Governance and Fraud - Term Paper Example

Governance and Fraud By student’s name Course code+ name Professor’s name University name City, state Date of submission Table of Contents PART 1: CORPORATE CULTURE AT ENRON 3 Introduction 3 Enron’s Corporate Culture 3 Appropriate Normative Theory of Ethics 5 Kohlberg’s Theory 7 PART 2: CORPORATE FRAUD CASES 9 Rezaee’s CRIME Framework 9 Australian Wheat Board, an Australian case of Corruption 10 Halifax Bank of Scotland (HBOS), a European case of Financial Statement Fraud 12 1Malaysia Development Berhad (IMDB), an Asian Case of Asset Misappropriation 13 Recommendations 14 References 15 PART 1: CORPORATE CULTURE AT ENRON Introduction The scandal involving Enron and its officials has been described as the largest corporate failure in history precipitated by poor corporate governance approaches by the management of the company. Enron was an American energy company based in Houston, Texas. In the late 1990s, the company was growing at a fast rate and was considered as one of the America’s most innovative companies. By 2001, before its collapse, the company had become one of the world’s leading energy, communications and pulp and paper companies (Yuhao 2010, 37). The company’s management failed to disclose the true status of the company and used the mark to market accounting which reported estimations of future incomes and future net value of the cash flow. As a result, the management of the company misled investors and the public that the company was performing well financially while it was not. However, in late 2001, it was discovered that the reported financial condition of the company was as a result of systematic and well-planned accounting fraud leading to the collapse of the company (Khedekar 2010, 164). This section deals with Enron’s corporate culture that contributed to its collapse. Enron’s Corporate Culture Corporate culture is a term used to refer to the beliefs, values as well as the behaviors that guide the employees and management of a company in the pursuit of the achievement of the company’s goals and objectives. The corporate culture of a company, therefore, influences the decision-making of the management and employees of a company (Pavel and Encontro 2012, 4). Based on this foundation, one can rightly state that the corporate culture Enron greatly contributed to the decision-making that led to the collapse of the company. The incidents that led to the collapse of Enron were all part of the corporate culture that had been created by the management of the company. Enron’s management was desirous of ensuring that the company was leading in all sectors. They sought perfection to ensure that they maintain their standing as innovators in the business world. As a result, the management created and encouraged a culture where employees were allowed to find loopholes in the legal and ethical systems that governed the operations of the company. The management allowed and encouraged the employees to circumvent the systems that were meant to protect the shareholders’ interests. This was done all with the aim of maintaining the position of the company and that of the management in the market. In the company, minor rule breaking was acceptable as long as it promoted the achievement of the goals of the company (Khedekar 2010, 165). The corporate culture at Enron was based on values of risk-taking, entrepreneurial creativity and aggressive growth. These values portray a positive corporate culture. However, a combination of these values with the management’s tendency to encourage and allow workers to take unethical actions created the culture that led to the poor decision-making by the management leading to the collapse of the company (Khedekar 2010, 166). The fact that the employees were allowed to take bold risks coupled with the management’s permissiveness towards unethical actions meant that the employees could engage in unethical conduct and get away with it. In Enron, incentives and bonuses in the form of cash, as well as stock options, were made available for the employees that were considered to be moneymakers (Pavel and Encontro 2012, 4). This made Enron a very competitive workplace and everybody was in a rush to close deals, whether good or bad as long as they can get bonuses. The aggressive environment created a culture of competition rather than cooperation. This led to an individualistic mentality among the employees as they focused on looking out for themselves. They could take bold risks for the sake of retaining their jobs and earning the bonuses (Boswell 2013, 15). The culture created at Enron equated size with success such that those employees who closed big deals would be rewarded and, as a result, the management strived to grow the company even more. The dedication towards growing the company went out of control, and the management began to hide debts to protect the reputation they had created. In addition, even when the company’s failures were exposed to the public, the leaders’ concern was to save themselves without giving much thought to the interests of the shareholders. They had the opportunity to make things right, but they decided to use more lies to hide the fraud in the company. Their actions clearly emanated from the corporate culture they had created in the company. The unethical actions taken by Enron employees were a reflection of what the employees had learnt from the top management of the company (Khedekar 2010, 166). Appropriate Normative Theory of Ethics Normative ethical theories are products of normative ethics which is the study of ethical action. Normative theories of ethics, therefore, portray the different perspectives that try to explain the source of the morality or ethical force of an action or rule. There are three main views on how to answer moral questions namely virtue ethics, deontological ethics and consequentialism (Gamlund 2012, 5). Virtue ethics focuses on a person’s inherent character, rather than their actions, in determining whether an action is moral or ethical. Deontological theories focus on the moral obligations and duties of a person. This means that an individual’s action will be considered to be moral or ethical if it is consistent with their obligations and duties or consistent with what is right. Consequentialist theories, on the other hand, state that whether or not an action is moral or ethical depends on the consequence or outcome of the action (Gamlund 2012, 10). Enron’s corporate culture, as discussed above, promoted unethical behavior and individualistic thinking. Competition rather than cooperation was cultivated and employees could not count on each other for the benefit of the company. The top management did not care much about how things were done so long as the end result promoted the achievement of the goals of the company. Based on this analysis, consequentialism theories best describe the theory behind the decision-making at Enron. The moral evaluations for consequentialism theories focus on the consequences or results of an individual’s actions. As long as the actions of an individual produce proper consequences, then they are moral or ethical. There are many theories that fall under consequentialism category of normative ethical theories. Egoistic consequentialism best explains the decision-making by Enron’s top management. Egoistic consequentialism argues that an action is ethical if the results of such an action maximize the benefits for that person (Gamlund 2012, 31). As long as an individual’s actions produce proper consequences for the individual, then the actions are ethical. This explains why the management focused on creating a competitive workplace where individualism was cultivated. Rewards were given for individual efforts and the consequences of such efforts. The decision to hide the true financial position of the company was meant to protect the reputation of the managers rather than the shareholders. To the management, their actions were ethical as long as they benefited them as opposed to the company and the shareholders. This also explains why they refused to make things right when they had the chance and instead chose to shift blame in a bid to protect themselves. Kohlberg’s Theory Lawrence Kohlberg, a psychologist, discovered that individuals move through distinct stages of morality as they mature. Based on this position he developed a theory of moral development to explain the different levels of moral development (Kohlberg 2009, 1). Kohlberg’s theory of moral development has three levels which have two stages each. These levels are the pre-conventional, conventional and post-conventional levels (Kohlberg 2009, 1). The pre-conventional level applies to children below the age of 9 years. Under this level, there are two stages namely the punishment and obedience orientation and the self-interest orientation (Kohlberg 2009, 1). The obedience and punishment orientation is the first stage in Kohlberg’s theory of moral development. In this stage, the physical consequences of a child’s actions will determine whether the action is good or bad. The second stage is the self-interest orientation where the morally right behavior is determined by what is in an individual’s self-interest. At this stage, a person shows little or no interest in other people’s interests unless such interests will further their individual interests. The conventional level is where a person will judge the morality of an action by comparing the actions to the views and expectations of the society. The third and fourth stages fall under this level namely the good boy good girl orientation and law and order orientation respectively. Individuals whose reasoning falls under the good boy good girl orientation consider good behavior to be what is approved by others and pleases them. Individuals live up to the expectations of others towards them (Kohlberg 2009, 1). In stage four, the law and order orientation, and the individual is guided by the need to maintain law and order. Moral behavior, therefore, is doing one’s duty and showing respect to authority. At the post-conventional level, individuals exhibit personal ethics. It consists of stage 5, the social contract orientation, and stage six, universal ethical principle orientation. In stage five, what is considered as morally right is based on an individual’s rights and agreed standards. In stage six, an action is considered to be right based on an individual’s chosen ethical principles (Kohlberg 2009, 2). Based on the discussion on the different stages of the theory of moral development by Kohlberg, Jeff Skilling, the former CEO of Enron, is at the second stage of Kohlberg’s theory. This is because his actions do not reflect, even to a small extent, any regard to the interests of others. Skilling’s concern and what he considered to be right was what was in his best interests. The decision to hide the true financial status of the company did not benefit the company or the shareholders. It only benefited Skilling and the other managers. As a result, Skilling falls under the self-interest orientation. Sherron Watkins, on the other hand, is at stage five of the theory, that is, the universal ethical principle orientation. The decision by Watkins to disclose the fraudulent actions of Enron’s management was based on her self-chosen ethical principles. She did what no other employee of the company thought of doing by exposing the rot in the company. Her actions were beyond seeking approval from the public or merely maintaining law and order. Her actions reflected her personal convictions and well-chosen ethical principles that could not allow her to ignore the rot in the company. PART 2: CORPORATE FRAUD CASES Corporate fraud cases that have been precipitated by the lack of transparency in financial reporting have cost investors, creditors, employees and pensioners lots of money. Such fraud threatens investor confidence in financial reports. Due to the adverse effects of corporate fraud, the business community has turned its focus on different types of corporate fraud in a bid to restore sanity and confidence in the business world. This section looks at three different cases of corporate fraud and analyzes them based on the CRIME framework by Zabihollah Rezaee. Rezaee’s CRIME Framework According to Rezaee (2005, 280), a thorough review of corporate fraud cases revealed that there are five interactive factors that explain why these high profile financial frauds occur. These interactive factors are cooks, recipes, incentives, monitoring and end results represented by the acronym CRIME. Rezaee argues that a combination of these factors leads to the commission of corporate fraud. The first letter stands for “COOKS” which means the perpetrators of the fraud. Research shows that majority of the corporate fraud cases occur with the involvement, knowledge or approval of the top management or officials of the company including the CEOs, CFOs, presidents and treasurers. There is a consensus that corporate fraud occurs through the actions or inactions of the top management team. As a result, company officials such as CEOs have been held personally liable for any occurrences of fraud in their companies. The second letter stands for RECIPES. Recipes refer to the different ways in which fraud is committed in the companies affected. Financial fraud in a company can occur in different ways such as overstating revenues as well as assets and also understating the liabilities of the company (Rezaee 2005, 282). Rezaee states that most of the corporate fraud cases involved manipulation and falsification of financial information with another percentage involving the misappropriation of assets. The third letter stands for “INCENTIVES” which represent the different motivations for perpetrators of corporate fraud which may be economic, egocentric or psychotic. The fourth letter “M” stands for “Monitoring” which represents the need to establish a monitoring system to detect and prevent fraud in companies. The absence of effective monitoring systems creates room for fraudulent activities. The fifth letter “E” stands for End Results” which represents the severe consequences that are associated with cases of corporate fraud. Australian Wheat Board, an Australian case of Corruption The Australian Wheat Board scandal, commonly referred to as the AWB oil for wheat scandal, was a case that involved paying of bribes to Saddam Hussein’s regime. AWB was responsible for grain marketing in Australia and in the mid-2000s investigations revealed that the company was giving bribes to the Saddam’s regime to secure lucrative wheat contracts (Hobday 2015, 1). The Cooks or the perpetrators of the scandal were the top management of AWB. After the investigations into the scandal, several top officials of the AWB were prosecuted including Trevor Flugge, the AWB chairman at the time of the scandal. These officials used middlemen although on several occasions between 1996 and 2001 he led delegations to Iraq. The Recipes of the corruption scandal or the ways in which the bribes were given involved secretly inflating the contract prices for the supply of wheat to cater for the additional costs resulting from the bribes (Whitton 2007, 1). The bribes were paid as cost of transportation by trucks belonging to Alia, a Jordanian company yet it had no trucks. The corruption also involved sending fraudulent invoices to the UN to cover up the bribes. The Incentives for the corruption scandal was the economic benefits arising from the deal. Through the bribes, AWB had become the single largest supplier of wheat in Iraq. AWB was supplying approximately 90% of the wheat consumed in Iraq. This meant more profits for the company and commissions for the top management. Regarding the aspect of Monitoring, the Board of the company was required to ensure that the contracts entered into between the company and foreign governments complied with all legal requirements. However, the fact that the bribes continued for a long time means there was a failure on the board. The Department of Foreign Affairs was also required to check the contracts with the aim being to prevent any breaches, but the contracts were never checked leading to the scandal. The End result of the scandal was international condemnation and litigation for the breach of international laws. The Australian law enforcement also conducted investigations into the scandal and prosecuted some of the officials of the company (Hobday 2015, 1). The scandal led to a restructuring of the company and its conversion to a private company. Halifax Bank of Scotland (HBOS), a European case of Financial Statement Fraud The failure and collapse of Halifax Bank of Scotland (HBOS) was as a result of flawed strategy and a business model that had inherent vulnerabilities arising from an unusual focus on asset growth, short-term profitability and market share. This exposed the bank to fraud. One of the senior directors at the bank, Lynden Scourfield used to force firms that were seeking loans to use his friend, David Mill’s consultancy firm (Bank of England Prudential Regulation Authority 2015, 16). They would then take control of the firms and plundering their bank accounts. This led to the loss of £1bn from small firms. The Cooks of the scandal were top managers of the bank. There was the Scourfield, a senior director at the bank, two managers of the bank and four associates. The recipe of the scandal was through forcing small firms to use Mill’s consultancy firm which was used to destroy the businesses and thereby benefiting the David Mills. The incentives were the lavish sex parties that were held, lavish gifts such as super yachts and lavish holidays. Scourfiled and his cronies in the bank would receive lavish gifts and sex parties every time they forced clients to use Mills consultancy services. The Monitoring of the activities of the bank and its officials of the bank was the responsibility of the top management (Dunkley 2017, 1). The management was supposed to put in place adequate internal controls and also ensure that none of the top managers acted in a way to encourage fraudulent activities. The lack of such monitoring systems led to the financial fraud. The result of the scandal was the collapse of small firms affected by the scandal and the prosecution of the top managers involved in the scandal. David Mills and Lyndem Scourfield received 15 and 11 prison sentences respectively. 1Malaysia Development Berhad (IMDB), an Asian Case of Asset Misappropriation The 1MDB financial scandal involved the theft of hundreds of millions of dollars from a state-owned investment fund in Malaysia. The purpose of the fund according to Malaysia’s Prime Minister, Najib Razak, was to promote economic development in Malaysia. However, investigations by the US Department of Justice revealed that over $3.5bn had been stolen from 1MDB. The Cooks of the fraud were 1MDB officials who treated the public trust as their bank account where they laundered the stolen money through complex transactions and fraudulent companies (Ramesh 2016, 1). An adviser to the Najib Razik was at the center of the scandal hence prime minister Razik was also connected to the scandal. The recipe of the scandal was the use of fraudulent transfers of money from the fund through dubious transactions and fraudulent companies. The stolen money was laundered and deposited in offshore banks and companies. The incentive was the economic benefit that resulted from the fraud. The officials who were involved meant to benefit from the fund by sharing the stolen money. The lack of a proper and effective monitoring system to ensure that the transactions involving the fund were scrutinized to ensure transparency led to the fraud (Ramanathan 2016, 4). The fact that it was a public fund means that all transactions should have been authorized by a board or a special committee for the sake of transparency and integrity. The end result of the scandal was that Najib, the Prime Minister, sacked all his critics who were members of the cabinet and enacted a security law to protect himself from any prosecution. The loss of the public funds also had an adverse effect on the economy. Recommendations Corporate fraud leads to devastating effects on investors, employees and other stakeholders. As a result, there is a need for all corporate stakeholders to find ways to detect, identify and prevent corporate fraud. The scandal involving AWB should have prevented by having a sound internal control system. There should have been a proper system to ensure that the transactions entered into by the company were consistent with legal requirements. This could have been achieved by working closely with the Department of Foreign Affairs. This could have provided the required checks and balances. For AWB officials to be involved in the corruption scandal, there must have been a lack of a proper corporate governance system (Chartered Institute of Management Accountants 2009, 13). A proper corporate governance system is founded on transparency, integrity and accountability. If the top management was transparent and accountable regarding the transactions, then the corruption would not have happened. The presence of a proper system of internal and external auditing would also have helped detect the fraudulent contracts and uncovered the corruption. The HBOS scandal could have been prevented had the board of directors of the bank set up proper internal controls. Proper internal controls would have helped detect the fraud in the bank by questioning the lavish lifestyle of the senior director and his cronies. This would have led to an audit of their lifestyles hence exposing the fraud. For banks as well as companies and other financial institutions, there is need to hire fraud examiners to review the company’s books and also look at the employees in order to detect and prevent fraud. In addition, if the board and the top management had encouraged a positive corporate culture, the fraud would have been prevented since such a culture would push the employees to only engage in ethical practices (Chartered Institute of Management Accountants 2009, 15). For 1MDB scandal, the board should have established a mechanism such as having a combined team of internal and external auditors to track the performance of investment fund. This would have ensured that any financial impropriety would have been detected in advance. For the officials of the investment fund to embezzle money, the internal auditors ought to have noticed as they prepared the financial reports. External auditors should also have questioned the transactions (Chartered Institute of Management Accountants 2009, 15). Both the internal and external auditors ought to have been more vigilant in preparing and analyzing the financial reports. The board should also have ensured that public officials are not involved in the running of the investment fund. The involvement of public officials in the management of the fund created conflicts of interest that led to the fraud. References Bank of England Prudential Regulation Authority 2015, The failure of HBOS plc (HBOS), Financial Conduct Authority. Boswell, S 2013, The smartest guys in the room: Management lessons from Enron’s leaders, Maryland University. Chartered Institute of Management Accountants 2009, Corporate fraud, Chartered Institute of Management Accountants. Dunkley, E 2017, UK watchdog restarts probe into HBOS fraud case, Available at: https://www.ft.com/content/61664a4e-1b69-11e7-a266-12672483791a [Accessed 30 April 2017] Gamlund, E 2012, Ethics, University of Bergen. Hobday, L 2015, Trevor Flugge, former AWB chairman, faces court over Iraq oil-for-food scandal, Available at: http://www.abc.net.au/news/2015-10-12/ex-awb-chairman-trevor-flugge-court-iraqi-oil-for-food-scandal/6846396 Khedekar, D 2010, Corporate crime: A comparison of culture at Enron and Satyam, Economics and Business Journal: Inquiries and Perspectives, 3(1), 156-171. Kohlberg, L 2009, Stages of moral development, Available at: http://info.psu.edu.sa/psu/maths/Stages%20of%20Moral%20Development%20According%20to%20Kohlberg.pdf [Accessed 30 April 2017] Pavel, T and Encontro, M 2012, The Enron scandal, Chalmers University of Technology. Ramanathan, R 2016, Governing state-owned enterprises: Lessons learned from 1MDB, Institute for Democracy and Economic Affairs. Ramesh, R 2016, 1MDB: The inside story of the world’s biggest financial scandal, Available at: https://www.theguardian.com/world/2016/jul/28/1mdb-inside-story-worlds-biggest-financial-scandal-malaysia [Accessed 30 April 2017] Whitton, E 2007, Kickback: Inside the Australian Wheat Board scandal, Available at: http://www.theaustralian.com.au/archive/news/kickback-inside-the-australian-wheat-board-scandal/news-story/8a42942c1f0a7d0d72ee2bc3c29b9a5e [Accessed 30 April 2017] Yuhao, L 2010, The case analysis of the scandal of Enron, International Journal of Business and Management, 5(10), 37-41. Read More