The seven signs of ethical collapse

There has been a certain smugness of late amongst governance officials. One often finds ethics officers at companies declaring: “I am sick of hearing about Enron.” Well, aren’t we all? Perhaps once we have taken the lessons of Enron to heart, we can stop talking about Enron – but thus far the evidence that those lessons have been absorbed is not convincing.

In the United States, 80 companies are now under investigation for issues surrounding their grants of options to corporate officers. In one of those companies, several of its former officers have been indicted. In others, boards have terminated those officers. BP’s announcement that it would be forced to close a major oil pipeline came along with the news that employees and others have been raising the red flag about the problems with the pipeline for a decade. And Franklin Raines, the former CEO of Fannie Mae who testified post-Enron in favour of the Sarbanes-Oxley reform legislation even as he denounced corporate financial misdeeds, headed a ship described by one auditor as not even being on the page “if that page represented the boundaries of the accounting and financial reporting rules”.

In the words of the great 1960s musical group Buffalo Springfield, “there’s something happening here” – and what is happening is, unlike the song, quite clear. We have not stepped back to see common threads and applied controls for those threads. Instead, we remain poised with reporting systems, ethics officers, ethics codes, ethics training, and a host of other best practices that do not address the real issue (Enron had one heck of a code of ethics and all the other components of a solid ethics program, but these did not seem to provide a barrier for roguish behaviours). We continue to arrive on the scene just a bit too late to prevent the crimes, constantly in mop-up, contrition and PR-nightmare mode.

The real next step in ethics and compliance is getting our arms around what exists in organisations to allow such obvious missteps, misdeeds and financial scandals to breed and grow. In hindsight, we find ourselves shaking our heads in wonder at the perpetrators and asking: “What were you thinking?” and “How could this happen?” Perhaps more importantly, we should be asking the same of those employees who were not participants but saw the scandal evolving and let it fester. Understanding what they were thinking offers the key to unlocking the mysteries of ongoing ethical lapses and collapses. We can no longer blame only the rogues when there are eyewitnesses.

With apologies to Tolstoy, all unethical companies are alike. In the companies that have crashed ethically (and in many cases crashed and burned), we find not just common factors, but fixable cultural traits that breed profoundly mystifying ethical lapses. Identifying those factors and then putting antidotes into the system are the keys to preventing good companies from going bad. I believe there are seven qualitative factors that breed and nurture unethical conduct. Indeed, these factors may well be more important than any financial analysis of a company, because the numbers are credible only if the culture that put those numbers together is credible itself.

Sign #1: Pressure to meet those numbers

All companies and organisations have goals and feel the pressure to ‘meet the numbers’. A company with a poor ethical culture, however, has graduated meeting those numbers into a zone of perversity. Employees in these companies start with the number they want to report and work backwards, making things fit using accounting interpretations, and eventually just making it all up to reach the predetermined number.

A quick look at the companies that collapsed shows an odd obsession with numbers. HealthSouth’s last annual report before all the indictments and its multibillion restatement included this achievement: that it had met earnings predictions to the penny for 47 quarters in a row. In some companies, the goal was not just profit, but to be master of the universe (or at least the NYSE). Former WorldCom CEO Bernie Ebbers described his strategy for WorldCom in 1997: “Our goal is not to capture market share or be global. Our goal is to be the No. 1 stock on Wall Street.” Even the goals should have had us at least scratching our heads if not divesting. For example, in January 2002, former Tyco CEO Dennis Kozlowski, being touted by Business Week as the best CEO in America, gave a wild numbers promise: “Kozlowski vows Tyco’s earnings will once again grow by more than 20 percent a year. That would bring him closer to his ultimate goal: inheriting the mantle once worn by Jack Welch.” 20 percent per year? Come on, folks.

The price-fixing settlement by Marsh McLennan (MMC) came in the post-Enron era because of numbers pressure. As MMC’s profitability increased, employees colluded not just on the accounting, but also with others to thwart competition and guarantee their contract renewals. Roger Egan, President and COO of MMC, explained the culture and the fear in this statement to his direct reports in a meeting: “Each time I see Jeff [Greenberg, then CEO of MMC] I feel like I have a bull’s eye on my forehead.”

The antidotes for this pressure include the simple act of managers explaining the rules – as one CEO said to his employees: “I need you to meet your numbers, but I don’t want you to do anything stupid to get there.” Goals should go hand-in-hand with parameters, the lines we do not cross to reach goals.

Another important antidote is reviewing whether actions taken are consistent with those values and lines that establish the parameters for meeting numbers. How do we deal with grey areas in law and financial reporting? Do we encourage employees to discuss their concerns? Do we reward employees who do the right thing and, as a result, do not meet their numbers? Are we consistent in disciplining employees who cross those lines? Are we consistent on discipline when the employee is a top performer? Or do we look the other way? In dealing with a culture of numbers, what managers tell employees is important. What managers do and how they treat employees who make ethical choices is critical in curbing the culture of numbers.

Sign #2: Fear and silence

As I begin my 30th year of teaching and research, I am certain of one thing: in any ethical debacle involving a business or other organisation, there is never an issue of employees not seeing the ethical issue. Companies and their managers really do not need ethics training; they need training on how not to silence employees when they are concerned about an ethical or legal issue. There is an element of black comedy in each of the companies that experienced ethical collapse, because the knowledge that their companies were crossing ethical lines was pervasive among employees. According to USA Today, Enron employees circulated via e-mail a Top 10 list called “Top 10 Reasons Enron Restructures so Frequently.” Number seven on the list was “because the basic business model is to keep the outside investment analysts so confused that they will not be able to figure out that we don’t know what we’re doing,” and number one was “forget all the hype about Fortune’s number one – congratulations to Enron for having entered Guinness Book of World Records with 942 organisations in one year.” In 1997, as a videotape bears out, Enron executives had a farewell dinner and roast for Rich Kinder, President of Enron prior to Skilling assuming the reins. In a skit that was part of the roast that evening, Rich Kinder’s executive assistant played Kinder, Jeffrey Skilling played himself and a third Enron employee played an accountant. Skilling has a line in which he suggests that Enron move from “mark-to-market” accounting to “hypothetical future value accounting” because such a move will “add a ka-zillion dollars to the bottom line.”

In this type of culture, employees may see the issue, but they remain silent; if they do share their concerns, they are either terminated or (perhaps more insidiously) flatlined in the organisation. They are not team players because they insist that the company play by the rules. These were companies in which executives did not want bad news and sycophants were promoted. KPMG recently settled its tax shelter fraud charges for over US$300 million. When those shelters were in full swing, one of the partners raised concerns that perhaps KPMG had crossed legal lines with the tax shelter structure. The response of the partner in charge was: “You’re either on the team or off the team.” Dissent-not-welcome-here was the signal.

One reporter’s conclusion about the culture at HealthSouth summarises the essence of a culture of fear and silence. “Interviews with associates of Mr [Richard M] Scrushy [then-CEO] government officials and former employees, as well as a review of the litigation history of HealthSouth, paint a picture of an executive who ruled by top-down fear, threatened critics with reprisals and paid his loyal subordinates well,” reports Fortune’s John Heylar. Diana Henze, who was a VP for Finance at HealthSouth, refused to certify HealthSouth’s financial statements in 1999 because the numbers had been changed so many times and she suspected fraud. Ms Henze’s punishment was that she was passed over for a promotion that had been hers; a less qualified person got the job. When she asked why she was passed over, HealthSouth’s then-CFO responded: “You have made it clear that you won’t do what we ask.”

The antidotes for the culture of fear and silence are straightforward: tell employees to speak up, give them the means to speak up, and do not punish them for raising concerns and issues. A state-of-the-art reporting system is meaningless if your treatment of employees who raise issues is inconsistent with your avowed desires for reporting. Many companies fail to have the one-on-one discussions with employees that are necessary to understand how they really feel about the culture and their comfort levels with reporting concerns.

There is one additional antidote for fear and silence that works but remains largely a ‘someday’ to most organisations. This antidote puts ethics as a component in annual performance reviews. The hesitance is remarkable given that the US requires companies use both the carrot and stick approach. To benefit from the reduced sentencing provisions should they get into legal difficulty, companies must be able to show that they not only disciplined employees who violated company standards and the law, but also that they rewarded employees for honouring the same. One company has a 10 percent weight on employee annual reviews for their ‘forthrightness’. Employees are required to give at least one example of how they behaved forthrightly with a customer, a fellow employee or investor during the past year. Positive rewards are powerful signals that curb the fear and silence.

Sign #3: Young ‘uns and a bigger-than-life CEO

This sign is a structural one. The companies that collapsed ethically all had an iconic CEO lauded by community and media who headed up a group of weak direct reports. These CEOs are the stuff of urban legends, unchallenged by even the business press despite signs pointing in the direction of fraud. For example, in 2001, Sanjay Kumar, Computer Associate’s charismatic CEO who was heading a company with phenomenal numbers performance, held a conference call to answer questions about a New York Times story that had raised issues about the company’s accounting practices. Kumar said that the story had “misleading and at times false information.” He explained: “Standard accounting rules [are] not the best way to measure [CA’s] results because it has changed to a new business model offering its clients more flexibility.” His status allowed him to escape unscathed from the questions and with that shallow explanation, but by 2006, the company would issue massive restatements and Kumar would enter a guilty plea to federal charges of fraud.

Iconic CEOs need direct reports who do not challenge their authority, judgment or ethics. They surround themselves with a sycophantic management team. Sometimes the scenario is a family affair. At Adelphia, the iconic former CEO John Rigas was known to the locals in Coudersport, Pennsylvania (where Adelphia was headquartered) as “a Greek god.” His sons and sons-in-law were his direct reports. The company collapsed under what prosecutors called a classic case of Rigas using the company as his personal piggy bank. He was convicted of fraud, along with one of his sons.

In these companies, iconic CEOs surrounded themselves with youthful ‘useful idiots’ who raise no questions. When former Tyco CEO Dennis Kozlowski was asked in 2001 how he chose his executive team, his response was a classic iconic one: “I hire them just like me: smart, young, want to be rich.”

The antidote here is simple: beware the iconic CEO. The plodder CEO should enjoy something of a resurgence. Look for CEOs who spend time at the company with the employees. Wendelin Wiedeking, the CEO of Porsche, has turned that company around in everything from production efficiency to vehicle design over a 12-year period. Wiedeking spends time on the factory floor: “I’ve got friends in the factory. I don’t need bodyguards there, like some other CEOs.”
Another antidote is to always question even the most outstanding of performers when it comes to CEOs. Even GE’s Jack Welch needed a little confrontation. The failure to disclose Welch’s retirement package resulted in SEC sanctions against GE. And it all surfaced thanks to an affair and a messy divorce. Therein lies another important antidote: watch for affairs, high levels of personal expenses and investments, and dramatic shifts in behaviour in CEOs. If a board wants an ethical atmosphere, raucous behaviour in the executive suite will not get it there.

Sign #4: A weak board

The boards of companies at risk for ethical collapse are just plain weak. Again, with apologies to Tolstoy, just as all happy families are alike and all unhappy families are different in their misery, all effective boards are alike and all weak boards are ineffective for different reasons. Some of the boards are weak because members lacked experience. Others were weak boards because they consisted of friends who would do management’s bidding. At WorldCom, the board was referred to by insiders and outsiders alike as ‘Bernie’s Board’. Conflicts of interest caused weakness and deference at other companies. At HealthSouth, the directors were doing business with the company and with the CEO. Some boards were weak because board members failed to attend meetings or the meetings did not include meaningful discussions of proposals and issues.

The antidote for this sign is a strong board, a tall order. But, there are some simple suggestions that can help. Dig deep on conflicts. Look for philanthropic arrangements, donations and relationships that do not trigger legal disclosure. The NYSE board was fraught with unperceived conflicts, which resulted in Chairman Richard Grasso’s obscene compensation package. The CEOs whose companies were regulated by Chairman Grasso served on the committee that established his compensation. Grasso’s pay surpassed even the highest paid CEO on the board by US$55 million.

Another antidote for a weak board is individual directors with strong backbones. When I was working with the board of a non-profit organisation that had been forced to terminate its CEO following an ugly series of events including personal issues (affairs and divorce, again), loans and questions about the award of company contracts, the board members felt humiliated when it all became public. When I asked them why they went along with it all despite their gut instincts to say “No!”, one of them explained: “Because it’s hard to sit in a room and disagree with people you respect who think it’s okay.” Therein lies the heart of corporate governance: being able to raise questions about troubling issues that no one else sees or is willing to say aloud.

Sign #5: A culture of conflicts

In these ethically collapsed companies, the officers hired relatives, contracted with companies owned by relatives, and generally used the company for family and friendly profit. There is a distinct atmosphere of back scratching in these companies. Ken Lay’s son, Mark created two privately held technology firms and then managed to sign Enron, a Fortune 100 company, as a customer. Enron even invested in one of them. Then the company hired Mark Lay as a consultant at a salary of US$1 million for a three-year contract. Enron used a travel agency that was co-owned by Lay’s sister, Sharon, whose Alliance Worldwide Travel booked more than US$10 million in travel for Enron and its employees.

The dotcom industry was fraught with a different type of conflict. When the dotcom companies went public during the internet bubble, stock for their IPOs was doled out to suppliers, customers, family, lawyers who drafted the documents for the stock offerings, and anyone else willing to believe in selling air as a product. Those who created the dotcom myth profited by dumping their stock allocations from their interrelationship into the market during the frenzy of the IPO.

Effective management of conflicts is the antidote here. And effective management requires that we believe that conflicts of interest cloud judgment. Once we have that belief, there are just two things to be done to manage a conflict of interest: disclose it or don’t do it. For board members and family members, the ‘don’t do it’ is the best option. For the types of conflicts with the IPOs, the disclosure would have made all the difference.

Sign #6: A culture of innovation like no other

“You know, if we hadn’t had all those expenses, we would have had earnings.” This quote has been attributed to a dotcom CEO during the EBITDA era. In these collapsed companies there was a belief that they were so brilliant and innovative that the mundane rules of accounting, corporate governance, and even basic economics did not apply to them.

These companies are somewhat entrepreneurial, and somewhat justified in their belief of superiority because they have done so well initially. HealthSouth was touted as a healthcare provider whose delivery model would change the industry. Enron truly was visionary in its recognition that a national energy market would reduce prices for everyone. At the time that telecommunications deregulation was just beginning, Bernie Ebbers of WorldCom employed a simple economic model to grow a business: buy long distance wholesale, sell it retail, but at a cheaper price than the bulky baby bells. Dennis Kozlowski took Tyco from a sleepy lab and research company to a multinational conglomerate. When Al Dunlap became CEO of Sunbeam, after his phenomenal performance at Scott Paper, the stock market made Sunbeam’s stock soar.

Yet, in a way, their brilliance was their downfall. They all did so well with their innovations and creativity that they wanted it to continue in perpetuity. They felt different, above the fray and the mundane. From soaring heights, they all slipped into fraud.

Antidotes require that we rein in the innovators with the checks and balances of wisdom and business experience. Grounding them in accounting rules and the inevitabilities of economic cycles goes a long way. I visited with the CEO of a grocery store chain in Louisiana that has enjoyed 300 percent growth in sales in its Baton Rouge stores as New Orleans residents who were victims of Hurricane Katrina have migrated there. The CEO must rein in his young employees who have enjoyed phenomenal bonuses through an act of God – they cannot continue at this pace nor should they try any manipulations to keep the growth going.

Sign #7: Goodness in some areas atones for evil in others

This factor is evidenced by the consistent thread that both the managers and the companies themselves perceived themselves and, indeed, were perceived as good citizens. Philanthropic, environmentally sound and diversity-dedicated, these companies were recognised for their good deeds and contributions. Their noblesse oblige benefited many.

Enron was a philanthropic giant in Houston. WorldCom and its officers were described by elected officials as ideal corporate citizens. Bernie Ebbers had raised US$500 million for a college fund drive. Bernie was also a Sunday school teacher at his church, the regular Sunday school teacher there. The Adelphia Rigas family was perhaps the most generous of them all, taking personal interests in the people of Coudersport and helping them with everything from free movies to plane flights to medical centres for specialised treatments. HealthSouth and Scrushy together helped build the Richard M Scrushy Public Library, the Richard M Scrushy Campus of Jefferson State Community College, and the Richard M Scrushy Parkway. AIG’s former CEO, Hank Greenberg, served on boards for nonprofits.

Generous, helpful and diligent in their community efforts, the companies played a sort of balancing game. So long as they were good to the environment, strong on diversity, involved in the community and generous with charitable donations, their conduct at work was not a problem for them. They rationalised and justified their wrongful financial transactions and reporting because these were ways to get money to do good things.

The antidote for this factor is simple: do not equate socially responsible behaviour with virtue ethics. Ethics is not a continuum that allows us to assume that because there is the higher order of philanthropic giving that the basics good behaviours of honesty in transactions and reports are along for the ride. Dedication to environmentalism, community, diversity and other SR goals do not translate into solid accounting practices. In evaluating companies, the emphasis on doing good may well be a cover for what goes on internally. Be very cynical about corporate generosity and social responsibility.

Conclusions on the seven factors

Spotting the seven factors of ethical collapse and applying the antidotes can help boards, executives, employees, analysts and investors. The seven factors are a means of evaluating those company traits that, while not measurable, control the content of the financial reports and whether executives will move into fraud. The seven signs are not just another set of thoughts on corporate governance. They are tools of prevention designed to curb what has happened far too many times in far too many companies. With the seven signs we need no longer stand aghast and ask: “What were they thinking? How could this happen?” We now know how. We also now know that the key to prevent is getting the antidotes to the seven signs in place to move from our defensive clean-up position to aggressive prevention.

Marianne Jennings is Professor of Legal and Ethical Studies at the WP Carey School of Business, Arizona State University. This article is adapted from the book, The Seven Signs Of Ethical Collapse, just published by St Martin’s Press, 2006.