How to Reform Corporate Ethics in American Business Today
Corporate ethics is an important sphere of American business the regulation of which is of utter importance. It comprises the rules how the company operates: its management, control and responsibility for improper actions. The regulations of corporate governance and implementation of effective corporate ethical standards affect the situation of the economy of the state. Inefficient regulations may lead to huge problems, such as the Great Depression of 1933, ENRON case of 2007, global financial crisis of 2008, because of which the whole world economy was negatively affected, a lot of investors were defrauded, money stolen and etc. Scholars believed that the unreliability of corporate managers and the market in these cases, government regulators needed to restore confidence in the securities markets (Ribstein, 5).
In response to such huge collapses as ENRON, WorldCom, Tyco, and other corporate accounting scandals, the Congress decided to enact the so-called “Sarbanes-Oxley Act”, officially named as “The Public Company Accounting Report and Investor Protection Act of 2002”, which introduced a number of changes to the Securities Exchange Act of 1934 (Coffee Jr.).
One of the major changes were that it imposed higher auditing standards and regulated the professional accountants’ activities. It also increased the independence of audit committee of publicly held companies and strengthened the authority and level of liabilities of the audit committee. The committee has to be composed of independent directors only and all of these measures were intended to make the disinterested parties control the auditing activities and make them more cautious with their activities because of the higher level of liability. The Act also created the “Public Company Accounting Oversight Board”, a self-regulatory body, which was responsible for the implementation and enforcement of the new rules on accounting standards. However, Ribstein argues that this monitoring cannot be effective in tackling with fraud by highly motivated insiders. He contends, “The laws are likely to have significant costs, including perverse incentives of managers, increasing distrust and bureaucracy in firms and impeding information flows. The only effective antidotes to fraud are active and vigilant markets and professionals with strong incentives to investigate corporate managers and dig up corporate information,” which can be hard to achieve (Ribstein, 6). Interesting fact to mention is that NYSE (New York Stock Exchange) Board of Directors adopted and submitted new listing standards such as “no material relationship” requirement imposed on the board, meaning that board must have no material relationship with the company. In addition, NYSE provided for increasing to five years “the “cooling off” period for board service by former employees of the issuer or its auditor (Ribstein 15).
Another change was that the Act increased the level of liability of the chief executive officers and chief financial officers. This is because in the examples of ENRON, WorldCom, the problem was that the officers were involved in the fraudulent activities, making it hardly difficult to identify the wrongful activities of the company. Hence, in particular, the rule requires that CEOs and CFOs make continuous reports on certification of the company’s financial situation and they are to be held criminally liable for any knowingly false statements (Sections 302, 906). This provision definitely was intended to make the management more cautious about their statements and check all the documents they are signing and certifying, thus promoted avoidance of the problem of mechanical certification.
The Act requires to make continuous disclosures on any changes in the financial situation of the publicly held corporations, all the necessary material information that may adversely affect the financial standing of the company (Title IV). This rule is intended to protect the legitimate rights of the future investors, so that they are provided with adequate public notice before making investment decisions and existing shareholders of the company and provide transparency in securities regulations and corporate governance.
In addition, the Act encourages the companies to implement Codes of Ethics as part of the internal documentation of the corporation (Section 403). This provision was justified by the fact that some chief managing officers in some cases seemed to claim that they did not know about the substance of the regulations and thus did not perform their obligations. The underlying ground for this rule was that If a corporation had a Code of Ethics, it would implement all the necessary and relevant requirements of the federal and state’s regulations in the internal ethical rules, so that officers would be informed about the existence of all the necessary rules and prevent future violations of the regulations.
Another change worth mentioning is that the Act protected “whistleblowers” and thus allowed flow of information from different people who were in possession of material information and this was insured by the protection provided to such people.
Hence, on the abovementioned grounds, the basic policy changes were concerned with such issues as:
independence of auditors and directors, so as to insure their disinterest and inaccessibility to finances of the company;
increasing disclosure requirements, thus insuring provision of public notice and protection of investors by providing important material information;
increasing liability of CEOs and CFOs, who were in most previous cases in charge of hiding the fraudulent activities of the companies;
enhancing possibilities for private enforcement and protection of whistleblowers, thus providing access for protection and disclosure.
There is high level of criticism addressed to the efficiency of the Sarbanes-Oxley Act. One of the problems was that the reforms enacted in response to ENRON collapse were intended to reduce the level of fraud by promoting the independence feature that certain amount of directors and especially auditors have to be independent and not anyhow related to the material situation of the company. However, scholars believe that independence reduces access to information, and thus it seems not to achieve the basic goal of lessening the fraud in corporate governance arena and concur the incentives of the fraudsters (Ribstein, 21).
The next argument is that it is undeniable that the new regulation decreases the risk of future violations and fraudulent activities of corporate executives. However, research shows that the costs of the implementation of the regulations providing for this decrease are much higher that the benefit from the achieved result, “including deterring beneficial transactions, increasing the adversarial nature of corporate governance, reducing executives’ incentives to increase firm value, and diverting executive talent to closely held firms” (Ribstein, 22).
Before moving to proposal of new policy measures it is important to elaborate on the Credit Crunch, so that to be able to identify the key issues that the government needs to tackle. The crisis occurred in 2008, because of the unethical lending practices in the US. The global financial crisis happened because of the bad loans scheme at that time, so called sub-prime mortgage plans. These mortgages were extremely high risk, because the mortgagees were people without stable income and reasonable potential to repayments of all installments, and most of them violated traditional underwriting standards for the industry (Lewis et.al., 79). As long as the debtors were unable to pay and investors unwilling to invest anymore, a number of banks started collapsing.
The problem was that securitization of assets or mortgage backed securities attracted many investments. The scheme of securitization provided that banks provide loans for people in need for money, in particular case, for housing needs. The bank would make a pool of mortgages and issue securities backed up by these pools of mortgages depending on the level of risk and sell them to investors. The banks would get repayments for the loans from the investors and investors would get the money from installment payments for mortgages of the pool depending on the percentage of the investors’ interest. However, banks failed to estimate the risks of sub-prime lending and the problems began when people were unable to repay their debts (Hudson, 833).
One of the major cause of the Credit Crunch was the regulatory failure of the government to overlook or anticipate that such an increase in easy credit on housing and continuing bubble will eventually cause collapse of the system. For example, the government could impose a regulation that all the debt transactions had to be insured or somehow backed up. The problem with the sub-prime lending was that banks were easily providing loans to those who were unable to provide collateral as a security for the loan. Hence, banks were taking the risk on themselves (Hudson 834).
The next is the mechanical application of standard form master agreements, which contained rules regarding the already known problems and were not open to clear analysis of the market. Master agreements pose a number of problems, because in this case with the crisis, bank specialists were discouraged to analyze each lending transaction individually and assess the risks of nonpayment, its effects on the market etc. hence, no one was in the position to see the upcoming risk of the whole market collapse (Hudson, 842).
Hence, with this respect it is evident that the negligence in conducting proper risk assessment and greediness resulting in blind pursuit of attracting investments may results in such adverse consequences affecting the economy of the whole country. This economic situation could not be recovered unless the help of the government in providing budget for those banks that are too big to fail, meaning that their failure would result in collapse of the whole economy.
Policy measures:
Taking into account all the above mentioned issues and previous experience of the US in regulating financial markets and limited corporate governance regulations, the following policy changes have to be suggested:
More separation of commercial banking activates from investment activities. In other words, the decision maker should impose a certain limitation on investment activities of commercial banks. This would build trust of the population in banking system of the state, making them aware of the fact that banks are not going to use people’s deposits or mortgages in investments or to attract investments. Also, this would make commercial bank managers disinterested in fraudulent schemes as long as there is a cap on investment activities. Hence, the corporate management would be precluded beforehand from the engagement into unethical activities.
Banks providing loans should always be cautious in providing mortgages on sub-prime mortgage market and in any other market, providing that loans are properly secured and they have a back-up plan in case of inability of the debtor to pay. Managers should be encouraged to conduct a case by case analysis and risk allocation of each transaction and make reasonable decisions. This may be required through ethical rules, which would have to implemented in the internal documentation of the corporation and make each manager aware of the personal ethical obligation to review each contract not mechanically, but conduct a proper analysis of the financial situation the debtor and the bank.
Disclosure and public notice feature of the current regulations are effective in a sense that management of the company aware of the fact that it will have to continuously provide all the material information regarding the financial situation of the company builds trust of the investors. However, as acknowledged by the Sarbanes-Oxley Act management can be tempted to conduct fraudulent activities through making up different complicated schemes. One of the ways of doing a positive disclosure to SEC is the way employed by the managers of the ENRON Corporation, where they used to create separate subsidiary and keep all their debts off the books of the corporation, but on the accounts of the subsidiaries or so called special purpose entities (Palepu, Healy, 12). Nobody was able to identify the real financial standing of the corporation and directors were in the position to take away a huge amount of money without being disclosed.
Hence, the decision maker may impose certain checking or disclosure requirements regarding the reasons and purposes of a creation of special purpose entities. This may preclude the management and directors from resorting to creation of the subsidiary or other entities for the purposes of hiding the accounts and debts of the corporation. Because the SEC may discover that something wrong is being done by the company. Or another requirements would be an obligation to keep proper books of finances of the company and make the executives personally liable for inappropriate and misleading book-keeping. In addition, the obligation to certification of documents by executives and criminal liability for misstatements in the documents implemented by Sarbanes-Oxley Act should be maintained.
It is important to impose high ethical standard and restructure the reporting system within the corporate governance. One of the important scholarly proposition was that reporting should be directed not to the CEOs, but to the board of independent directors. Also, maybe the corporation should be required to create a new specialization like the Risk Assessment manager who will have an obligation to assess all the possible risks the company is facing within certain periods and make reports to the SEC or internally to the board, which would be responsible for the information provided in the risk assessment documentation.
It is impossible not to mention the fiduciary duties concept as they directly affect the corporate ethics of the corporation. The directors should be first of all encouraged to protect and act in the best interests of the corporation making them care more not only on increasing the finances of the company, but also maintain reasonable level of risk allocation, balance between equity and debt financing of the corporation, protection of the shareholders’ rights. In addition the corporations may be required to implement the Code of Ethics and Career Growth programs with a full description of bonus acquisition, directors and managers’ appraisal mechanisms and make a full disclose of this information to the SEC. So that to prevent indirect uncontrolled flow of money in the name of bonuses and encouragement payments for executives.
The next suggestion is of more direct relevance to problem of corporate ethics. It may be reasonable for the decision maker to impose certain personal leadership and ethical excellence promotion program, where directors and other executives would be encouraged to act in good faith and in the best interest of the corporation. This may be done in such a way as to increase the positive competition between companies on the most successful ethical performance. The decision maker may impose such rules that those directors who are found to be engaged in fraud would be disclosed to the world and prevented from working in certain positions as to make executives more careful with their own personal image and reputation in the country. When every person will be interested in personal reputation growth and independence, the one is more cautious as to losing his face and indirectly his personal standing among successful pool of directors and managers.
After all, the decision maker thus is encouraged to maintain the system introduced by the Sarbanes Oxley Act, but also make some additional changes to the regulation. As long as it is never possible to fully eliminate the fraudsters, it should be kept in mind that there will always be some executives who will be tempted to get more gains for themselves and thus come up with new and more complicated schemes and thus act unethically. However, the objective of the state to make a considerable decrease of this kind of actions and learn on the past mistakes, however, without being closed to new evolutions of the systems of corporate governance and financial regulations.
References
Hudson A. (2009). The Law of Finance. Sweet & Maxwell. 829-840.
Coffee J.C. Jr. & Seligman J. 2003. An Introduction and Progress Report on the Sarbanes-Oxley Act” Securities Regulation 2003 Supplement. Foundation Press New York.
Lewis V. and Kay K.D. and Kelso Ch. and Larson J. (2010). Was the 2008 Financial Crisis Caused by a Lack of Corporate Ethics? Global Journal of Business Research, Vol. 4, No. 2. 77-84.
Palepu K. & Healy P. M. (2003). The Fall of Enron Journal of Economic Perspectives, Vol. 17, No. 2, Spring 2003. 2-45. Available at SSRN: http://ssrn.com/abstract=417840 or http://dx.doi.org/10.2139/ssrn.417840.
Ribstein (Deceased) L. E. (2002). Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002. Journal of Corporation Law, Vol. 28, No. 1. Available at SSRN: http://ssrn.com/abstract=332681 or http://dx.doi.org/10.2139/ssrn.332681.
The Sarbanes-Oxley Act, 116 STAT. 745.
