Corporate Ethics Failures in the US and Lessons to November 6, 2004 Be learned by Managers Around the Globe

Corporate Ethics Failures in the US and UNF Fast Facts Lessons to Be learned by Managers Around the Globe • Number of Students: 14,064 MBA Economics • Student to Faculty ratio: 22:1 Dr. Nowak • In-State Undergraduate Tution:$2,757/year (based on 15 semester credit hours/term Jeffrey E. Michelman, Ph.D., CPA, CMA Associate Professor of Information • Undergraduate degrees: 50 with 115 areas of Systems concentration University of North Florida • Graduate Degrees: 26 with 65 areas of [email protected] concentration

November 6, 2004

What is the 2003 Corruption Perceptions Index? • The TI Corruption Perceptions Index (CPI) for 2003 ranks 133 countries in terms of the degree to which corruption is perceived to exist among public officials and politicians. Glenn E. Estess, Sr. President, • It is a composite index, drawing on 17 different polls and Rotary International surveys from 13 independent institutions carried out among business people and country analysts, including surveys of What we are speaks so loudly that residents, both local and expatriate. • In 2002, the CPI included only 102 countries. people don’t hear what we say. • In 2002, the CPI included only 102 countries. • The large increase in coverage relates to the fact that more Address to District 6970 valid and reputable sources have been found that can be September 20, 2004 incorporated. http://www.transparency.org/

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Country CPI 2003 Surveys Standard High-low CPI 2003 Surveys High-low rank Country Score used deviation range Country Standard Canada 8.7 12 0.9 6.5 - 9.4 rank Country score used deviation range Luxembourg 8.7 6 0.4 8.0 - 9.2 1 Finland 9.7 8 0.3 9.2 - 10.0 11 United Kingdom 8.7 13 0.5 7.8 - 9.2 2 Iceland 9.6 7 0.3 9.2 - 10.0 16 Germany 7.7 11 1.2 4.9 - 9.2 Ireland 7.5 9 0.7 6.5 - 8.8 Denmark 9.5 9 0.4 8.8 - 9.9 18 USA 7.5 13 1.2 4.9 - 9.2

3 New Zealand 9.5 8 0.2 9.2 - 9.6 Estonia 5.5 12 0.6 4.7 - 6.6 33 Uruguay 5.5 7 1.1 4.1 - 7.4 5 Singapore 9.4 12 0.1 9.2 - 9.5 40 Hungary 4.8 13 0.6 4.0 - 5.6 6 Sweden 9.3 11 0.2 8.8 - 9.6 Brazil 3.9 12 0.5 3.3 - 4.7 Bulgaria 3.9 10 0.9 2.8 - 5.7 7 Netherlands 8.9 9 0.3 8.5 - 9.3 54 Czech Republic 3.9 12 0.9 2.6 - 5.6 Australia 8.8 12 0.9 6.7 - 9.5 Mexico 3.6 12 0.6 2.4 - 4.9 Norway 8.8 8 0.5 8.0 - 9.3 64 Poland 3.6 14 1.1 2.4 - 5.6 Mozambique 2.7 5 0.7 2.0 - 3.6 8 Switzerland 8.8 9 0.8 6.9 - 9.4 86 Russia 2.7 16 0.8 1.4 - 4.9

Fraud Triangle Financial Statement

• Financial statement fraud causes a decrease in Perceived Pressure market value of stock of approximately 500 to 1,000 times the amount of the fraud.

$7 million fraud $2 billion drop in stock value

Perceived Opportunity Rationalization

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Current Executive Fraud-Related Problems Largest Bankruptcy Filings • Misstating Financial Statements: Quest, , , WorldCom, etc. Company Assets (Billions) When Filed • Executive Loans and Corporate Looting: John Rigas 1. WorldCom $101.9 July, 2002 (Adelphia), Dennis Kozlowski (Tyco--$170 million—the 2. Enron $63.4 Dec., 2001 $15,000 umbrella stand) 3. Texaco $35.9 April, 1987 • : Martha Stewart, etc. 4. Financial Corp of $33.9 Sept., 1988 • IPO Favoritism: Bernie Ebbers ($11 million) America • CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, 5. Global Crossing $25.5 Jan., 2002 Ford, GE, IBM 6. Adelphia $24.4 June, 2002 (Consulting Contracts, Use of Corporate Planes, Executive 7. United Airlines $22.7 Dec. 2002 Apartments with meals, maids, etc.) 8. PG&E $21.5 June, 2002 • Exorbitant Stock Options for Executives 9. MCorp. $20.2 March, 1989 10. Kmart $17.0 Jan., 2002

WWhyhy So Many Financial Statement Why so many financial statement all of Frauds All of a Sudden? a sudden? 1. Good economy was masking many problems • Good economy was masking many problems 2. Moral decay in society • Moral decay in society 3. Misplaced executive incentives • Executive incentives 4. Unachievable Wall Street expectations—rewards for • Wall Street expectations—rewards for short-term short-term behavior behavior 5. Large amounts of debt and leverage • Nature of accounting rules 6. Nature of accounting rules • Behavior of CPA firms 7. Behavior of CPA firms • Greed by investment banks, commercial banks, and investors 8. Greed by executives, investment banks, commercial • Educator failures banks, and investors 9. Educator failures

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Good Economy Masked Moral Decay Problems • With increasing stock prices, increasing profits and • Attendees at the April, 1998 Business Week Forum of • With increasing stock prices, increasing profits and Chief Financial Officers: increasing wealth for everyone, no one worried about – 67% of CFOs said they had fought off other executives’ potential problems. requests to “misrepresent corporate results” • How to value a dot.com company: – 12% of CFOs admitted they had “yielded to the requests” – Take their loss for the year while 55% said they had “fought off requests” to misrepresent corporate results – Multiply the result by negative 1 to make it positive – Multiply the result by negative 1 to make it positive • Honesty studies – Multiply that number by at least 100 – People are becoming less honest – If stock price is less than the result…buy; if not, buy anyway – Less modeling and labeling • People were making nonsensical investment decisions

Ethical Problems Executive Incentives The Transformation of Andersen • Meeting Wall Street’s Expectations – Stock prices are tied to meeting Wall Street’s earnings • When Leonard Spacek was managing partner of Andersen, forecasts DuPont wanted Andersen to be its auditor but wanted the CPA firm to bless the equity method of accounting in a – Focus is on short-term (quarterly) performance only business combination. Andersen said no and walked away – Companies are heavily punished for not meeting forecasts from the DuPont audit. Another “Big 8” firm won the – Executives have been endowed with hundreds of millions DuPont audit. of dollars worth of stock options—far exceeds salary-based • In Waste Management, Andersen told management it needed compensation (tied to stock price) to change its accounting. Management said “No.” They • Bernie Ebbers (WorldCom) agreed that management would work on several things to fix – 1997 Compensation--$935,000 per year the problem during the coming year. When they arrived for – 1997 Stock options—1.2 million shares at $26 per share— the next year’s audit, Andersen saw that nothing had been stock went to $64.50 ($46.2 million in profit) done. When they asked why, Waste Management stated that – Performance is based on earnings & stock price they were not going to change. Andersen continued to be the auditor and turned a blind eye to the abuses.

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Incentives for F.S. Fraud High Amounts of Debt &

Incentives to commit financial statement fraud are very Leverage • During 2000, Enron’s derivates-related liabilities increased from strong. Investors want decreased risk and high returns. $1.8 billion to $10.5 billion Risk is reduced when variability of earnings is decreased. • Enron hid billions in off-balance sheet (SPE) debt Rewards are increased when income continuously • Enron’s on-balance sheet debt was huge improves. • WorldCom had nearly $100 billion in debt – Not only did Bernie Ebbers borrow $100 billion for WorldCom but he Firm A Firm B also racked up over $1.3 billion in personal debt while CEO of WorldCom • Every company that committed financial statement fraud had huge amounts of debt

186 public companies with $368 billion in debt filed for bankruptcy in 2002—includes WorldCom, Conseco, Global Which firm will have the higher stock price? Crossing, United Airlines

Nature of Accounting Rules • In the U.S., accounting standards are “rules-based” Educators instead of “principles based.” • Haven’t taught “ethics” enough (can’t make up own – Allows companies and auditors to be extremely creative rules to meet own needs) when not specifically prohibited by standards. • Need to teach students about fraud—need a “fraud” – Examples are SPEs and other types of off-balance sheet course—wouldn’t financing, revenue recognition approaches, merger recognize a fraud if it hit reserves, pension accounting, and other accounting schemes. them between the eyes – When the client pushes, without specific rules in every • Need to teach students situation, there is no room for the auditors to say, “You how to think—more can’t do this…because it isn’t GAAP…” analytical skills; less – It is impossible to makes rules for every situation – It is impossible to makes rules for every situation memorization

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Dennis Kozlowski and Tyco Enron Fraud Dennis Kozlowski and Tyco • Compared to other financial statement frauds, Enron was a very complicated fraud. (WorldCom, for example, was a $7 • http://www.cbsnews.com/stories/2003/10/01/nationa billion fraud that involved simply capitalizing expenses (line l/main575962.shtml costs) that should have been expensed (Accounting 200 topic.) Enron involved many complex transactions and accounting issues.

• “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity—although they probably lied too.” http://online.wsj.com/page/0,,2_1040,00.html?mod=home_in_depth_reports Senator John Dingell

http://www.cbsnews.com/stories/2004/03/05/national/main604248.shtml

Enron’s History Role Players • In 1985 after federal deregulation of natural gas pipelines, Enron Enron was born from the merger of Houston Natural Gas and Andersen InterNorth, a Nebraska pipeline company. – • Enron incurred massive debt and no longer had exclusive rights to Founding and last CEO David Duncan – its pipelines. Audit Partner • Needed new and innovative business strategy • Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a young consultant Jeff Skilling – named Jeffrey Skilling. CEO from 2/2001 to 8/2001 Michael Odom – • His background was in banking and asset and liability Risk Mgt Partner management. • His recommendation: that Enron create a “Gas Bank”—to buy – and sell gas CFO Nancy Temple – • Feb. 2001-- Fortune magazine names Enron “The Most Innovative Firm Attorney Company in America” -- company was worth $60 billion • Dec. 2001 – Enron files the biggest bankruptcy in U.S. history Michael Kopper – (now exceeded by WorldCom) Assistant to Fastow

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Aggressive Nature of Enron Enron’s Arrogance “Those whom the Gods would destroy they first make • Because Enron believed it was leading a proud.” revolution, it pushed the rules. – Employees attempted to crush not just outsiders but Enron’s banner in lobby: Changed from “The World’s each other. Leading Energy Company” to “THE WORLD’S – “Enron was built to maximize value by maximizing LEADING COMPANY” the individual parts. – “Enron traders were afraid to go to the bathroom “Older, stodgier companies will topple over from their because the guy sitting next to them might use own weight…” Skilling information off their screen to trade against them.” Conference of Utility Executives in 2000: “We’re going to eat your lunch”….Jeff Skilling Enron took more risk than others—”it swung for the fences.”

Ken Lay • Ken Lay Son of a Baptist minister, grew up in Tyrone, Mo. Earned doctorate in economics Jeff Skilling from University of Houston. • Jeff Skilling Earned MBA from Harvard and went to work for McKinsey & Co., world's – Was perhaps Houston's most influential power largest management consulting firm... broker. Helped win approval for baseball park and was close to major politicians. ... – Joined Enron in 1990, drove it from a – In 1984, became chairman and CEO at Houston lumbering pipelinepipeline companycompany intointo Natural Gas. It merged with InterNorth within a year, and the new something akin to a Wall Street trading house ... company was dubbed Enron. ... Resigned Jan. 23, 2002. Became president and chief operating officer in 1997 • Legal status: Lay awaiting trial on 11 criminal counts, – Named CEO in February 2001, resigned just six months later. including to commit wire and , perpetrating wire, securities and bank fraud, and making • Legal status: Named in 35-count indictment accusing him of insider trading, securities fraud, wire fraud, false and misleading statements to employees at a company conspiracy and lying on Enron financial statements. meeting, as well as to banks, securities analysts and corporate – Prosecutors are seeking his River Oaks mansion, and credit-rating agencies. he could theoretically get 325 years in prison, plus $80 HoustonChronicle.com million in fines. HoustonChronicle.com

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Lea Fastow Andrew Fastow Lea Fastow • Lea Fastow Comes from prominent Weingarten • Andrew Fastow Earned MBA from family, which once owned area's dominant Northwestern ... Joined Enron in 1990 ... supermarkets... – A protege of Skilling, who named him – Met husband, Andrew, at Tufts University chief financial officer ... Lauded by CFO outside Boston, graduating with him in 1984, Magazine for "innovative financing techniques" ... working with him at Continental Bank in and – Set up off-the-books partnerships that benefited Enron earning MBA with him at Northwestern University... by hiding debt and inflating revenue ... Dismissed Oct. – Rose to become assistant treasurer at Enron -- she served as 24, 2001. executive assistant of one of Enron's dubious off-the-book • Legal status: Facing 98 counts, he pleaded guilty in January partnerships -- but left in 1997 to care for her sons. 2004 to one charge of conspiracy to commit wire fraud and • Legal status: Pleaded guilty to one tax misdemeanor for one charge of conspiracy to commit wire and securities not reporting personal income from an Enron side deal on fraud. her 2000 return. – He is to serve 10 years, forfeit $23.8 million, including – Sentenced to one year and prison and one year of homes in Galveston and Vermont, and forfeit claims on supervision after her release. another $6 million. HoustonChronicle.com HoustonChronicle.com

Sherron Watkins Michael Kopper • Sherron Watkins Attended high school in • Michael Kopper Majored in economics at Duke Tomball ... Earned bachelor's and master's University, earned a graduate degree at the degrees at University of London School of Economics ... – Wrote now-famous memo to Ken Lay on – Worked at Toronto Dominion Bank before joining Aug. 15, 2001, describing , then Enron in 1994 ... met with him to discuss her concerns ... – Became key aide to Chief Financial Officer Andrew Fastow and – Resigning as Enron vice president after its bankruptcy, she co- helped create off-the-books partnerships. wrote a book, Power Failure: The Inside Story of the Collapse of Enron, • Legal status: Admitted giving kickbacks to Fastow and of Enron, about her experiences at Enron. pleaded guilty to money laundering and wire fraud in – Named one of Time magazine's Persons of the Year for 2002, she is a familiar face on the nation's public lecture circuit. August 2002. He is awaiting sentencing.

HoustonChronicle.com HoustonChronicle.com

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Ben Glisan Jr. ExecutiveExecutive • Ben Glisan Jr. Clear Lake native, earned bachelor's and master's degrees from UT – ... Worked for Coopers & Lybrand accounting firm in and in Houston SummarySummary before joining Enron in 1996 ... – Rose to treasurer in 2000 ... Earned $1 million on $5,800 This study covers 508 investment in one partnership ... Fired in February 2002. cases of occupational • Legal status: Pleaded guilty to one count of conspiracy to commit wire and security fraud in September 2003 but did fraud totaling over not agree to cooperate with prosecutors. $761 million in – The first Enron figure to go to prison, he is serving five years. losses. Forfeited $900,000 seized by government, plus $412,000 in taxes he paid on the money.

HoustonChronicle.com

Executive Summary Executive Summary Executive Summary • This study covers 508 cases of occupational fraud • Our data strongly supports Sarbanes-Oxley’s requirement for audit committees to establish totaling over $761 million in losses. All information confidential reporting mechanisms. Occupational was provided by the Certified Fraud Examiners (CFEs) frauds in our study were much more likely to be who investigated these cases. detected by a tip than through other means such as • Organizations suffer tremendous costs as a result of internal audits, external audits, and internal controls. occupational fraud and abuse. Participants in this • Among frauds committed by owners and executives, study, anti-fraud specialists with a median 16 years’ which tend to be the most costly, over half of all cases experience in the fraud examination field, estimate that were identified by a tip. the typical U.S. organization loses 6% of its annual • Confidential reporting mechanisms reduce fraud revenues to fraud. losses significantly. The median loss among organizations that had anonymous reporting • Applied to the US Gross Domestic Product for 2003, this mechanisms was $56,500. translates to approximately $660 billion in total losses.

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Executive Summary Executive Summary Executive Summary • While Sarbanes-Oxley only requires publicly traded • More effective internal controls are needed to detect companies to establish confidential reporting fraud. Internal controls ranked fourth – behind By mechanisms for employees, our data strongly suggests Accident – in terms of the number of frauds detected in that these programs should also embrace third-party our study. sources such as customers and vendors. • Furthermore, the frauds that were detected by internal • AmongAmong cases that were detected by a tip, 60% of the tips came controls tended to be relatively small, with a median loss from employees, 20% of the tips came from customers, 16% of $40,000, which was by far the lowest of any detection came from vendors, and 13% came from anonymous sources. method. • Companies that have implemented basic employee hotlines to • More effective types of internal controls are needed to ensure Sarbanes-Oxley compliance could detect significantly detect fraud, especially larger frauds that may involve more frauds by making their hotlines available to third parties senior personnel overriding or circumventing traditional as well. internal controls.

Executive Summary Executive Summary Executive Summary • Small businesses suffer disproportionately large losses due to occupational fraud and abuse. The • The median recovery among victim organizations in median cost experienced by small businesses in our study our study was only 20% of the original loss. Almost was $98,000. 40% of victims recovered nothing at all. • This was higher than the median loss experienced by all • Despite this fact, organizations were less likely to but the very largest organizations. Small businesses are but the very largest organizations. Small businesses are take legal action against owners and executives who less likely to be able to survive such losses and should take legal action against owners and executives who better protect themselves from fraud. had committed fraud than they were against • The loss caused by occupational fraud is directly employees and managers. related to the position of the perpetrator. Frauds • This may remove a useful deterrent and committed by owners and executives caused a median unnecessarily expose such organizations to additional loss of $900,000, which was six times higher than the loss of $900,000, which was six times higher than the high-dollar frauds. losses caused by managers, and 14 times higher than the losses caused by employees.

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Executive Summary • Most occupational fraudsters are first time offenders. Only 12% of the fraudsters in our study had a previous conviction for a fraud-related offense. The WorldCom Fraud • Criminal background checks can help organizations make informed hiring decisions, but they will not weed out all fraudsters because most frauds are committed by apparently honest employees. • The most cost-effective way to deal with fraud is to prevent it. According to our study, once an organization has been defrauded it is unlikely to recover its losses. • The median recovery among victim organizations in our study was only 20% of the original loss. Almost http://www.cbsnews.com/stories/2002/06/25/national/main513425.shtml 40% of victims recovered nothing at all.

Martha Stewart and Martha Stewart and Samuel Waksal (cont.) • What's Happened: Dr. Waksal was sentenced to 87 months in prison Samuel Waksal after pleading guilty to charges that included securities fraud. • The Allegations: Authorities believe company founder Dr. – He must pay more than $4 million in fines and back taxes and was banned for life Samuel Waksal tipped off family and friends that the drug from leading a public company. maker's application for a promising cancer drug was about to – The SEC brought civil insider-trading charges against Dr. Waksal's father, Jack maker's application for a promising cancer drug was about to Waksal. Ms. Stewart and Mr. Bacanovic were indicted on charges including be rejected, allowing them to dump the stock before it obstruction of justice, tied to Ms. Stewart's sale of ImClone shares. Both pleaded tumbled. not guilty. – Mr. Faneuil pleaded guilty and became the government's star witness in the • Dr. Waksal shared the same broker with his close friend criminal trial of Ms. Stewart and Mr. Bacanovic. Martha Stewart, and authorities believe the broker arranged – The judge in that trial dismissed the most serious charge of securities fraud against to tip off Ms. Stewart that Dr. Waksal's family was selling Ms. Stewart. The jury convicted her on the remaining counts and Mr. Bacanovic on stock. all counts but one. • Ms. Stewart has resigned all of her posts at her media empire. She still • Who's Who: faces an SEC civil complaint against her for insider trading. – Dr. Samuel Waksal, former CEO • What's Next: Ms. Stewart was sentenced July 16 to 5 months in prison, – Martha Stewart, decorating guru and Waksal friend 5 months of home confinement and two years probation, plus a $30,000 – Peter Bacanovic, Lynch broker for Dr. Waksal and Ms. fine. The judge ordered a stay of sentence pending her appeal. Mr. Stewart Bacanovic received a similar sentence, but his fine was set at $4,000. An unfavorable verdict against Ms. Stewart in the civil case may mean other – Douglas Faneuil, Merrill Lynch brokerage assistant fines and other penalties.

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