Unethical conduct by corporate executives and employees — ranging from outright fraud to excessive salaries and perks for CEOs — can inflict much greater financial damage than deadly terrorist acts, visiting American experts warned in a recent symposium in Tokyo.
Over the past several years, both the United States and Japan have witnessed a series of corporate scandals that eroded investor confidence and resulted in massive losses for shareholders — including the recent case involving Japanese Internet firm Livedoor Co.
In both countries, a major corporate fraud typically develops in a similar fashion, said W. Steve Albrecht, associate dean of the Marriott School of Management at Brigham Young University in Utah.
It starts with a seemingly minor decision by a handful of top-ranking executives, but it soon implicates many others at the firm as the problem becomes bigger and bigger and ultimately gets out of control, Albrecht told the May 15 symposium at Keidanren Kaikan.
The symposium, organized by Keizai Koho Center under the theme — “Ethics in business — What should we learn from the experience in the U.S.?” — was also attended by Ned C. Hill, dean of Marriott School of Management, and was moderated by Naoaki Okabe, senior executive officer and editorial page writer of Nihon Keizai Shimbun.
“In recent years, corporations have had significant problems that have shaken investor confidence. Losses worldwide have exceeded $15 trillion,” Albrecht said. “Ethical problems caused companies money; and good ethics is good business.”
Quoting from a research by Transparency International, a German organization that evaluates the extent of corporate corruption and bribes worldwide, the scholar noted that unethical behavior “has destroyed more wealth than all the terrorist acts combined.”
Albrecht pointed out that the decline in share prices on the Nasdaq stock exchange in the U.S. precipitated by a series of corporate scandals including energy giant Enron and phone and data services group WorldCom was 10 times as sharp as the fall triggered by the Sept. 11, 2001 terrorist attacks on New York and the Pentagon.
Four of the 10 largest corporate bankruptcies in the U.S. history — WorldCom, Enron, Global Crossing and Adelphia — were caused by ethical problems, he noted.
There are various forms of ethical problems at corporate management resulting in financial damage, such as: financial statement fraud aimed at making a company’s performance look better to investors; sloppy accounting; unauthorized loans extended by the company to its executives; special favors and deals to friends; executives cheating or not telling the truth; “obscenely” high amounts of executive pay; and exorbitantly rich retirement perquisites that are often not adequately disclosed.
Inflating the income
Why do these problems happen? Albrecht, who has served as expert witness in several cases of high-profile corporate fraud, cited the case of an American company whose management improperly inflated its operating income by more than $500 million before taxes — or more than one-third of the total operating income reported by the firm.
“The goal of this scheme was to ensure that (the company) always met Wall Street’s growing earnings expectations. (The management) knew that meeting or exceeding these estimates was a key factor in keeping the stock price high.
“The participants in this illegal scheme included virtually the entire senior management of the company, including, but not limited to, the CEO, chairman, president, chief financial officer, and other accounting people. In total, 20 people participated,” he said without identifying the company, which he said he is not allowed to disclose because of a confidentiality agreement.
Such a case typically starts with some kind of pressure — the company failing to meet earnings forecasts or a cash flow problem, he said. Then the top executive looks for an opportunity — a pliant board of directors or weak internal controls — then starts to rationalize, he added.
They may start out by doing some aggressive accounting, but will soon cross the line and become dishonest, Albrecht said.
“But the CEO can never do it alone . . . and has to involve the accounting people, . . . and pretty soon they have to involve other people” — either by offering them big rewards, such as additional stock options or higher salaries, or play on their fear of losing jobs, he said.
The problem with such fraudulent behavior, he noted, is that if you overstate the company’s income in the current period, you have to make the income bigger in the next period, and even bigger in subsequent years.
What happened at Livedoor, the once high-flying Japanese Internet firm, appears to be “very similar” to typical cases in the United States, Albrecht said.
Former Livedoor President Takafumi Horie and its other executives are accused of inflating financial figures to make it look like they had billions of yen in profits even though the company was in the red.
“It was growing very rapidly, the stock price was going high, and Mr. Horie needed to keep the stock prices high,” he said.
Horie allegedly created fictitious orders and incomes by overriding internal control, but “certainly Mr. Horie was not able to do by it himself,” he added.
Albrecht also said a lack of good internal controls by management could result in fraudulent acts by the employees — similarly causing financial damage and eroding investors’ worth.
Japan has witnessed its share of such frauds, including a major case in the 1990s when a Sumitomo Corp. copper trader was found to have embezzled $2.6 billion over nine years, he said. “There are many examples like this in Japan, in the United States, and South Korea.”
And these fraud scandals eat into the profitability and competitiveness of companies. If a company’s profit margin is 10 percent, the company has to earn 10 times as much as the income lost by an embezzlement or fraud in order to recover the losses, he said.
Albrecht cited the recent example of General Motors Corp., which was hit by a $436 million fraud by an employee.
“Because it had a profit margin of 10 percent, it had to generate 10 times (the income lost in fraud), or $4.36 billion in additional revenue to get back to where it would have been without the fraud,” he said. “If you assume one U.S. car costs $20,000, then GM has to make more 218,000 to gain back the income it lost.”
While its rivals Toyota, Honda, Hyundai or Ford did not have such a problem and were able to move ahead, GM had to play a catchup to get just to the pre-fraud level, he said. “General Motors was less competitive (because of the problem). . . . You can see that fraud is very costly.”
Hill, dean of Marriott School of Management, said business ethics can be summarized in simple ideas — whether you treat others as you want to be treated, or whether there is respect, honesty and trust between the parties that engage in transactions.
And good ethics make business sense, while bad ethics can increase transaction costs, he added.
If a person wants to sell a product to another and if the two parties trust and respect each other, the former will be confident that the latter will pay up when the goods are delivered, and so the two parties can do business at a minimum cost, he said.
But if they do not trust each other, they may hire and retain lawyers to be ready in case promises are broken, make security or insurance arrangements in case the product is stolen, or the government may intervene to impose regulations to avoid trouble, he said.
“That increases the cost, all because we don’t trust each other.”
One recent example in the United States of corporate misdeeds adding cost to business, Hill said, is the introduction of the Sarbanes-Oxley Act of 2002 that followed a series of major corporate scandals. The law, among other things, requires the management and auditors to provide an assessment of internal controls and has resulted in sharp rises in audit costs for companies.
“Why do we have Sarbanes-Oxley? That is a cost we have to pay because of unethical behavior.”
Studies show that shares of companies with strong, well-governed board of directors outperform the overall stock market, he said. Also, “democratic” firms that listened to their employees and gave them channels of communication to the top management, are found to perform better than companies led by “dictatorial” executives, he added.
Albrecht also cited a survey of 5,200 companies by a Massachusetts Institute of Technology researcher, which showed that share prices of companies that have introduced good corporate governance are 40 percent higher than those that did not.
Compromising on business ethics can bring short-term value, Hill noted. “Enron, for several years running, was the darling of Wall Street — had greater returns than any other corporations in America. “Livedoor did the same in Japan, but that was only short-lived. Eventually their unethical behavior caught up with them. So in the long run, unethical behavior hurts,” he said.
Hill expressed alarm over results of various surveys indicating that lack of honesty — a measure of unethical behavior — is widespread in American society.
In one study by a university in New Jersey, as many as 75 percent of business students answered “Yes” to a questionnaire item asking whether they cheated to get into graduate school, he said. “These are the future leaders of American corporations.”
Honesty under siege
Integrity also appears to be in question at corporate offices. Hill quoted another survey of company employees showing that 65 percent of respondents do not report ethical problems that they have witnessed — many of them fearing accusations of not being a team player, or retribution from their superiors.
Hill stressed that teaching ethics in business is a multilayered process. First, people must have an understanding of personal ethics — concepts of right/wrong, fair play, respect for the rights of others, honesty, personal integrity, etc. The next process is to translate those values to business — to understand what constitutes fraudulent practices, misleading advertisements, and so forth.
In addition to the understanding of these principles, they also need to have an “ethical courage” — a willingness to pay the price for being ethical, for example, to quit the company rather than take part in fraud, he said.
And finally, Hill said, they need to have “ethical leadership” — an ability to create an ethical environment in an organization, or to encourage others to behave ethically.
The point is “to set the tone at the top of the corporation . . . to create an organization where ethical values are expected, ethical behavior is rewarded, unethical behavior is punished, and people see top management behaving ethically and knowing that that’s important for the company,” he said.
Ethical leadership is particularly important for the management because a vast majority of corporate employees belong to a swing group, who could become either honest or dishonest depending on the environment within the company, he said.
What happened at Enron, he said, may be that this swing group, who would go where the wind blew because they lacked the guidance of a firm ethical belief, went with the dishonest group within the company.
“The question is, which way will your organization swing?”