demand side under each. For a proper focus, we concentrate only on the government as the supply side and business house as the demand side – G2B domain.

Other things being equal, uncertainty/asymmetry in relation to inputs may be regarded as complexity, uncertainty in the process may be construed as ambiguity, and uncertainty in the outputs as risk – all this both on the supply side and demand side. Table 2.5 is a representation of uncertainty involved in the sources and sub-sources of corruption. When specifically applied to each cell, ethics can piecemeal combat corruption. Additionally, Appendix 2.3 presents the essentials of the famed USA’s Sarbanes- Oxley Act of 2002 to Combat Corporate Frauds. [See Business Executive Exercises 2.4 to 2.8].

All businesses have a responsibility to the common good. Because corporate executives and organizations are both economic and social institutional forces, their responsibilities to the public are large and go beyond the sanctions of law and demands of competition. In serving each other, they must strike at some unity that goes beyond a mere melding of self-interests to sharing of socially responsible values and ideals. Howsoever defined, the social good of investors is very high, and the investing public recognizes this good. Corporate irregularities of whatever form reduce this potential for social good by depriving investors of necessary, objective and timely securities information to which they are entitled. This goal is achieved in USA through existing organizations such as GAO, SEC, DOJ, and CFTC.

It is possible that corporate executives would justify their improper action under the guise of situationism. The latter affirms that when confronted with conflicting rights or duties, it is usual to let the situation with all its circumstances define whose rights should prevail. But this does not mean that the rights of shareholders, investors, employees with 401K moneys invested in the company, and other stakeholders should be totally disregarded, as seems to be the case with the corporate irregularities. In fact, moralists (e.g., Rawls 1971) prescribe that under situationism one is obliged to give additional protection to the rights of the disadvantaged.

Concluding Remarks

There are three dimensions to any corporate fraud: the human, the technology, and the legal dimension. The most important one is the human. People will always try to find ways to get around any regulatory system if it is to their advantage to do so. Any legal or technology system is only as good as people that designed it. Consequently, there will always be someone smarter and more knowledgeable that is willing to take the risk of exploiting the system for one’s own benefit.

There are several issues that make it difficult to predict, uncover or control corporate corruption and fraud. When the top-level business executives are corrupt, it is difficult for the mid-level managers to detect or uncover the deceptive acts and the problems underlying them. Moreover, the mid-managers would be worried about their jobs, especially if whistle blowing is punished in corporations. Additionally, corporate executives involved in fraudulent activities that could launder billions of unearned personal profit to them would not hesitate to pressurize and bribe subordinates into silence even if the latter detected something irregular. Some subordinated could be could be easily seduced to keep quiet "for the good of the company" or "only until the mess is straightened out." A sense of personal loyalty may deter some from resigning their jobs under such strenuous situations.

As managers move from one place to another, it is possible they inherit an already messy business from a previous executive, and would be reluctant to expose the situation for any number of personal or professional reasons. Thus, many instances internal audits do not work and are just another form of unnecessary nuisance in the bureaucracy. The Enron bankruptcy raised questions about the validity of the independent audits and of the business practices of the accounting industry itself. It is clear that the auditors failed to pinpoint the problems with companies involved in corporate scams. The accounting practices are relatively simple. It is just hard to believe how easy it was for the accounting firms to disguise the truth, without resorting to collusion between the audits and accounting branches of the implicated firms as an explanation. It is just hard to believe that the accountants would miss the magnitude of these frauds. Clearly, the Enron executives did not abide by the usual accounting principles and rules.

There were systems level failures at several points that allowed many corporate frauds and scams to remain undetected until they were so large and unredeemable. Some of the biggest accounting firms such as Arthur Anderson, Deloitte & Touché, Ernst & Young, KPMG, and PriceWaterhouse Coopers

21 increased their earnings by offering consulting services to the same companies they audited. These firms clearly compromised their credibility and independence when they had to audit their own work. The Securities and Exchange Commission failed to bar accountants from also being consultants for the same company due to extensive pressure from the accounting lobbying groups. The same groups have contributed millions of dollars to individuals, PAC's, and soft money contributions to fight any SEC rules change.

Whatever may be the underlying motivation for corporate scams, what we advocate is a corporate ethical culture that is guided by some teleological rules and deontological imperatives. Some of these have clear managerial implications, such as:

1. Corporate or personal good should not take primacy over social good of the stakeholders. 2. A corporate strategy should gratify the maximum number of people affected by that strategy (Rule Hedonism). 3. The total sum of utilities generated by any strategy should exceed that of any comparable alternative strategy (Rule Utilitarianism). 4. A corporate strategy should seek the happiness of the maximum number of people affected by that strategy (Rule Eudemonism). 5. A corporate strategy should result in an action that can be the norm for all persons in such situations (Rule Formalism: Universalizability). 6. A corporate strategy should result in an action that must be based on reasons that one would be willing to have all others use to judge that corporation’s strategy (Rule Formalism: Reversibility). 7. A corporate strategy should fulfill the implied contractual duty to protect the rights and duties of all stakeholders affected by that strategy (Rawls Contractualism). 8. A corporate strategy should fulfill the implied macro social contractual duty to protect the rights and duties of all stakeholders affected by that strategy (Integrated Social Contracts Theory). 9. A corporate strategy must observe all legitimate laws that bind (Rule Legalism).

Subsequent handouts will clarify and discuss these rules in greater detail. Any corporate strategy that fulfills one or more of these nine rules has lesser likelihood of corrupting into a corporate scam or indulging in the corporate “virtue” of selfishness (Rand, 1964). What we need at this juncture is a real pursuit of virtue, specifically the virtue of caring for others (see Gilligan 1982; Noddings 1984), and a keen sense of corporate social responsibility (Mascarenhas 1995). Unless corporate executives “aim higher” (Bollier 1997), and incorporate virtue in their corporate strategies (see Morris, 1997), they will never appreciate the “social contracts” they have implicitly signed with society by their corporate position and mission (Donaldson & Dunfee 1995, 1999).

Table 2.1: Characterizing Physical Transactional Abuses

Physical Level of Inputs Process Outputs Remarks Transaction Ambiguity Abuse Compelling Ambiguously All transparent Perfect Compelling but A Win-Win physical non- Fair products and information; full fair trade with bilateral exchange violent services awareness and mutual gain. in the standard persuasions motivation to act; There is much microeconomic no physical scope for sense inducements other marketing than puffery and here. persuasions Con Game Inherently High The victim’s Con Game: the Personal fraud Ambiguous with information response to the victim plays and scam one gets social consent asymmetry; the evidence is not along, but involved in thief commands simply to misread it suffers loss consciously or but the victim but go along with it. without unconsciously. plays along. knowing it. Skimming, Ambiguously Belief you are Every day theft of Could add up to Often, occult Pilfering unfair not noticed small items from sizeable compensation for the organization amount over one’s low wages many and frequent occurrences Theft by Stealth Unambiguously One-sided The victim is Theft by Thief is cunning, Unfair and One- intervention to physically absent or stealth: the contriving, sided theft. The psychologically victim suffers stalking, victim is unaware of the loss without scheming, and unaware or action of the thief. knowing it. vigilant for the absent. right occasion to steal. Theft by Fraud Inherently High The action is Theft by Fraud: Corporate fraud, Ambiguous with information noticed but The victim corruption and no consent asymmetry; the misinterpreted. suffers loss by bribery are here thief commands. Pure embezzlement. misreading under various evidence. forms. Theft by Force Unambiguously Force, physical Coercion is the only Theft by force. The thief knows Unfair or mental or reason why Transaction for more than others psychological; transaction occurs; the thief; loss in the forced threatening and parties no longer for the others. transaction. The intimidating Pareto informed; No marketing felon’s elements; high the victim is needed here, overwhelming information physically deterred other than superiority of asymmetry; from responding. bullying and power accounts Pure robbery. coercing to give for the victim’s in. cooperation. Larceny Unambiguously Larceny is It is taking and Larceny is a It is a transaction Unfair felonious carrying, leading, cunning way of with minimal stealing using riding, or driving taking goods consent from the tricks, frauds, way another against the will victim, who may chicanery, person’s personal or consent of be silent and non- obfuscation, and property. the owner but resistant out of the like. with a fear of attack. felonious Fraud is a subset intent. of larceny.

Table 2.2: Characterizing Non-Physical Transactional Abuses

Type of Level of Inputs Process Outputs Remarks Verbal Ambiguity Abuse Promotional Ambiguity is Pre-existing It works within the Persuasion results Most advertising is Persuasion moderate consensus. The logic of the prevailing given enough prior persuasive in this sense. value of the consensus, and defines consensus between PR is also persuasive transaction can no new symbols or buyer and seller. when you fit news be established signs. material into a prior within it. consensus. Trickery Ambiguity is No pre-existing Implies the use of You unconsciously Is a con game in moderately social buyer- tricks or ruses in capitulate to the disguise where the high seller consensus. deceiving others. wiles of advertising victim is drawn into a social consensus Chicanery Ambiguity is No pre-existing Implies the use of You are charmed Is a con game in high social buyer- petty trickery and by glossy disguise where the seller consensus. subterfuge, especially, brochures; victim is drawn into a in legal actions. social consensus

Beguile Ambiguity is No pre-existing To mislead people by You unconsciously Is a con game in very high social buyer- one’s charm or capitulate to the disguise where the seller consensus. persuasion of cheating freebies and victim is drawn into a or tricking. charms that come social consensus inside cartons. Seduction Ambiguity is Involves It is a strategy Enticement of a The consumer must be highest construction of a whereby consumers consumer into an moved in stages from new consensus, a are induced to tolerate exchange where old agreements to new. deliberate and or overlook ambiguity is stepwise process. unsustainability, or resolved by a deny it. In this sense, private social seduction is more consensus that the voluntary than fraud consumer plays a and more part in collaborative than constructing. entertainment - a playful game form Deception Ambiguity is Involves Consumers are Deception in when. Often, consumers are moderately construction of a influenced by non- consumers change influenced by non- high new consensus, a substantial attributes their behavior for substantial s of a deliberate and and features of a reasons not product at the expense stepwise process. product or service. objective but on of disregarding its beliefs and intrinsic aspects impressions made (Gardner 1975). on them by promotions. Cheating Ambiguity is No pre-existing Cheating is often Cheating is Consumers, high for social buyer- fraudulent and trickery + customers, clients trickery + seller consensus. dishonest exchanges deception and buyers get often deception towards one’s tricked via clients ambiguous marketing promotions.

Table 2.3: Commonest Frauds by Type, Perpetrators, Methods, Victims, and Costs of Deception Type of Fraud Method of Victims of Costs of Deception Fraud Perpetrators Deception Deception Management Top executives Creative and Organization, Loss of market valuation, Tobin’s Q, Fraud such as CEO, aggressive Investors, brand equity, supplier goodwill and CFO and chief accounting such as Employees, customer loyalty and investment accounting officer earnings Suppliers, opportunity; loss of earnings, share (CAO) management; Customers price, and corporate image Income smoothing Shareholders, Possible bankruptcy Gain on sale and Creditors or lenders Loss in financial performance ratios Wash trading such as P/E, EPS, ROIC, RONA, ROI, ROE & total shareholder return (TSR) Securities Top executives Illegal insider trading Public investors who All of the above, plus violation of Fraud with insider do not have access insider trading laws with litigation information to inside information losses Investment Any individual Tricking or conning Unsuspecting False prizes/sweepstakes Scams involved in such into worthless investors, especially Unnecessary magazine sales scams investments the elderly, Worthless buyer club fees Telemarketing fraud teenagers, the Unrealized advance fee-loans marginalized Work-at-home schemes Deceptive travel/vacation packages Tax Fraud Corporate and Failure to report IRS State and local Violation of Title 26, US Code # 7201 non-corporate tax income from fraud or tax authorities Bribes may not lawfully be deducted evaders bribes; filing false as business expenses returns Loss of tax money to governments Racketeering Racketeers Criminal violations Commercial Racketeer influenced and Corrupt Corrupt of commercial exchange partners Organizations (RICO) statue violated; organizations exchange laws and affected by Title 18, US Code # 1961 ordinances; racketeering Money laundering Vendor Fraud Vendors Significant over- Government with Shipment of inferior or fake goods Suppliers charging either singly defense contracts; Overcharge for purchased goods Brokers or by collusion Innocent Deprivation of goods paid for Distributors Non-shipment of corporations and Counterfeit goods Retailers goods paid for customers Employee Employees Skimming, theft; Employers, Losses in cash, kind, morale, work- fraud or At all non- Cheating on time, Shareholders, efficiency, sales and performance due embezzlement executive levels money, quality of Customers, to occupational fraud work Other employees Computer Computer hackers, Illegal access to a The public, defense, Violates Title 18, US Code # 1030 Fraud code-breakers, and protected computer national security and classified data vaulting or classified all governments destroyers data; hacking affected by classified data Bribery and All those engaged Bribery & kickbacks; Suppliers Bribery violates Title 18, US Code # Kickbacks in bribery, strategies Prime contractors of 201, and the Foreign Corrupt Practices kickbacks, and government projects ACT (FCPA), Title 15, US Code # 78. foreign corrupt Kickbacks violate Title 41, US Code practices #s 51-58. Customer Some customers Not paying for goods The vendors Consumer theft costs Fraud Some borrowers purchased; getting Retailers Bad debts; consumer credit abuse; Angered something for Banks tricked into Violated loan covenants customers getting nothing; conning granting loans or Free rider costs; Unpaid interest even with banks to make loans funds transfers Non-amortized capital employers or transfer funds

Table 2.4: A Taxonomy of Occupational Fraud and Abuse [See Wells (2004:46)].

Fraud Major Sub-types Action Types Conflict of Purchase Sales schemes Joint venture Strategic Other Interest schemes schemes alliance schemes Bribery Invoice Bid rigging Concealed perks Family Other kickbacks favors Corruption Illegal To self To subjects To other groups Gratuities in Gratuities in as Abuse gratuities kind stocks Purchase Sales Extorting Distorting Other Economic undercharges surcharges commissions Sales extortion performance

Larceny Of cash on From the deposit From Other hand marketable securities Billing Shell company Non- Personal schemes accomplice purchases vendor

Payroll Ghost employees Commission Workers schemes; schemes compensation falsified wages Fraudulent Expense Mischaracterizing Overstate Fictitious Cash Disbursements reimbursement expenses expenses expenses; related schemes multiple Asset reimbursements Check Forged maker or Altered Concealed Misappro- tampering endorsement payee checks priation as Register False voids False Other Fraud disbursements refunds Sales Unrecorded Understated Other

Skimming Receivables Write-off schemes Lapping Unconcealed schemes Refunds Used returns Tampered Stolen returns returns Inventory Misuse Misuse of Misuse of Misuse of Misuse of other & All inventories payables receivables liquid assets Other Asset False sales & Purchasing Unconcealed Assets Larceny requisitions shipping & receiving larceny and transfers

Asset/revenue Timing Fictitious Concealed Improper Overstatements differences revenues liabilities & disclosures; Financial expenses improper asset valuations Fraudulent Asset/revenue To make lean To provide for To Other harms Statements Understatements years look future leaner jeopardize good years budgets Non- Employment Fudging Doctoring Overstating Understating financial credentials Internal External credentials credentials documents documents

Table 2.5: The Supply and Demand Side of Fraud and Corruption: An Input, Process and Output Analysis

Structure of Corruption Source of Sub-Source Structured Inputs to Structured Processes Structured Outputs of Corruption of Corruption: of Corruption: Corruption: Risk Complex People and Ambiguous Exchange Consequences Corruption Instruments Situations

Corrupt G2B politicians; G2B information asymmetry; Information asymmetry Corrupt G2B government G2B Opaque transactions; products; Corrupt officials; G2B Obfuscation and G2B Seduction and Deception; People Ministers with key G2B chicanery; GEB Blackmail and beguile portfolios; G2B subtle bribery demand; set-up; Unfair G2B lawyers and G2B Structured deception; G2B judges G2B Excessive bribery or robbery; Supply Side Excessive industry/market Overbearing G2B Government market opacity; (Laws & regulation; bureaucracy; Structured market injustices; Corrupt Complicated industry Ambiguous law interpretation; Loss to the government ex- Governments) Instruments excise/tax haven laws; Many G2B authorization checker; Complex mining licensing requirements; Lost business opportunities; or Means systems; Ambiguous G2B bid Tax Losses – govt. deficit Complex Public bidding process/selection; budgets; tenders; Consequent loss in GDP growth;

Unethical/immoral Tax evasion; bribery- Loss in taxes to the exchequer; executives; proneness; Loss in bribery payments to Overbearing middle Export duty violation; the industry; Corrupt managers; Import-quota violation; Loss in market capitalization; Unscrupulous accountants; Over-Maximizing profits; Loss in brand image and People Corrupt internal auditors; Low ethical and moral equity; Corrupt external auditors; thinking; B2G Demand Corrupt B2G distribution Bribing government Weakened B2G creativity; Side and retail managers; distributors and retailers; Delayed R&D and innovation (Business Corrupt B2G supply chain Bribing or pressurizing G2B owing to corrupt B2G deals; Houses) managers; suppliers; Stalled and stagnant business; Banking and credit opaque Bribing and buying G2B bank Losses due to G2B and B2G Corrupt B2G instruments; credit; delays; Instruments Financial analyst (e.g., BSE) Deceiving financial analyst by Loss in sustainable competitive pressurized demand; fraud; advantage (SCA) to or Means Institutional Shareholder Silencing institutional governments and businesses; demands; shareholders by promises; Consequent loss in market Customer Buying business licenses and share; demands/complaints; project approvals via B2G Loss in RE & corporate bribes; growth for the nation and industries; Loss in GDP, EBIT, EPS, ROI;

Turnaround Executive Exercises

2.1 In understanding and investigating the nature of corporate fraud and its related crimes in your company, discuss the following:

a) What is fraud? What are its essential legal elements? b) What is occupational fraud? How is it different from corporate fraud? c) What is corporate fraud? What are its legally constitutive elements? d) What is corporate abuse? What are its basic elements? e) How is corporate fraud different from corporate abuse? f) How is fraud different from deception? g) How is fraud different from misleading? h) How is fraud different from deliberate misrepresentation? i) How is fraud different from unintentional errors? j) How is fraud different from trickery? k) How is fraud different from chicanery? l) How is fraud different from larceny? m) How is fraud different from robbery? n) How is fraud different from embezzlement? o) How is fraud different from stealing? p) How is fraud different from skimming?

2.2 Investigate the following corporate frauds and estimate their impact in relation to: a) corporate cash flow crisis, b) employee jobs and pensions, c) company stock prices, and d) social economic loss.

a) During 1998-2000, Andrew Fastow, CFO at Enron, negotiated and set up outside partnerships to conduct Enron business. As the principal in these partnerships, however, Fastow also negotiated with Enron on behalf of the partnerships. b) During 1999-2001, Qwest Communications inflated revenue using network capacity “swaps” with Enron and improper securities for long-term deals. c) During 2001-2002, AOL inflated sales by booking barter deals and ads it sold on behalf of others as revenue to keep its growth rate up and seal the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers. d) In 2002, Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion. e) In February 2002, World Crossings engaged in network capacity “swaps” with other carriers to inflate revenue. f) In February 2002, Global Crossings engaged in similar network capacity “swaps” with other carriers to inflate revenue. It also shredded documents related to securities practices. g) In March 2002, WorldCom booked $3.8 billion in operating expenses as capital expenses. h) In March 2002, WorldCom gave founder, Bernard Ebbers, $400 million in off-the-book loans.

2.3 Examine the following employee occupational abuses. In what way are they different from fraud? How are they different from corrupt practices? How are they different from crimes? How are they economically harmful to the employer? How are they morally harmful to the employees? How are they socially harmful to the economy, society and the nation? What employee’s fiduciary duties to the organization do they violate? How do they violate employee’s moral duties of honesty and self-esteem to themselves?

a) Use sick leave when not sick. b) Come to work late or leave work early. c) Take a long lunch or break without approval. d) Indulge in slow and sloppy work. e) Declare or punch more hours than worked for and be paid.

f) Work under the influence of alcohol or drugs. g) Take products or stationery belonging to the organization (pilferage). h) Pad your expense accounts. That is, collect more money than due on business expense reimbursements. i) Use employee discounts to purchase goods for relatives or friends.

2.4 Consider the following case of accounts receivable fraud. The bookkeeper of a small but growing bread company prepared bills to be sent to customers and was responsible for collecting payments. Recently, sales have been increasing because of new customers and augmented sales revenue from existing customers. A surprise internal audit, however, revealed that bank deposits were not growing proportionately to the increasing sales revenues. On examining the customer copies of sales invoices, a fraud examiner found that the amounts being billed were higher than the amounts being recorded in the cash receipts journal for the same transaction. Office copies of the invoices had been altered to reflect the falsified journal entry. The bookkeeper had stolen over $15,000 before the fraud was discovered. The bookkeeper was dismissed. He agreed to pay back $15,000, however, lest he should be prosecuted (see Silverstone and Sheetz 2007: 28).

a) How do you classify this fraud? b) Which of the five traditional accounting cycles is its source? c) How do you identify exceptional and questionable account balances and variations? d) Also, how could you detect it much earlier before the damage it created? e) Which fundamental rule of accounting does this fraud violate, and why? f) Hence, how would you prevent such frauds in the future?

2.5 Consider the following case of accounts payables fraud. An administrator of a school board in a small city had full authority for all items payable from the board’s annual budget. As an administrator, he traveled frequently to education conventions and meetings of administrators in the state capitol and across the country. An excellent CPA but a non-pleasant personality, he was not endeared to the board, and the board was slow in approving his travel budgets. Frustrated and embittered, the administrator used his own signing authority to approve personal expenditures and write checks to himself. He started padding the expense accounts. For instance, he would charge mileage when using company’s leased car. He used the board’s credit card to fill gas in his own private car. He submitted and approved several bills regarding meals and entertainment on weekends and repairs to his car. His secretary blew the whistle on him, and forensic fraud examiners found that invoices for many transactions did not exist. He was dismissed from the job, but no specific charges were laid against him (see Silverstone and Sheetz 2007: 30).

a) How do you classify this fraud? b) Which of the five traditional accounting cycles is its source? c) Hence, how could you detect it much earlier before the damage it created? d) How do you identify exceptional and questionable transactions? e) Which fundamental rule of accounting does this fraud violate, and why? f) Hence, how would you prevent such frauds in the future?

2.6 Consider the following case of payroll fraud. A suburban construction company employed several hundred laborers at any given time. For an efficient lean operation management, the home-office included a one- person accounting department, with a long-serving bookkeeper/controller who coordinated the weekly payroll, printed the payroll checks, signed the checks with the owner’s stamp, and hand-delivered the checks to the job sites, and reconciled the company’s bank account. Owing to lack of any checks and balances, the payroll clerk continued paying checks to several laborers long after they were gone, i.e., to ghost employees. He would endorse the checks and deposit them in his own account. At the same time, he paid the withholding taxes, union dues, and other deductions at source. An alert bank teller eventually noticed the fraud, but only after several years and when the clerk had taken over $600,000 (see Silverstone and Sheetz 2007: 31).

a) How do you classify this fraud?

b) Which of the five traditional accounting cycles is its source? c) Hence, how could you detect it much earlier before the damage it created? d) How do you identify exceptional and questionable transactions? e) Which fundamental rule of accounting does this fraud violate, and why? f) Hence, how would you prevent such frauds in the future?

2.7 Consider the following case of inventory fraud. Suspecting some flow play, the board of directors of a gold refiner company hired some forensic investigators to check the inventory of gold in the company. The investigators discovered several brass bars of exactly the same weight as a gold bar on the inventory. An interview with a smelter worker revealed that brass scrap had been melted down, cast into bars and added to the inventory. There was no record of brass bars, however, on the inventory list. Instead, forty-five bars had been valued at $8 million on the balance sheet. Another $5 million was classified as gold bars “in transit.” The fraud had been going on for five years when it was discovered. On further investigation, it was found that the CEO had perpetrated the crime together with his VP of Finance, in an attempt to hide operating losses that would have jeopardized their positions and depressed the stock value of the company. The CEO and the VP of Finance were both charged with fraud, convicted, and served a prison sentence (see Silverstone and Sheetz 2007: 32-33).

a) How do you classify this fraud? b) Which of the five traditional accounting cycles is its source? c) Hence, how could you detect it much earlier before the damage it created? d) How do you identify exceptional and questionable inventory evaluations? e) Which fundamental rule of accounting does this fraud violate, and why? f) Hence, how would you prevent such frauds in the future?

2.8 Consider the following case of capital expenditures fraud. By law, mortgage brokers are limited in their business activities to specific mortgages, and investors to invest in them. For example, an investor would give the broker $50,000 to be invested in a particular mortgage at the prevailing rate per annum to be paid monthly. Often, certain brokers would violate their investment limits and issue other money instruments. A government agency responsible for overseeing mortgage brokers was concerned that many brokers were borrowing and lending money as if they were licensed as banks or trust companies. The agency hired some forensic investigators to examine the books of a randomly selected group of mortgage brokers. The investigators found that one broker had exceeded his authority by issuing so-called corporate notes secured by the company’s guarantee rather than by a mortgage. This broker used the money instead to purchase property for himself, who then reduced his risk by selling partial interests to his family members or other relatives. By the time the forensic investigators discovered this fraud, the broker had taken in more than $5 million by issuing corporate notes and invested in high-risk ventures that failed to pay rates of return required to service the corporate notes. The broker, however, met his monthly obligations to his investors through borrowing on a bank line of credit and was quickly overextended. The government agency revoked the broker’s license, and closed his operations with the help of several banks who took over the mortgages to protect the investors (see Silverstone and Sheetz 2007: 33-34).

a) How do you classify this fraud? b) Which of the five traditional accounting cycles is its source? c) Hence, how could you detect it much earlier before the damage it created? d) How do you identify such exceptional and questionable mortgage transactions? e) Which fundamental rule of accounting does this fraud violate, and why? f) Hence, how would you prevent such frauds in the future?

Appendix 2.1: Recent Insider Trading Irregularities [Source: Fortune, September 2, 2002, pp. 64-74].

Company Total Biggest Takers Individual Remarks Haul Haul ($Billions) ($Millions) Qwest 2,260 Phil Anschutz, Director, 1,570 As part of BellSouth’s deal to buy some of Communications Jo Pe Nacchio, former CEO 230 Qwest, Anschutz sold his Qwest stock of 33.228 million shares to BellSouth at $47.25 for $1.57 billion when its market price was $39.44. Broadcom 2,080 Henry Samueli, CIO, 810 Nicolas boasts that he pays Broadcom Henry Cicholas, CEO, 799 employees so little that they have to sell (both co-chairmen) their stock to pay their bills. AOL Time Warner 1,790 Steve Case, Chairman, 475 Ex CEO Gerald Levin, who masterminded Bob Pitman, former COO, 225 the AOL-Time Warner merger, and left it Jim Barksdale, Director 213 May 2001, did not cash in single share over this period. Gateway 1,270 Ted Waitt, CEO 1,100 Founder Waitt spent $9.36 million in June to buy back 2 million Gateway stock trading around $4 in June 2002. The stock peaked at $82.5 in November 1999. Ariba 1,240 Ron DeSantis, former EVP, 222 With an unusually short post-IPO lockup Keith Krach, Chairman, 191 period, these executives began selling their Paul Heagarty, Director, 127 stock barely 4 months after Ariba went Edward Kinsley, former CFO 114 public in June 1999.

JDS Uniphase 1,150 Kevin Kalkhoven, former CEO, 246 “I have made zero sales in 2002.” says Danny Pettit, former CFO, 206 Strauss, CEO since May 2000. Today all Josef Strauss, CEO & Co-Chair 175 my options are underwater. I need a submarine to read them.” I2 Technologies 1,030 Sanjiv Siddhu, Chairman, CEO, 447 Founder Siddhu, who still owns 27% of Ramesh Wadhwani, Vice- the company, sold most of these shares Chairman, 160 after the stock peaked at $110 in March Sandeep Tungare, former 2000. I2 Tech. now trades at less than Director 144 $1.0. Sun Microsystems 1,030 Bill Joy, CTO, 103 Joy sold one million Sun shares in October Ed Zander, former President 100 2000, 15% of his stake. He sold all his other tech holdings around the same time.

Enron 994 Lou Pai, former Division Head, 270 Jeff Skilling and Andy Fastow cashed $68 Ken Lay, former CEO, 102 million each worth of Enron stock, Rebecca Mark, former Div. Hd. 80 respectively. Ken Rice, former Division 74 Head Global Crossing 951 Gary Winnick, Chairman 508 Winnick also sold another $227 before January 1, 1999. Charles Schwab 951 Charles Schwab, Chairman, 353 Schwab’s sales “have never amounted to CEO, more than a few percentage points of his David Pottruck, President, CEO 188 total holdings in any one year,” says a spokesperson.

Yahoo 901 Tim Koogle, former CEO, 160 Co-founders Jerry Yang sold only $30 Jeff Mallett, former COO, 148 million during this period, while David Gary Valenzuela, former CFO 116 Filo sold none.

Cisco Systems 851 John Chambers, President, 239 Estrin also cashed $61 million of stock in CEO, 72 February 2000, a month before it peaked Judith Estrin, former CIO at $80.06; she left Cisco that April.

Company Total Biggest Takers Individual Remarks Haul Haul ($Billions) ($Millions) Peregrine Systems 818 John Moores, Chairman 646 Peregrine is restating revenues from April 1999 to December 2001, during which Moores dumped $530 million of stock. Sycamore 726 Gururaj Deshpande, Chairman, 137 BY the time main customer, Williams Networks Dan Smith, President, CEO, 129 Communications, went bankrupt last Director, April, these insiders had done most of Chi Kong Shue, EVP 122 their selling.

Nextel 615 Craig McCaw, Director, 343 McCaw also cashed $115 million from Communications Daniel Akerson, former CEO 117 XO Communications, the Telecom he founded that went belly-up June 2001.

Foundry Networks 582 Bobby Johnson, Chairman, 308 We are going to create shareholder wealth CEO the old fashioned way, said Bobby in January 2000. Market cap has since fallen 95%! Juniper Networks 557 Scott Kriens, Chairman, CEO, 148 Last May, with stock down 96% from its Pradeep Sindhu, Vice- 108 high of $243, executives exchanged their chairman, 87 booming options for ones priced at Peter Wexler, VP $10.31!

Infospace 541 Naveen Jain, Chairman, CEO 406 Jain claims he plowed much of this gain into Net stocks; “I lost $80-100 million just on Inktomi and Verisign.”

Commerce One 531 Thomas Gonzales, former 115 Tenenbaum who got a chunk of CTO, 75 Commerce One stock when he sold Vio Jay Tenenbaum, former Systems to the company in January 1999, Director left last April. Gonzales died last fall.

AT&T 475 John Malone 348 AT&T bought Malone’s company, TCJ, in a stock deal in March 1999. Malone left his post as an AT&T director in 2001. Network Appliance 470 David Hitz, EVP, 111 Hitz says his selling is systematic: “It’s an Thomas Mendoza, President, 58 extremely consistent pattern of about 2.5% Daniel Warmenhoven, CEO, 48 of my remaining shares per quarter.” Director Inktomi 431 Paul Gauthier, former CTO, 107 Peterschmidt hasn’t sold any Inktomi David Peterschmidt, Chairman, 84 shares since February 2001. “Investors CEO would flip if they found they did,” says a spokesperson. Priceline 417 Jay Walker, former Vice- 276 Walker bought $125 million of Priceline chairman, 45 shares from Delta Airlines in November Timothy Brier, former EVP 1999, before the stock began falling. Vignette 413 Ross Garber, former CEO, 98 Founders Garber and Webber did most of Neil Webber, former CTO 92 their selling after they left Vignette’s Board in July 1999 and October 1999, respectively. Totals: Totals: No. of Companies: 25 No. of Executives involved: 55

Sum 23, 074 Sum: 14,147 Mean 923 Mean per executive: 257 Std. Dev. 502 Std. Dev. 262

Appendix 2.2: Recent Accounting Irregularities [Source: Fortune, September 2, 2002, pp. 64-74].

Company Total Biggest Takers Individual Remarks Haul Haul ($Billions) ($Millions)

Qwest 2,260 Phil Anschutz, Director, 1,570 As part of BellSouth’s deal to buy Communications Jo Pe Nacchio, former CEO 230 some of Qwest, Anschutz sold his Qwest stock of 33.228 million shares to BellSouth at $47.25 for $1.57 billion when its market price was $39.44. Gateway 1,270 Ted Waitt, CEO 1,100 Founder Waitt spent $9.36 million in June to buy back 2 million Gateway stock trading around $4 in June 2002. The stock peaked at $82.5 in November 1999. Ariba 1,240 Ron DeSantis, former EVP, 222 With an unusually short post-IPO Keith Krach, Chairman, 191 lockup period, these executives began Paul Heagarty, Director, 127 selling their stock barely 4 months Edward Kinsley, former CFO 114 after Ariba went public in June 1999.

I2 Technologies 1,030 Sanjiv Siddhu, Chairman, 447 Founder Siddhu, who still owns 27% CEO, of the company, sold most of these Ramesh Wadhwani, Vice- 160 shares after the stock peaked at $110 Chairman, in March 2000. I2 Tech. now trades at Sandeep Tungare, former 144 less than $1.0. Director Sun 1,030 Bill Joy, CTO, 103 Joy sold one million Sun shares in Microsystems Ed Zander, former President 100 October 2000, 15% of his stake. He sold all his other tech holdings around the same time.

Enron 994 Lou Pai, former Division 270 Jeff Skilling and Andy Fastow cashed Head, $68 million each worth of Enron Ken Lay, former CEO, 102 stock, respectively. Rebecca Mark, former Div. Hd. 80 Ken Rice, former Division Head 74 Global Crossing 951 Gary Winnick, Chairman 508 Winnick also sold another $227 before January 1, 1999. Cisco Systems 851 John Chambers, President, 239 Estrin also cashed $61 million of CEO, stock in February 2000, a month Judith Estrin, former CIO 72 before it peaked at $80.06; she left Cisco that April.

Sycamore 726 Gururaj Deshpande, Chairman, 137 By the time main customer, Williams Networks Dan Smith, President, CEO, Communications, went bankrupt last Director, 129 April, these insiders had done most of Chi Kong Shue, EVP 122 their selling.

Company Total Biggest Takers Individual Remarks Haul Haul ($Billions) ($Millions)

Nextel 615 Craig McCaw, Director, 343 McCaw also cashed $115 million Communications Daniel Akerson, former CEO 117 from XO Communications, the Telecom he founded that went belly- up June 2001.

Juniper Networks 557 Scott Kriens, Chairman, CEO, 148 Last May, with stock down 96% from Pradeep Sindhu, Vice- its high of $243, executives chairman, 108 exchanged their booming options for Peter Wexler, VP 87 ones priced at $10.31!

Priceline 417 Jay Walker, former Vice- 276 Walker bought $125 million of chairman, Priceline shares from Delta Airlines in Timothy Brier, former EVP 45 November 1999, before the stock began falling. Vignette 413 Ross Garber, former CEO, 98 Founders Garber and Webber did Neil Webber, former CTO 92 most of their selling after they left Vignette’s Board in July 1999 and October 1999, respectively.

Appendix 2.3: The Sarbanes-Oxley Act to Control Corporate Frauds

Hurriedly passed by the U. S. Congress in 2002 in the wake of Enron and other giant corporate scandals of 2000-2002, the Sarbanes-Oxley (SOX) Act 4 seeks to reduce the likelihood of fraud by making public company CEOs and CFOs directly accountable for the internal disclosures and financial statement of their organizations. Senior managers will also be subject to greater oversight from boards that are more independent, internal audit committees and external audits. A major objective of SOX Act was to control and combat corporate fraud by: a) developing better reliable information about company’s operations to avoid making bad decisions, and thus, b) improving the reliability of financial reporting, and c) restoring investor confidence. The ACT went into effect in 2002, and public CEOs and CFOs had to implement it by fiscal year 2004. The SOX, also known as Public Company Accounting Reform and Investor Protection Act of 2002, was intended to provide a proper accounting framework and rules for public companies by improving the accuracy and reliability of corporate financial statements and disclosures made pursuant to the securities laws. The goal of SOX is for internal controls to be so effective that degradation of the system through fraud is virtually impossible (Silverstone and Davis 2005: 23).

SOX seek to prevent and punish corporate corruption. SOX created a Public Company Accounting Oversight Board (PCAOB) whose functions are to register, oversee, investigate and discipline all Public Accounting Firms (PAF) that audit public companies. SOX require the creation of an audit committee comprising of independent directors of the issuer company. The issuer company’s PAF auditor will be under the control of the audit committee. The CEO and the CFO of the issuer company will sign all its official financial statements and disclosures.

Compliances with SOX are enshrined in three brief Sections: 302, 404 and 906.

 Section 302 (Title III): Corporate Responsibility for Financial Reports: Section 302 requires that CEOs and CFOs personally certify:

1. The accuracy of financial statements and disclosures in the periodic reports issued by the corporation, 2. That these statements fairly represent in all material aspects the results of operations and financial condition of the company, 3. That the financial controls and procedures of sox have been implemented and evaluated, and 4. Any changes to the system of internal control since the previous quarter will have been noted.

 Section 404 (Title IV – Enhanced Financial Disclosures): Management Assessment of Internal Controls: Reports filed with the SEC must include all material off-balance sheet transactions and relationships that may have material effect on the financial status of an issuer. Additionally, Section 404 requires:

a) An annual statement of the issuer to contain an internal control report which shall state that the management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting; b) CEOs and CFOs to periodically assess and vouch for their effectiveness, and c) That no loans be extended to senior executives.

4 On June 18, 2002, the Senate Banking Committee passed a bill (#2673), a legislation crafted by Senator Paul Sarbanes (D- MD), mostly in reaction to the confusion and distrust in the US financial markets caused by a series of gigantic corporate scandals involving Enron, Global Crossing, Arthur Anderson etc., in late 2001. The bill was expected to die in the House owing to its draconian implications, but got triggered on June 25, 2002 when WorldCom’s announced overstating earnings in their previous five quarters by over $3.8 billion due to improper accounting procedures. On July 15, 2002, the Senate passed the Sarbanes’ bill by a 97-0 vote. In the House, Michael Oxley (R-OH) made a few significant changes to the bill and sent it to the House floor where it passed almost unanimously. Later, the new version of the bill (now called Sarbanes-Oxley) was passed by the Senate 99-0 and in the House with a 423-3 vote. On July 30, 2002, President Bush signed the Sarbanes-Oxley Act of 2002 as law, describing it as “the most far-reaching reforms of American business since the time of Franklin Delano Roosevelt,” (Whalen 2003).

 Section 906 (Title IX – White-Collar Crime and Penalty Enhancements): Corporate Responsibility for Financial reports: Section 906 requires CEOs and CFOs to sign and certify the report containing financial statements; they must confirm that the document complies with SEC reporting requirements and fairly represents the company’s financial condition and results. Willful failure to comply with this requirement can result in fines up to $5 million and imprisonment from five to 20 years.

Moreover, Title VIII on Corporate Criminal Fraud and Accountability adds other injunctions:

a) It is a felony for knowingly destroying, concealing or falsifying a document to impede and investigation; b) All auditors should maintain audit work papers for five years; c) The statute of limitations and securities fraud will be increased to five years; d) Imprisonment for defrauding shareholders will increase to 25 years, and e) All whistleblowers will be protected from management retaliation.

By Section 404, companies are also obliged to include an internal-control report as part of the annual report that should minimally include the following:

a) A statement acknowledging responsibility for establishing and maintaining adequate internal control over financial reporting. b) A statement identifying and specifying the internal-control framework to evaluate the effectiveness of internal control over financial reporting. c) An assessment of the company’s internal control over financial reporting as of the end of the most recent fiscal year. d) Disclosure of any material weakness in the company’s internal control over financial reporting (the latter is deemed ineffective if any material weakness exists). e) A statement that the independent external auditor has issued a report on the company’s assessment of internal control over financial reporting, and f) A statement that the company’s external auditor has examined and reported his/her assessment of requirements under (c) and (d) above.

The first step toward SOX compliance is the establishment of an audit committee composed of financially experienced members of the board of directors, who are independent (in the sense, they perform no other corporate duty, receive no compensation other than their directors’ fees). At least one member of the audit committee must be a financial expert (the SEC will judge the level of expertise based on previous responsibilities, education, and experience with internal controls and the preparation of financial statements). The audit committee will not have members with close family ties among directors such that concentration of power in too few hands is avoided. The audit committee is responsible for hiring and compensating both internal and external auditors and any other consultant, and is thus, a logical body to oversee the entire SOX compliance process. Without meddling with everyday company affairs, the audit committee must be able periodically to access all major financial and accounting transactions to identify, monitor and question any unusual transactions and novel practices within the company. [See Turnaround Executive Exercise 2.5].

By Section 406, titled “Code of Ethics for Senior Financial Officers,” corporations must have a Code of Ethics “applicable to its principal financial officer and comptrollers or principal accounting officer, or persons performing similar functions.” That is, the senior management together with the audit committee must devise a Code of Ethics for the company that focuses on:

1. Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of professional and personal interest; 2. Full, fair, accurate, timely and understandable disclosure of relevant matters in the company’s regular filings, and 3. Compliance with applicable government rules and regulations.

The Code will also prevent improper insider trading. The senior management must explain the code of ethics to all levels of employees, each of whom should receive a copy. The Code should provide for the segregation of conflicting duties, periodic reconciling of accounts, and have these reconciliations reviewed by someone independent of the reconciliation process. [See Turnaround Executive Exercise 2.6].

Costs and Benefits of Sarbanes-Oxley Act

SOX’s benefits to the investor public are obvious (Yallapragada 2007: 69):

a) It has established an accounting industry watchdog; b) It makes CEOs and CFOs responsible for all official financial statements, their procedures of internal controls and their contents; c) It mandates the companies and their auditors to assess the effectiveness of internal controls; d) It strengthens the role of the board of directors, and e) It forbids cozy relationships between accountants and executives.

The major problems with the SOX, however, relate to interpreting of and complying with Section 404. Audit fees have skyrocketed – average cost for a midsize company of implementing SOX, especially Section 404, have been over $1 million. The costs may not justify the benefits of compliance. In fact, implementing SOX has been minting money to accounting firms and trial lawyers (Powell 2005). In this regard, SOX particularly hurts smaller and midsize public companies. SOX also places too much burden on CEOs and CFOs who must divert time from business decisions to internal controls and their effectiveness. Hence, many companies have stopped dealing with NYSE and, instead, chosen foreign stock exchanges, especially the London Stock Exchange (Factor 2006). Whereas from the 1990s, when the vast majority of IPOs were made in the US financial markets, since 2002, there has been a steady migration of IPOs to foreign stock exchanges (Murray 2006).

SOX, moreover, has many ethical challenges. Under SOX, if the company is indicted, the CEO and the board must prove they are directly overseeing and monitoring an ongoing comprehensive ethics program that assures SOX compliance throughout the company. SOX also implies that ethical guidance and reinforcement should come from the top management (Galla, Cavico and Mujitaba 2007). Before SOX, business ethics was important; after SOX, it is mandatory. SOX, however, does not provide clear ethical criteria, leaving the responsibility for ethical and moral education within the company to each organization. SOX assumes that ethical behavior can be enjoined by laws and rules, even though conventional thinking on moral development (e.g., Kohlberg 1969, 1984; Rest and Narvaez 1994) believes that people develop ethical behavior in response to social norms and organizational ethical climate in the environment they work and live, and not from rules. The corporate frauds that plagued the companies were not because existing laws and rules were inadequate. Corporate frauds were executive ethical failures. Corporate executives with their concern for demonstrating high financial performance to shareholders and Wall Street analysts devised creative accounting practices with the collaboration of their accountants, and hence, set a tone for unethical behavior (Verschoor 2004). Can SOX change this unethical behavior through mere rules and penalties?

In 2006, year two of implementing SOX, many companies are still struggling setting effective internal control systems that CEOs, CFOs, and the independent and external auditors can assess and vouch for (Wagner and Ditmar 2006). In this regard, the Public Company Accounting Oversight Board (PCAOB) has come up with various rules, standards, and elaborations that may help companies with SOX compliance. If a company, however, can demonstrate a strong control environment, then it can reduce the overall scope of its internal-control evaluation, reduce in the sense that the company need not carry out as many internal tests and the auditors may do less corroborating, resulting in lower compliance costs.