Ethics in FinanceAdvanced Managerial Finance

Spring 2013

Ethics in FinanceEthics has always been important in finance.Ethics and economics were once taught together. Adam

Smith was a scholar of moral philosophy.Recent events (financial crisis of 2007-2008) however,

have concentrated the attention of the public on the finance discipline.

Many in the public have the perception that unethical behavior on the part of investment bankers is mainly responsible for the crisis and its aftermath: bankruptcies, foreclosures, unemployment, etc.

Financial innovation or engineering allow U.S. and foreign investors (some unwillingly) to invest in the U.S. housing market. MBS and CDOs

Ethics in FinanceLearning goal 6: BBA graduates will develop

ethical decision-making skills (from the AOL COBA document)

“Ethics, also known as moral philosophy, is a branch of philosophy that involves systematizing, defending, and recommending concepts of right and wrong behavior.”

“Ethics is the branch of study dealing with what is the proper course of action for man.”

Ethics in FinanceCorporate scandals have prompted the U.S.

government to pass the following two financial reforms:

The Sarbanes–Oxley Act of 2002 is a United States federal law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms.

Wall Street Reform and Consumer Protection Act of 2010.

Ethics in Finance Sarbanes–Oxley Act: contains 11 titles that describe specific mandates and

requirements for financial reporting.1. Public Company Accounting Oversight Board (PCAOB): oversight of public

accounting firms 2. Auditor Independence 3. Corporate Responsibility: Specifies the responsibility of corporate officers for

the accuracy and validity of corporate financial reports. Section 302 requires that the company's CEO and CFO certify the integrity of their company financial reports .

4. Enhanced Financial Disclosures: pro-forma figures and stock transactions of corporate officers

5. Analyst Conflicts of Interest 6. Commission Resources and Authority 7. Studies and Reports 8. Corporate and Criminal Fraud Accountability 9. White Collar Crime Penalty Enhancement10. Corporate Tax Returns : CEO must sight the firm’s tax returns11. Corporate Fraud Accountability

Ethics in FinanceThe Sarbanes–Oxley Act of 2002

“The Act changes the existing regulatory structure, such as creating a host of new agencies in an effort to streamline the regulatory process, increasing oversight of specific institutions regarded as a systemic risk, amending the Federal Reserve Act, promoting transparency, and additional changes. The Act purports to provide rigorous standards and supervision to protect the economy and American consumers, investors and businesses, purports to end taxpayer funded bailouts of financial institutions, claims to provide for an advanced warning system on the stability of the economy, creates rules on executive compensation and corporate governance.”

Ethics in FinanceCan these regulations make managers more

ethical?Do they help managers to distinguish

between right and wrong?Can rules and regulations alone prevent

future corporate scandals and fraud?Can these rules be counterproductive?

Ethics in FinanceWorldCom Inc.The firm falsified $11 billion in operating profits!Background

Firms invested heavily in telecommunications leading to an oversupplied market.

Firm had used unrealistic expectations of growth in Internet use.

Collapse of the Internet bubble put the firm in jeopardy.

Firm’s costs were largely fixed and had high operating leverage.

Ethics in FinanceWorldCom Inc.The firm falsified $11 billion in operating profits!Background

Firms invested heavily in telecommunications leading to an oversupplied market.

Firm had used unrealistic expectations of growth in Internet use.

Collapse of the Internet bubble put the firm in jeopardy.Firm’s costs were largely fixed and had high operating

leverage.Even small declines in revenues led to sharp declines in

earnings.

Ethics in FinanceBeginning of the end…

3rd quarter of 2000 WorldCom faced $685 million in write-offs as customers defaulted on lease commitments. The CFO, Scott Sullivan, pressured 3 accounting

managers to move operating expenses to the firm’s reserve accounts.

1st quarter of 2001 the firm loses $771 million. CFO directs accounting managers to shift operating costs to capital-expenditure accounts.

This accounting practice continued for all of 2001 and the firm planned to implement it for all of 2002.

Ethics in FinanceThe SEC became suspicious of the abnormally

positive financial performance of WorldCom. The firm ordered and internal auditing of the books.

The three accounting managers met with the SEC, the FBI and the U.S. attorney’s office. WorldCom’s internal auditor revealed on June 25, 2002 the discovery of $3.8 billion in fraudulent accounting.

Additionally it was revealed WorldCom had shifted $7.2 billion to its MCI subsidiary.

WorldCom lost $180 of its equity market value in 2002.

Ethics in FinanceThe three accounting managers, Scott

Sullivan and Berbard Ebbers (CEO) were all convicted of fraud and sentenced to jail.

Other unethical behaviors included the falsification of WorldCom’s board minutes to approve the acquisiton of Intermedia Communications Inc. in 2001.

WorldCom filed for bankruptcy and emerged from it as MCI Communications. Verizon acquired the firm in 2005.

Ethics in FinanceCan these regulations make managers more

ethical?Do they help managers to distinguish

between right and wrong?Can rules and regulations alone prevent

future corporate scandals and fraud?Can these rules be counterproductive?

Ethics in FinanceThe shields against fraud are:

A culture of integrityStrong governance

rules, processes, or laws by which businesses are operated, regulated, and controlled

Strong financial monitoring

What is the Agency Problem in a corporation?

Ethics in FinanceThe conflict that arises between managers of

a corporation and its shareholders due to the separation of management and ownership.

Managers prefer projects that generate revenue today at the expense of long-term projects that sustain the firm’s long-term financial performance.

How can the shareholders align their best interest with that of the managers?

Ethics in Finance1. Executive compensation

Performance bonuses Stock options

2. Market for corporate control Hostile takeovers Proxy fights Leveraged buyouts

Ethics in FinanceMichael Jensen in a paper published in 2005

argues that:Executive compensation can be

counterproductive because it can lead to the manipulation of the firm’s financial performance or to pursue a culture of aggressive growth at any cost. Equity compensation just adds fuel to the fire.

The market for corporate control solves the problem of undervalued equity but offers little remedy for the case of overvalued equity.

Ethics in FinanceSo why is ethics important in finance?

Because ultimately only managers doing the right thing can prevent corporate fraud. Regulations can’t.

Five positive arguments for bringing ethics into financial decision making:

1. Sustainability2. Ethical behavior builds trust3. Ethical behavior builds teams and

leadership, which promotes excellence

Ethics in Finance4. Ethics sets a higher standard than laws and

regulations: they tend to trail rather than anticipate behavior

5. Reputation and consience

Ethics in Finance Steps to promote ethical behavior in your

firm Adopt a code of ethics Talk about ethics with your team and firm Reflect on your dilemmas Lead by example