Analysis and Critique of Current Cases

USE COURSE NOTES AND READINGS Term Paper Guidelines For this assignment you will prepare your term paper essay as you proposed in Assignment 1. Please see the attached document which provides detailed instructions and guidance on the format and content requirements for your term paper. Review the requirements carefully! Re-review them before submitting the term paper to make sure you have met all requirements and followed the prescribed format! As you prepare and write your Term Paper assignment, please note the instructions below regarding formatting. It mostly reflects the outline that you received to assist in developing your essay proposal. You must adhere to these basic headings. Marks will be deducted for failure to use these headings. You can add additional headings that will improve the understandability of your essay. Include source materials from the lesson readings but you must also show that you completed your own research. Sources that are acceptable include: books, articles from scholarly journals, newspaper articles, and magazine articles. Do not include Wikipedia or Internet Encyclopedias as references. Your use of source materials will be included in the content grading. Footnoting is required to avoid plagiarism as well as to provide information for the readers so that your sources can be consulted for detailed review. Title Page Abstract – on its own page Introduction • Establish your key points or arguments. • Explain why the subject was chosen for study • State the purpose of your essay – your thesis statement The body of your essay including discussion • Present your ideas in a logical flow. You must demonstrate that you are able to apply the concepts from the course to your topic. This requires appropriate referencing of all sources. • Be sure to include competing points of view and then explain how your perspective on the topic is based on your readings. • Your paper must reflect your analysis and critique of the information that you have learned from the weekly readings. Analysis and application of concepts is essential so avoid merely reciting what you have read or enumerating facts. You must provide evidence-based arguments that connect or substantiate the main argument that you have set out in your introduction. Conclusion • Reference the purpose of your essay as stated in the introduction . • Summarize your key points. References • Properly cite all references using APA style.

Lesson 1

The integrity of a corporation is often equated to the behaviour of its leadership.  We have witnessed many dramatic and tragic examples of corporate fraud by senior executives who have not only compromised the corporations that they lead, but also the shareholders who have, perhaps naively, felt confidence in the integrity of leadership. Accounting firms, entrusted to protect the public interest, have themselves been found guilty of obstruction of justice.

White-collar crime is a generic term introduced by Edwin Sutherland in the 1939 for crimes involving commercial fraud, investor and consumer fraud, insider trading, embezzlement and other forms of dishonest business ethics. The term comes from the perception that these are crimes committed by persons of respectability in the higher echelons of a corporation.  The link to white collars is the view that these fraudsters wear white shirts and do not use physical force to commit illegal acts but commit fraud through deception and trickery.

A robber who threatens violence may affect only one individual.  A corporate ‘robber’ can victimize thousands. Sometimes, it appears that the justice system punishes the robber more severely than the executive who may have cheated shareholders out of millions of dollars. The fact that there are real victims of white-collar crime cannot be denied. Corporate corruption, executive ‘looting’ and white collar crime can lead to lost investments for investors, retirement savings pension and employee pension funds.

Corporate fraud cases have become well known across North America.  Enron, WorldCom and Tyco are American examples. Nortel, Royal Group Technologies Ltd., Cinar, Earl Jones, Vincent Lacroix, Livent are Canadian examples. Canadians are now learning about penny stock scams, such as the Hollinger, YBM Magnex, Atlas Cold Storage (accounting fraud), and the Ian Thow investing scandal. The Bre-X fraud case illustrates that billions of dollars can be lost in corporate fraud cases.

Income trust cases include Portus Alternative Asset Management Inc. and Portus hedge fund.  The Norbourg Asset Management Limited case involved mutual fund investments by 9,200 investors and $130 million in funds that were misappropriated due to management misconduct.

Aside from the personal losses involved in these cases, another ramification is the crisis of confidence in stock markets. This highlights the need for changes in audit practices to return public confidence in the financial system. Some suggest, however, that real change will only arise from changing the culture of greed and focus on short-term profits.

According to Whitney D. Gunter of York College in Pennsylvania, white collar crime occurs when four essential dimensions converge at one time: Money, Trust, Greed, and Opportunity. Money, Opportunity, and Trust are dimensions that are external to the person.  They can be addressed through appropriate internal management controls and a culture of corporate ethics so that every single employee understands legal and ethical responsibilities.

Greed, however, is intrinsic to the human condition. Some suggest that greed and corruption among corporate executives constitute the major reason for the increase in corporate fraud witnessed during the past two decades.  Sutherland once said that white-collar crime can happen “if, and only if, the weight of favorable definition [to crime] exceeds the weight of the unfavorable definitions.” This translates into “a person will commit a crime when there is a belief that the benefits outweigh the risks”. Therefore, there needs to be obvious and severe consequences for corporate criminals that demonstrate that crimes for profit will ultimately be detected and the perpetrators punished. This risk of punishment needs to be understood in the boardroom and in corporate culture and communities.

Through the course materials, you will be introduced to theories regarding the external and internal factors that engender corporate deviance. Some theories focus on the individual while others focus on

the social context.  Edwin Sutherland introduced the differential association theory that explains how deviance is influenced by the environment in deciding which norms people learn to violate. You will also look at the differential opportunity theory developed by Richard Cloward and Lloyd Ohlin and Robert Merton’s anomie strain theory as an explanation for corporate fraud.

Within current business literature, the topic of Corporate Governance is gaining attention.  Shareholders are typically unable to monitor management with sufficient rigor to identify fraud. Internal monitoring mechanisms, such as a supervisory board (composed of non-executives), can be helpful if they are allowed to operate with independence and full disclosure from the corporation. Other weaknesses in effective governance to address fraud have been noted within the American context, where government regulatory departments are often managed by the corporations that are to be regulated such as the FDA, USDA, and FTC.

Canada is not immune to accusations of government and political participation in corporate fraud (e.g. the sponsorship scandal, which involved the misuse and misdirection of public funds which were intended for government advertising in Quebec).

Further to the Enron Tyco and WorldCom cases, the United States government passed the Sarbanes Oxley Act of 2002 that was designed to increase corporate transparency and safeguards for investors.  This act has led to stronger auditing tools and guidelines for corporate directors who have a legal responsibility to follow these guidelines.

There is no doubt that government regulations are necessary to address corporate fraud. The Canadian government has recently introduced legislation that sets out mandatory minimum terms of imprisonment for corporate fraud.  In the Earl Jones Canadian $50 million Ponzi scheme, Earl Jones was sentenced to 11 years imprisonment with an early release potential for 2011. In comparison, Bernie Madoff found guilty of a larger multibillion dollar Ponzi scheme was sentenced to 150 years in prison.

The corporate scandals of late came as a great shock not because of the enormity of failures, but because of the discovery of questionable accounting practice that was prevalent and widespread within the corporation. In the aftermath of these scandals, the public was informed that accounting irregularities and lack of proper oversight played a significant role in the misleading financial position and demise of the company. A crucial element in the success or failure of any business is the financial reporting necessary for the corporate governance system to function effectively.

The ethics of business

Business Ethics are moral principles and values that seek to determine right and wrong in the business world.

Business ethics require entrepreneurs and other business persons to conform to principles of commercial morality, fairness, and honesty.

Lesson 2

Corporate fraud has a historic record of creating public scandals that have victimized society from an economic, psychological, and political perspective. In your readings, you may come across statements such as ‘fraud is a victimless crime’ that you must carefully consider before accepting at face value.

Organizations, employees and investors all suffer from the consequences of fraud. Later lessons will deal with punishment for corporate fraud and the types of deterrents such as incarceration or financial penalties.

Corporate fraud occurs when a corporation deliberately conceals or falsifies information to appear healthy and successful before shareholders. Companies that provide or communicate falsified financial information are committing corporate or shareholder fraud. Corporate fraud may involve a few individuals or many, depending on the extent to which employees are informed of their company’s financial practices. Directors of corporations may doctor financial records or disguise inappropriate spending. Fraud committed by corporations can be devastating, not only for outside investors who have made share purchases based on false information, but also for employees who often suffer the consequences when the true financial situation of the company is exposed.

Corporate crime can be complex and multi-faceted and refers to criminal acts committed by a corporation or by an individual acting on behalf of that corporation. It entails executives and executive officers engaging in illegal activity that are intended to benefit or support the interests of the corporation. In so doing, these actions taken on behalf of the corporation may subsequently benefit the careers and finances of the individuals.

In corporate crime the victims or potential victims are

• the general public (Illegal dumping of waste into the environment);
• the consumer (e.g. price fixing or the sale of inferior or unsafe products);
• the employee (e.g. unsafe working conditions);
• the government (e.g. tax evasion); or,
• a competitor (conspiracy with another organization in price fixing to elimination the competition).

Corporate crime is often confused with white-collar crime because in both cases the perpetrator typically has some sort of personal benefit resulting from their actions. :

White-collar crime is defined as deliberate acts motivated for personal benefit (prestige) or profit. The perpetrators of white-collar crimes are usually senior executives whose hierarchical positions give them decision-making authority and the independence to enable fraud. A white-collar crime involves a breach of trust that often leads to criminal offences of embezzlement or fraud.

Corporate crime also almost always is committed for financial benefit. However, the benefits are secondary. Corporate crime first benefits the organization through increased stock prices, capital investments, or higher purchase prices for assets or the actual company. Corporate crime also benefits the individuals involved at a secondary level. This may be in the form of increased income including bonuses or higher values of stock prices which benefits executives with remuneration packages that include stock options, shares, or registered stock units.  Corporate crime may also encourage passive complicity, as there are inherent risks for employees who suspect crime to lose their employment; therefore, silence to protect the criminal employee may occur.

Although there are a various forms of corporate crime, it most often encompasses fraud, embezzlement, bribery, tax evasion and cover-ups.

For an individual to be held accountable for crimes where the punishment could include incarceration, he or she must have acted outside the legal boundaries set by law or specific to the corporation.  The act must have been intended to illegally benefit a certain party causing foreseeable deprivation or inconvenience to another. This would include cases of embezzlement and fraud as well as product liability cases where corporations knowingly or negligently produce products that could cause harm to others.

To find the line between criminal behavior and acts that may offend some but are totally legal is complex. Consider the case where very large bonus payments are made to senior executive of companies despite the fact that shareholders have lost money and even employees have been laid off or terminated to cut costs. One must examine how a corporation works the responsibility of the corporation to the shareholders and, whether any federal or provincial regulations were violated at the time of the alleged corporate criminal act.

This distinction is an important one. Activities that might be considered breach of law such as corporate espionage are known to occur.  This includes theft of physical and intellectual property. However, these practices are not usually handled as corporate crime since no complaints are brought forward to law enforcement.  In part this is because corporate secrets might have to be revealed in court. Thus, in practice, charges of corporate criminal activity by one corporation against another are usually limited.

Corporate crimes against the corporation’s shareholders are almost always related to fraud resulting from misrepresentation of the corporation’s past earnings or potential for future earnings. Individual CEO’s have been accused of using a corporation’s assets as they would those of a sole-proprietor business. It could be determined that the CEO should be charged with embezzlement.

The nature of corporate crime depends heavily on the ‘doctrine of corporate personhood’. In the law, a corporation has the legal status of a person. This status, known as ‘corporate personhood’, enables a corporation to enter into contracts, own property, and issue bonds, and also gives its investors some protection from personal liability.

White-collar crime is a broad term that encompasses many types, most often of nonviolent criminal offenses involving fraud and illegal financial transactions. White-collar crimes include bank fraud, bribery, blackmail, counterfeiting, theft, embezzlement, forgery, insider trading, money laundering, tax evasion, and antitrust violations. As you have learned previously, it is difficult to determine the extent of these crimes because many incidents are not reported.

The concept of white-collar crime was introduced in 1939 by Edwin H. Sutherland.  He defined white-collar crime “as a crime committed by a person of respectability and high social status in the course of his occupation.” His theory also noted that people are more likely to commit crimes when they are surrounded by others engaged in criminal behavior. Sutherland expressed his concern about the lack of attention paid by law enforcement agencies to the investigation and apprehension of offenders when they had higher status occupations.

Today, the definition of white-collar crime may still be suggestive of the socio-economic status of the person committing the crime. A person in a middle or upper class position is often considered to have committed a white-collar crime. However, where the crime is violent in nature, it is not typically considered a white-collar crime.

There is some confusion regarding the appropriate distinction between white-collar crime and occupational fraud.  Occupational fraud is usually considered within three categories: asset misappropriation, corruption and bribery, and financial statement fraud.  Of course, sometimes all three kinds of fraud can be occurring at one time.

Asset misappropriations are the most common type of internal fraud. This includes taking cash, stealing inventory or equipment, payroll fraud, tampering with company cheques and billing schemes that pay out to the person not the company.

Corruption schemes include bribes and kickbacks from vendors who overcharge the company.

Financial statement frauds are aimed at enhancing the financial statements, producing an indirect benefit such as a larger bonus, increased stock price, or higher profit sharing. Financial statement fraud includes things like overstating a company’s revenue or assets and understating the liabilities and expenses.

The common characteristics of occupational fraudster are that they have more access to the operation and systems which makes it easier it to commit the fraud. As employees advance in their position or status, they are generally afforded more access to information, assets, and computer systems. This access and opportunity can make it very tempting to commit fraud.

Fraud isn’t limited to those who are senior in the organization; collusion between a senior manager and lower-level employees who may be better positioned to cover up the fraud is not uncommon.

A thought to consider, which can make the water murky when attempting to differentiate between white-collar crime and occupational fraud, is that individuals who commit fraudulent statement fraud are often in “high status” positions and thus labeled as white-collar criminals. Individuals involved in asset misappropriation or corruption more closely resemble “lower” and “middle class” offenders and may be labeled as occupational fraudsters.

In this lesson you focused on defining the terms associated with fraudulent activity within the business context. Next week’s lesson will focus on the laws that outline contravention or breach of corporate norms.

Lesson 3

Fraud can be defined as deceitful conduct that is designed to manipulate the victim to relinquish control or possession of something of value to the perpetrator. The offence of fraud is contained in section 380(1) of the Criminal Code of Canada (and is shown here in italics) and is described as:

(1) Every one who, by deceit, falsehood or other fraudulent means, whether or not it is a false pretense within the meaning of this Act, defrauds the public or any person, whether ascertained or not, of any property, money or valuable security or any service,

(a) is guilty of an indictable offence and liable to a term of imprisonment not exceeding fourteen years, where the subject-matter of the offence is a testamentary instrument or the value of the subject-matter of the offence exceeds five thousand dollars; or

(b) is guilty of

(i) an indictable offence and is liable to imprisonment for a term not exceeding two years, or

(ii) an offence punishable on summary conviction, where the value of the subject-matter of the offence does not exceed five thousand dollars.

The second part of the fraud section is designed to protect the investor(s) from fraudulent stock exchange transactions.

(2) Affecting Public Market

Every one who, by deceit, falsehood or other fraudulent means, whether or not it is a false pretense within the meaning of this Act, with intent to defraud, affects the public market price of stocks, shares, merchandise or anything that is offered for sale to the public is guilty of an indictable offence and liable to imprisonment for a term not exceeding fourteen years.

Section 382 and 382.1 of the Criminal Code is detailed and deals with criminal offences of fraudulent manipulation of stock exchange transactions and the prohibited insider trading and tipping inside information.

Although inside trading is prohibited under the Canada Business Corporations Act and under provincial securities law. These sections in the Criminal Code were enacted in the aftermath of the Enron and WorldCom incidences in the United States to deal with serious cases that warrant severe criminal penalties.

Section 397(1) Falsification of Books and Documents

(1) Everyone who, with intent to defraud,

(a)  destroys, mutilates, alters, falsifies or makes a false entry in, or

(b)  omits a material particular from, or alters a material particular in, a book, paper, writing, valuable security or document is guilty of an indictable offence and liable to imprisonment for a term not exceeding five years.

Privy

2) Everyone who, with intent to defraud his creditors, is privy to the commission of an offence under subsection (1) is guilty of an indictable offence and liable to imprisonment for a term not exceeding five years.

Section 400(1) False Prospectus

(1) Everyone who makes, circulates or publishes a prospectus, a statement or an account, whether written or oral, that he knows is false in a material particular, with intent

(a) to induce persons, whether ascertained or not, to become shareholders or partners in a company,

(b) to deceive or defraud the members, shareholders or creditors, whether ascertained or not, of a company, or

(c) to induce any person to

(i) entrust or advance anything to a company, or

(ii) enter into any security for the benefit of a company, is guilty of an indictable offence and liable to imprisonment for a term not exceeding ten years.

Definition of “company”

(2) In this section, “company” means a syndicate, body corporate or company, whether existing or proposed to be created.

Fraud occurs when there is a deliberate intent to deprive someone by deceit of property, money, valuable security, or service. The essential ingredients in committing the offence of fraud are deceit, falsehood or other fraudulent means and the mental element of subjective knowledge. The actual loss and deprivation is not an essential element of the offence. Carrying out the act or “performance” whether there is any loss/deprivation or consequences to the victim, warrants the offence of fraud.

In contrast to theft, fraud requires that the victim is an active and willing participant or at least allows the fraud to occur because of deceit in parting with the property or willing to give the perpetrator the property. In a situation of theft, however, the act is overt as the victim is unwilling but forced to part with the property.

With respect to sentencing, in 2009 the Canadian government enacted legislation specific to white-collar crime. As a result, anyone convicted of a fraud that exceeds $1 million will receive a mandatory minimum term of imprisonment of two years.  In addition, judges may consider factors such as the degree of the planning involved the complexity and duration of the fraudulent conduct and the financial and psychological impact that the fraud has had on the victim(s).

The question is whether these punishments will deter future fraud. As prescribed in the Criminal Code anyone guilty of an indictable offence is liable to term of imprisonment that is not to exceed fourteen years, where the subject-matter of the offence is a testamentary instrument or the value of the subject-matter of the offence exceeds five thousand dollars.

Recently in Canada white-collar crime has received some notoriety. Milowe Brost and Gary Sorenson were arrested for a $400 million scheme that channeled funds through a highly complicated series of companies.  Thousands of people were victims of this scheme.

Ian Thow was found guilty of defrauding victims of $8 million. After pleading guilty to 20 counts of fraud, he was sentenced to nine years in prison.

Norbourg Asset Management involved mutual fund investments by 9,200 investors and the misappropriation of $130 million due to management misconduct. The CEO Vincent Lacroix was sentenced to 12 years in prison and fined $255,000 on fifty-one charges.  After serving a sixth of his sentence, Vincent Lacroix was transferred to a halfway house.

Earl Jones surrendered to the police on July 27, 2009 and was released the next day on $30,000 bail. He was charged with fraud, conducting a Ponzi scheme involving approximately 130 investors who were defrauded of $50 million. In February 2010, Earl Jones plead guilty and was sentenced to an 11 years prison term. He will be eligible for conditional release after serving a sixth of the sentences in 22 months.

Lesson 4

There are many theories and psychological studies developed to explain the internal and external factors that influence an individual to commit fraud. The following theories such as anomie theory, social learning theory, organization theory, control theory, and rational choice theory can be applied to corporate fraud behaviors.

Differential Association Theory

Since Edwin Sutherland introduced the Differential Association theory, there have been many criminological theories that have adapted his basic principle. Sutherland suggests that crime is learned from frequent social interaction with other people who engage in this behavior. It is through this association that the individual adopts the attitudes, techniques, and motives for criminal behavior. The differential association theory contends that an individual with constant exposure to deviant or criminal behavior may begin to act in a similar manner.

Anomie Theory

Durkheim introduced the concept of anomie.  This term refers to a condition of social and cultural instability when formerly held values are no longer considered as viable or are absent.  The consequences of anomie have been identified as delinquency, crime, and suicide.  These can be the reactions to anomie or ‘normlessness’ in society.

Strain Theory

Strain theory identifies criminal behavior as the result of frustration and anger because socioeconomic goals cannot be achieved as desired by the individual. Merton argues that the distribution of wealth and opportunity in western society is unequal. This inequity places pressures on people differently and can lead to criminal acts to gain what is desired.  Agnew looked at the strain on an individual caused by the difference between one’s aspirations and actual achievements. This strain can lead to criminal behaviors to achieve aspirations.

Labeling Theory

Howard Becket introduced labeling theory in 1963.  Labeling theory suggests that as a label is assigned to behavior and individuals by those considered having social authority, these individuals begin to define themselves by the label and behave accordingly. Individuals and groups can be labeled and their actions are in response to that labeling. Labeling is based on the interaction between the individual and society.  The popularity of this theory has changed since the 1970′s but continues to be considered to have relevance today.

Consider the impact of labeling on high profile corporate fraud cases. Once the individual has been publicly identified, what is the impact on their subsequent behavior?

Rational Choice Theory

Rational choice theory states that humans behave in a purely rational manner and the actions they perform are for their own benefit (Scott, 2000). The theory says that there are rewards and punishments associated with each action and the individual contemplates risks and rewards to decide the benefits of proceeding with the criminal act.  Where the rewards are thought to outweigh the punishment, then the criminal act will be undertaken.

Social Control Theory

Social control theory examines how the rules and norms affect behavior. According to the theory, norms are socially-based guidelines around how to behave. Violations of these norms can have varying impacts ranging from social exclusion to incarceration. What are the restraints that prevent an individual from committing fraud within their organization?  Family, friends, beliefs, values and law enforcement can influence conformity within rules and norms.  There are formal control systems based on the legal system and law enforcement agencies. Informal control systems originate within social groups and include social customs.

Social Learning Theory

This theory explains criminal behavior as learned.  People learn through observing others’ behavior, attitudes, and outcomes of those behaviors. “Most human behavior is learned observationally through modeling: from observing others, one forms an idea of how new behaviors are performed, and on later occasions this coded information serves as a guide for action.” (Bandura). Social learning theory explains human behavior in terms of continuous reciprocal interaction between cognitive, behavioral, and environmental influences.

These theories are focused on the sociological explanations of criminal behavior in general.  In the next lesson you will explore some of the psychologically-based theories that have specific relevance to corporate fraud.

Lesson 5

Overconfidence (hubris) by the corporate executive is illustrated through their behaviors. Many corporate executives make business decisions based on pride without seeking expert advice.  Sometimes they also fail to realistically evaluate a business problem and then fail to take the right actions to address problems as they arise.

Because of their hubris and status in the corporate world, corporate executives and their actions are often seen in a positive light or at the very least thought to be above scrutiny.

This “halo effect” refers to the notion that positive attribution is given to a person because of their proximity to others or situations seen to be positive.  In well-known fraud cases such as Enron, the images portrayed by company executives as highly intelligent, creative and successful, perhaps even infallible, led stockholders to believe that there could be no risk to the company. This halo effect left employees and stockholders with a major financial loss.

Scott Plous in his book The Psychology of Judgment and Decision Making states that “…executives or management choose their course of action by using the satisfaction decision making model…to choose a path that satisfies your most important needs, even though the choice may not be ideal or optimal.”    In many business failures, executives committed fraud to fulfill their immediate desire for economic gain. Addressing narrowly defined and immediate needs, fraud is committed.

In a Financial Post article review of Canadian financial fraud cases of publicly traded firms from 1995 to 2005 (including Livent, Hollinger, Bre-X, Cinar, etc.), it is noted that “…hubris — exaggerated pride or self-confidence –constitutes a key reason why some successful executives or entrepreneurs engage in fraudulent activities.”

As an explanation for criminal behavior, hubris goes beyond rationality and shows the corporate executive to be overwhelmed by his own self-interest and unable to make rational decisions. “…managerial fraud goes beyond reflecting the rational pursuit of self-interest, a position that is put forward by most auditors or regulators”.

“No problem in judgment and decision making is more prevalent and more potentially catastrophic than overconfidence”

In a study of executive overconfidence, specifically unrealistically positive views regarding a company’s future performance, Schrand and Zechman (2010) state that these executives are “… more likely to ‘borrow’ from the future to manage earnings thinking future earnings will be sufficient to cover reversals.”   This overconfidence leads executives to begin to commit small amounts of fraud believing that this will be hidden as corporate profits increase. However, if profits do not increase, the fraud and misreporting acts increase instead.

Alarmingly, research also shows that along with increasing levels of education comes increasing overconfidence.  This can contribute to executives’ decisions to commit fraud.  Although intuitively, you may think that an executive with more experience and education may be more realistic and less likely to commit fraud, sometimes successful experience can heighten the sense that fraud will be undetected.

Though not germane to the psychology of fraud at the individual level, but relevant to the topic of corporate fraud, Schrand and Zechman also identify that there is no evidence that fraud and non-fraud companies are distinguished by governance.

You may recall the Greek myth in which Icarus ignored his father’s warnings not to fly too close to the sun. His confidence or ‘hubris’ influenced his judgment and as he flew too close to the sun, the beeswax that had been holding his wings melted and he fell to his death. Some authors have suggested that this myth applies to the overconfidence of the corporate executive who believes himself/herself to be more intelligent than any others and this can lead to the fraudulent acts that may escalate over time as long as they remain undetected.

References

Magnan Michel, Cormier Denis, LAPOINTE-ANTUNES Pascale, Corporate fraud’s red flag: arrogance

Drabinsky’s downfall began when he gave in to hubris, Financial Post Published: Tuesday, December 01, 2009

http://www(dot)financialpost(dot)com/executive/smart-shift/story.html?id=2287617#ixzz0kX0ZBBqA

PLOUS Scott, Book Review of The Psychology of Judgment and Decision Making

Philadelphia: Temple University Press, 1993

http://repository(dot)upenn(dot)edu/cgi/viewcontent.cgi?article=1094&context=marketing_papers

lesson 6

The constant pressure of profitability and the necessity or demand to increase profitability has been identified as one contributor to corporate fraud. In some respects, there is an impression that greed is an acceptable motivation for less ethical acts.  This can ultimately lead to illegal acts.  The high profile corporate fraud cases with which you are becoming familiar demonstrate that greed can destroy people and businesses. Public trust of a company relies upon public belief that ethical business practices are in place and are valued.

The problem is that most performance incentives affect the behavior of executives.  Typically, bonuses and stock option are given to executives who exceed profitability thresholds. Are there perverse incentives at play that can engender fraudulent acts?  And whose accountability is the incentive structure at the executive level?  Distortion of financial statements for personal gain may be a response to the structure of executive reward plans.

In your readings for this module, you will review the impact of greed on corporate and individual behaviors. To get you thinking about the impact of greed in the business culture let’s first look at a familiar case.

The excerpt below is from an Oct 26, 2009 article written by Larry Brown (National Secretary-Treasurer, National Union of Public and General Employees) that provides an opinion on corporate greed:

“It’s pretty clear that for too many Canadians, times are tough. As just one example, Nortel workers and retirees are facing huge losses of their pension plans, their severance, and their disability protection, because to all intents Nortel has gone belly-up.

But not all current or former Nortel employees are facing these problems. The CEO that got Nortel into this mess, John Roth, still has every penny of the $159 million he was paid while steering the company into the ditch, and the five senior company officials still have the $400 million they got paid between 1999 and 2008. The CEO who finished the job of making Nortel bankrupt, Mr. Zafirovski, still has the $40 million or so he was paid.

After putting the company into bankruptcy, Mr. Zafirovski applied to bankruptcy court for permission to pay eight senior officials about a million dollars each as a retention bonus just before he sold the company off in pieces. One would think the people who got a million dollars to stay with the company are now going to give it back, the company having disappeared and all. Now Mr. Zafirovski is suing the company he drove into the bankruptcy courts, for $12.2 million, including $3.6 million in bonuses he says he has ‘earned’.  But there is no money at Nortel for pensions or disability plans for the employees.

The awful thing is that Nortel isn’t an isolated case. The fact is that the people who made out like bandits, shoved money into their own pockets by the bucketful, and drove our economy into a crisis, have no apparent shame.”

The Nortel case is an excellent example of how performance incentives can have a major impact on the behavior in the C-suite. By understanding these motivators, you will be aware of potential opportunities for fraud especially in corporate financial reporting.

For the next lesson, you will learn about corporate governance and ethics and how they play a critical role in reducing fraud in the business context.

Lesson 7

As you will note from the lesson readings and your own research, there is significant analysis and hypothesizing about the motivations behind high profile cases.  Parmalat and Enron share the common element of misrepresentation in financial statements. How often is the defense offered that the Board of Directors had approved loans and bonuses paid to the executives of companies that find themselves in bankruptcy protection?

The executives in the Tyco case were reported to have paid themselves $170 million in unauthorized compensation.  In addition to the $430 million allegedly earned on their Tyco shares which was based on deceitful reporting of the company’s profitability in the late 1990’s, the executives received huge financial payments for a company actually in financial crisis.

Lesson 8

As you will note from the lesson readings and your own research, there is significant analysis and hypothesizing about the motivations behind high profile cases.  Parmalat and Enron share the common element of misrepresentation in financial statements. How often is the defense offered that the Board of Directors had approved loans and bonuses paid to the executives of companies that find themselves in bankruptcy protection?

The executives in the Tyco case were reported to have paid themselves $170 million in unauthorized compensation.  In addition to the $430 million allegedly earned on their Tyco shares which was based on deceitful reporting of the company’s profitability in the late 1990’s, the executives received huge financial payments for a company actually in financial crisis.

Lesson 9

The new millennium has been characterized by increasing incidences of fraudulent and improper corporate accounting. Misused and misdirected funds, intentional misstatement of revenues both over and under statements and misrepresentation of corporate assets are becoming more common in financial news headlines. All of these activities raise the issue of the role and accountability of financial audit firms on whom the public relies to identify illegal or even irregular financial behaviors.

The American federal government has relied on agencies such as the Securities and Exchange Commission (SEC) to investigate accounting practices of large corporations.  In addition to identifying firms with questionable accounting practices, the SEC also identified questionable practices by those firms who were entrusted with ensuring integrity in financial reporting.

In response to concern regarding accounting practices, in 2002 the Sarbanes-Oxley Act was introduced in the United States to address loose standards that had been in place for senior executive including auditors themselves. The specification of incarceration as punishment was intended to signal the government’s seriousness in addressing accounting irregularities that threatened American economic security. Sentences including a maximum twenty year jail term underscored the importance of this issue.

You can read about Canada’s response to the issue through Bill 198 in 2003 in this week’s readings.

The Canadian Public Accountability Board was created to establish standards for those firms that audit public companies and then to ensure that those standards are met. It includes an inspection unit to inspect the firms that audit public companies to determine compliance with professional and regulatory requirements.

Canadian Securities Administrators (CSA) has also introduced tighter rules including those specifics to the governance of Canadian public companies. Best practices include an independent board of directors.  Preferably the Chief Executive Officer and Chair should not be the same person. The Chair of the Audit Committee is considered to be a key role.  Auditors should be changed with sufficient frequency to avoid personal connections and allegiances to develop.

Use the Internet to research the case pursued by the Securities and Exchange Commission and Biovail in which four executives were accused of accounting fraud. The Ontario Securities Commission filed a similar case against the four executives.  Although the case is complex, it will provide you with insight into the impact of accounting practices on estimates of a company’s worth.  There are many similar cases. Also check out the 2007 case against BDO Seidman (an accounting firm found guilty by a jury and ordered to pay damages).

A frequently cited case of an audit firm being found guilty of criminal charges is the Arthur Andersen case as it related to its auditing of Enron. Note the following comment from the Powers Committee that had been appointed to look into the firm’s accounting in 2001: “The evidence available to us suggests that Andersen did not fulfill its professional responsibilities in connection with its audits of Enron’s financial statements, or its obligation to bring to the attention of Enron’s Board (or the Audit and Compliance Committee) concerns about Enron’s internal contracts over the related-party transactions”.[3]  In 2002, Anderson was also convicted of obstruction of justice.

Interestingly, with the increase in required oversight of auditing and accounting practices comes an increase in demand for skilled auditors and forensic accountants. According to Statistics Canada growth in the accounting industry resumed in 2003 partly because of tighter accounting standards that were successful at increasing investor confidence.  In 2003, employment in Canadian accounting services was estimated to be at almost 69,000 the highest level in the previous decade. Having an understanding of corporate accounting and auditing standards and the challenges facing auditors is marketable information.By understanding the cases described in the readings and research, you will understand the auditing and accounting issues that contribute to corporate fraud.

Lesson 10

Recent corporate accounting scandals highlight the need for effective corporate governance and institutionalization of a code of business ethics. These corporate frauds demonstrate that stakeholder theory generally is naive regarding business ethics. These cases also reveal the strong impact that bonus payments and other rewards can have on creating incentives for individuals to engage in unethical conduct.  Corporate executives must respect their professional obligations as employees.

As long as corporate fraud continues to be considered as a non-violent crime for which laws and law enforcement are lax, a change in accountability will be slow. Small fines and rare imprisonment appear to be insufficient deterrents. In contrast to times when the economy is in a growth phase, interest in corporate fraud increases when businesses close or declare bankruptcy.

Corporate scandals have had long-lasting and far-reaching impacts on the Canadian economy. The impact of corporate scandals is not limited to the investors and employees of those companies, nor is it restricted to publicly traded companies. In Canada, the Integrated Market Enforcement Team was established to detect, arrest/charge, and prosecute individuals and organizations involved in corporate fraud and market irregularities.

As noted in previous lessons, Americans are divided with respect to whether the benefits arising from the Sarbanes-Oxley Act outweigh the costs. In a study of the economic impacts of the Sarbanes-Oxley Act, Ivy Ziying Zhang concludes that “…the private costs of major provisions of Sarbanes-Oxley Act exceed their potential benefits”. Ziying Zhang estimates that the total direct compliance costs were $260 billion.  He concludes that direct and indirect costs could make the total cost of Sarbanes-Oxley Act $1 trillion dollars. He also concludes, somewhat controversially, that “….the requirement to tighten corporate governance is generally value decreasing for firms.”

GlobeScan President Doug Miller comments, “It’s a good news/bad news story. While the string of corporate scandals worldwide has undermined trust in large companies, it has not broken the public’s faith in the free enterprise system overall. However, our research reveals formidable public pressure for more regulation of the system. To keep ahead of this regulatory curve, companies will need to increasingly demonstrate that they are operating in society’s best interest rather than just their own. The social contract needs to be re-built around the free market.”   This has changed the focus of accounting firms whose previous focus on accounting consulting services has started to transition to auditing.

In the US, the Security and Exchange Commission (SEC) fined CIBC US$ 80 million for its role in Enron financial statements. The SEC also sued three of CIBC’s executives. In 2005, CIBC paid US$ 2.4 billion to settle a class action lawsuit brought by a group of pension funds and investment managers.  Conflict of interest between consulting and auditing work with the same company has garnered attention in the financial sector.

The impact of fraud is therefore not just the direct impact to individuals (employees, shareholders etc.) and companies. The cases of fraud that you have reviewed in this course have changed the way we regulate and monitor the corporate world. These changes are costly – the more oversight required, the more expensive it is to do business.

References

NICHOLLS Christopher The Characteristics of Canada’s Capital Markets and the Illustrative Case of Canada’s Legislative Regulatory Response to Sarbanes-Oxley, Commissioned by the Task Force to Modernize Securities Legislation in Canada,  June 15, 2006

http://www(dot)tfmsl(dot)ca/docs/V4(3A)%20Nicholls.pdf

GlobeScan – Global Public Opinion and Stakeholder Research, 20-Nation Poll Finds Strong Global Consensus: Support for Free Market System, But Also More Regulation of Large Companies, January 11, 2006

http://www(dot)globescan(dot)com/news_archives/pipa_market.html