Business & Professional Ethics

1. Business & Professional Ethics MMPA Program, 2003 Prof. L.J. Brooks Rotman School of Management University of Toronto

2. Corporate Policy & Practice • What principles do you associate with your firm in business dealings? • Do whatever it takes?... • Does your firm: • have an ethics code and an ethics officer? • encourage whistleblowers? • try to manage its reputation? • try to manage its ethics risks globally? • define its corporate citizenship?

3. Consequences • Corporate Scandals • Enron, WorldCom, Global Crossing, Tyco, Adelphia, Haliburton, ImClone, Xerox, … • Employees • Customers • Loss of reputation • Reform of Governance and Accounting

4. The Enron Affair • Management was: • out of control, and engaged in self-dealing • manipulating transactions & financial reports • Company imploded - Chap. 11 in Dec./01 • Investors misled, pensions lost • Executives plead the 5th, poor memory, ignorance, incompetence • Outrage • Auditor savaged, profession to be changed

5. Enron Stock Chart Weekly Prices 1997- 2002 Source: www.globe investor.com

6. Enron’s Business (10K-2000) • Transportation and distribution • Wholesale services • Commodity sales & services, risk management products, plants, etc • Retail energy services - gas, electricity • Broadband services • Nationwide fiber-optic network - build, market, etc. • Corporate and other • operation of water, renewable energy, and clean fuels plants plus other corporate activities

7. Enron’s Income (IBIT):Income Before Interest, Minority Interest and Income Taxes 200019991998 Transport & distribution ($ mil.) Trans. Services 391 380 351 Portland General 341 305 286 Wholesale Services 2,260 1,317 968 Retail Energy Services 165 (68) (119) Broadband Services (60) Exploration & prod. - 65 128 Corporate and other (615)(4) (32) IBIT 2,482 1,995 1,582

8. Enron’s Wholesale Services • …creation of networks involving selective asset ownership, contractual access to third-party assets and market-making activities. 10K p.36. • …uses portfolio and risk management disciplines, including offsetting or hedging transactions, to manage exposures to market price movements (commodities, interest rates, foreign currencies & equities). 10K p.37. • … sells interests in certain investments & other assets to improve liquidity & overall return, 10K p.37

9. Enron’s Financial Data 200019991998 Revenues (in Billions) 100.8 40.1 31.3 Operating income (Millions) 1,953 802 1,378 IBIT 2,482 1,995 1,582 Net Income before Cumulative Accounting Changes 979 1,024 703 Net Income 979 893 703 EPS (in dollars) - basic 1.22 1.17 1.07 - diluted 1.12 1.10 1.01

10. Enron’s Financial Data 20001999 Current assets (Billions) 30.4 7.3 Investments, other 23.4 15.4 Property, plant, equip, net 11.710.7 Total Assets 65.533.4 Current liabilities 28.4 6.8 Long-term Debt 8.6 7.2 Deferred credits and other 13.8 6.5 Shareholders’ Equity 11.59.6 Total Liab. & Shareholders’ Equity 65.533.4

11. Enron’s Changing Risk Profile Early By Risk 1990’s2000Level Pipelines, distribution networks   Low Retail energy  Low Power generation  Low Oil and gas exploration  Med. Alternative energy  M/H Hedging transactions  High Commodity trading transactions  High Broadband optical fiber networks  V. High Related party transact. (SPEs/Partnerships)  ???

12. Corporate Governance Role of the Board of Directors - traditional • strategic objectives - set or approve • appoint CEO, approve other officers • company policies and procedures: • set or approve • ensure dissemination and compliance • laws, regulations, & expectations of society • ensure monitoring and compliance • act as ethical conscience (Dey Report & CICA)

13. Corporate Governance Role of the Board of Directors • “to supervise, direct or oversee”…”day-to-day management must be delegated to others” Dey Report (1994) • 5 core functions (CICA/TSE, 2001): • Choosing the CEO and ensuring the team is sound • Setting the broad parameters the management team operates within • Coaching the CEO and team • Monitoring and assessing the performance of the CEO, setting the CEO’s compensation, approving the team’s • Providing assurance to shareholders and stakeholders about the integrity of the corporation’s financial performance, incl. Quarterly Reports.

14. Corporate Governance Audit Committee must: (CICA/TSE, 2001) • Provide assurance that external auditors are: • independent • satisfied accounting estimates & judgments are sound & in accord with GAAP • Develop sufficient rapport with external and internal auditors, and management to facilitate • Approve mandate of internal audit group, and ensure it has adequate resources to ensure an effective internal control framework & culture • Disclose mandate

15. Enron’s Governance Failure Begins • 1997 - Board suspends code of conduct to deal with an SPE (JEDI/Chewco) emergency: • Can’t find outside investor before year-end • Non-consolidation tests not satisfied: • Outside investor • 3%investment at risk • Control of decisions • Fastow (CFO) has Koppers - who reports to Fastow - appointed to run/invest/control SPE • No follow up on alternative controls • Now that guard is down/can be controlled

16. Enron’s Governance Structure © L. Brooks Board Ken Lay: Chair; Co-chair ZZZ Audit, Compensation Cees. Outside Law Firm Guidance Finan. Reports SPEs Missing Suspended Management Lay, Skilling: CEO Fastow, CFO; Koppers Causey, CAO; Buy, CRO Watkins; Kaminsky; McMahon Compliance Company Policies Code of Conduct Auditor Arthur Andersen Internal Audit ? Whistleblowers ? Consultant: Arthur Andersen

17. Governance Failure Allows • Fastow to control SPE transactions: • Sales of assets at inflated prices (False gains) • False hedging of losses on Enron investments (Falsely keeps losses off Enron Income Statement) • Exorbitant payments to Fastow & helpers • Hiding of SPE debt ultimately to be borne by Enron • Fastow to create more SPEs (LJMs…) • Manipulation of accounting disclosure

18. Partial Impact Payments to Fastow & helpers Invest._ReturnOther Fastow $25,000 $4.5 mil in 2 mo. $30 mil+stock options+ Koppers 125,000 10 mil (incl. $2 mil in fees friend) 2 others 5,800 1 mil Manipulated transactions in Q3 & Q4, 1999 Asset sales, plus 1 hedge contribute $229 profit of $570 before tax/$549 after tax ~50%

19. Control Benchmarks • General presumption regarding control • Normally – equity ownership >50% - must also prove control exists • SPE – U.S. equity investment (at risk) >3% (proposed 10%), Canada >10%(in certain situations) - must also prove control exists SPE benchmark lower due to uniqueness of SPE

20. Chewco/JEDI Kopper/DodsonDodson LP/GP Big/Little SONR River $11.4 GP LP $11.4 ENRON Chewco $132 LP Barclays GP $240 JEDI $240 + $11 +132 = $383 © I. Wiecek

21. Select Enron SPEs

22. Enron’s Governance StructureWas Short Circuited © L. Brooks Board Ken Lay: Chair; Co-chair ZZZ Audit, Compensation Cees. Outside Law Firm Guidance Finan. Reports Missing SPEs Suspended Management Lay, Skilling: CEO Fastow, CFO; Koppers Causey, CAO; Buy, CRO Watkins; Kaminsky; McMahon Compliance Company Policies Code of Conduct Auditor Arthur Andersen Internal Audit ? Whistleblowers ? Consultant: Arthur Andersen

23. Enron’s Ethical Culture • Code suspended, alternate controls ignored • Bogus trading floor for visiting analysts • California energy market manipulation • Whistleblowers/doubters came forward (to), but • Co-chair (Lay) resigned, 32 mil. … suicide? • Kaminsky (Fastow) …….. ignored • McMahon (Fastow)...transferred …now CEO • Sharon Watkins (Lay)… Enron’s law firm found no problem …fox in the chicken coup • No protected whistleblower path to the Board • Do we need an Ethics Committee?

24. New Board Responsibilities • Comprehensive Risk Management • Broad understanding of business model • Financial literacy • Guidance & Control framework • Focus on corp. culture, ethics & reputation • Business ethics…whistleblower protection plan • Ethics Risk Management • Trust, but challenge, don’t turn away • Caremark National Case, trend © L. Brooks

25. Comprehensive Risk Managementrequires understanding the business Risk Events Causing Drops of Over 25% Share Value, Percentage of Fortune 1000 companies, 1993-1998 Strategic ……………………………. 58% Customer demand shortfall (24) Competitive pressure (12) M & A Integration problems (7) Mis-aligned products (6) Operational …………….31% Cost overruns (11) Accounting irregularities (7) Management ineffectiveness (7) Supply chain pressures (6) Financial ………..6%[Foreign macro-eco, interest rates ] Hazard …….0%[Lawsuits, natural disasters] Source: Mercer Management Consulting/Institute of Internal Auditors, 2001

26. Comprehensive Risk ManagementincludesEthics Risk Management Ethics Risk Reputation Success Reputation is important • Arthur Andersen…………… survival • RT Capital…………reputational capital • Tylenol ……………competitive advantage Selling trust and credibility, not pills, … © L. Brooks

27. Comprehensive Risk Management depends upon the Corporate Ethical Culture • Comprehensive Risk Management utilizes both: A. Key risk factor identification& measurement B. Review of key business processes including the ethical culture that underpins process integrity • Ethical culture provides guidance for employees about when to adhere to the Code, when actions are not covered in Code, in a grey area, or in a crisis - tools to measure ethical culture do exist Enron’s Board failed to consider any of this! Few corporations do A, fewer do B! © L. Brooks

28. Audit Committee must • Understand key business operations • Understand comprehensive risk management model and reports • Examine key/large transactions • Ensure compliance with good policies • Ensure fair presentation Who wants this risk? How much should the members be paid? © L. Brooks

29. New Governance Issues For directors and senior officers: • Director’s Responsibilities • Financial literacy • Guidance and control systems • Ethics risk management • Comprehensive risk management How important is reputation, public interest,…

30. Emerging Risk-oriented Decision Criteria for Directors Criteria (New) Interests/Risks Considered • Profitability & legality …… Shareholders + • Fairness & rights …… Specific Stakeholders • Expectations Gap ………. the Public Interest

31. Overview of Key Problems • Governance failure at the Board level • Too much trust • Incompetence - awareness and/or understanding of role , control & reporting systems • Lack of motivation, conflicts of interest • Dishonest management, conflicts of interest • Culture of deception, self-interest • Manipulation of accounting and disclosure • Poor standard setting • Auditor deficiencies • Regulatory short-sightedness

32. Ethics Means... • What is right or wrong? • What/who determines? • Societal values • Individual values • Religious beliefs • Lots of interpretation possible • Stakeholder perspective

33. A Stakeholder Is... • Anyone who is affected by or can affect the objectives of the organization (Freeman, 1984) • Anyone who has something at risk as a result of a activity of the organization (Clarkson, 1995) • An organization must have the support of its primary stakeholders, to optimally achieve its strategic objectives

34. Success is Changing

35. Stakeholders are Very Important CEO’s Views on Top Challenges in 2000 1. Recruiting skilled staff 2. Pressures from stakeholders 3. Environmental demands Source: Smy, 1999

36. Accountability... • To stakeholders, not just shareholders: • Capital markets... • Consumers…also Nike…supplier codes • Employees... • Environmentalists... • Global, immediate info flow • Lingering liability • Increasing sensitivity, morality

37. Success/Wealth Creation Depends On • Relationships with Stakeholders • Relationships depend upon: • Reputation and • Values or hypernorms for most cultures

38. Reputation • Corporate reputation … the overall estimation in which the company is held by its constituents – customers, investors, employees, and the general public to the company’s name. Fombrun, Charles J., Reputation:Realizing Value from the Corporate Image, Harvard University Press, Boston, Mass., 1996, p.38

39. Tragic Loss of Reputational Capital Exxon • 14 trading days after Valdez Oil Spill, 3/24/89 • $3 billion approx. lost on $57.64 billion J & J • After the Tylenol tampering, 9/30/82 • $1.13 billion lost on $8.262 billion • In 1986, $1 billion lost on $9.1 billion

40. What makes a good reputation? Credibility Reliability Corporate Reputation Trustworthiness Responsibility Formbrun, p. 72

41. What Does Success Depend on? Support from Stakeholders where Long-term Success = f(Trust + Respect) Values: Honesty, Fairness, Compassion, Integrity, Predictability, Responsibility

42. Business Ethics... …the moral standards that apply to business policies, institutions and business behaviour. • Dealing with stakeholders • Identifying who, interests, priority • Corporate social contract • Stakeholder impact analysis

43. North American Pollution, gender... FCPA- bribes Sentencing Guidelines Disasters Caremark National Activist stakeholders Media Supplier codes Whistleblower Prot. European Environment Embarrassment Bribes, OECD Disasters Overall performance Public reporting Media CSR Reporting Global Ethical Developments

44. Crises Of Confidence • Financial scandals • Enron, WorldCom, Global Crossing, ImClone, … • Philip Services, YBM, Livent, Cendant • Bre-X • Barings Bank, R.T. Capital • Bizarre decisions • Bank mergers • Bank downsizing when profits are high

45. GE Whistleblower • Boss & bosses’ boss overcharging Israel for jet fighter engines • Gathered evidence for 4 years • Sued for $70 million - False Claims Act • US Government took case over • Whistleblower can get up to 25% • Settled for $59.5 + $9.5 mil. • How much would you give W/B? Why?

46. Governance • Legitimacy of non-shareholder interests: • US Sentencing Guidelines - 1991 • TSE - Report on Corp. Governance - 1994 • Directors responsible for corporate ethical culture • CICA - Criteria for Control Guidelines - 1995 • Ethical culture is essential for internal control • Caremark National Inc. - 1996............US • Need to look for problems and rectify, not sit back • Section 201B (US), CBCA Rev?..may consider • Reform • Sarbanes-Oxley Act, 2002

47. Ethical Corporate Culture Sound governance is based on shared ethical values & ethical decision making: • Values will determine attitudes & behaviour • Values are shaped & supported by an organization’s culture What Board of Directors and/or stakeholder group can afford external whistle blowing/or ethical slips?

48. 1999 Conference Board Report • Rapid increase in formulation, implementation and monitoring of BE practice standards • Consensus on key corporate values: • Global business practices need fixed reference points • Ethical decision-making procedures allow managers to act in accord with core, identifying company values • Ethical decision-making requires an employment environment of trust, free from reprisals for employee decisions and actions taken in good faith

49. Business Ethics Value Chain STAKEHOLDER SCREEN ACHEIVEMENT OF STRATEGIC OBJECTIVES CORPORATION GO Customers Employees Capital Markets Current: Shareholders Lenders Environmentalists Host Communities Governments NGOs INFLUENCES Governance Mechanism ACTIONS Primary CAUTION Formulation of Strategic Objectives Other BEHAVIOUR STOP DETERMINANTS OF VALUE…Success = f(Trust + Respect) CORPORATE CULTURE ETHICS PROGRAM &CODE TOP MANAGEMENT SUPPORT STAKEHOLDER SYNERGIES CHARACTER GLOBAL MEDIA PERCEPTION OF: TRUST RESPECT RELATIVE IMPACT RELATIVE SALIENCE LOCAL CULTURE

50. The Clarkson Principles Ethical performance should be managed to maintain support of the stakeholders by Principles of Stakeholder Management • Acknowledge & monitor concerns • Listen & communicate • Adopt sensitive processes and behaviour • Recognize interdependence • Work cooperatively • Avoid jeopardizing inalienable human rights • Acknowledge potential conflicts