On September 3, 2003, the New York State Attorney General filed a complaint against a mutual fund, alleging fraud through late trading and market timing, one of many complaints filed in U.S. courts in recent years. Five hundred and ninety-seven billion has been lost in the past five years at the hands of Enron, WorldCom, Reliance, Pacific Gas, and others. That is more than the gross national product of all but 10 nations. Who is responsible for this unethical behavior? Is it accountants, chief financial officers, chief operating officers, boards of directors, or lawyers? Are corporate ethical codes in place and being followed? Do they work? Who is above the law? Should anyone be? Is there a corporate or legal immunity given to a chosen few?

The United States Securities Exchange Commission (SEC) was created in response to the stock market crash of 1929 to oversee corporate business practices and to protect and inform the consumer. The downfall of these gargantuan corporations still happened despite the SEC. Again the United States government stepped in with the creation of the Sarbanes-Oxley Act of 2002 in hopes of further regulating corporate financial practices with stipulations about disclosure and ethics. As recent as November 2003, yet another mutual funds company, Strong Capital Management, Inc., had been charged with wrongdoing (“More signs of trouble,” 2003). Have the Securities Exchange Commission and Sarbanes-Oxley Act been effective?

History of Corporations

In 1819, U.S. Supreme Court Chief Justice John Marshall described a corporation as an artificial being, invisible, intangible, and existing only in contemplation of the law. In another case he declared that as an invisible, intangible, and artificial being, a corporation was certainly not a citizen under the Constitution (Paine, 2003). This fiction theory goes back to Pope Innocent IV who wrestled with punishment for ecclesiastical corporations. Unlike a real person, a corporation, he reasoned, became a creature of private agreement, a fictional umbrella for a private association of shareholders.

By 1900, natural entity theory squared with legal doctrine applied to corporations. A corporation could sue and be sued, have freedom of contract and rights to certain constitutional protections in the United States; it had been declared a citizen. In 1932 the institutional view became prevalent. Corporations were thought to have responsibilities not to just stockholders, but other stakeholders as well. The 1960s and 1970s reverted to fiction theory, and corporations were again viewed as artificial persons with artificial responsibilities. After 1991 organizational culpability appeared in new laws in the U.S. (Paine, 2003, p. 84).

Business Ethics Timeline 1960-2000

During the 1960s the United States underwent dramatic social unrest with the antiwar sentiment of Vietnam. Values shifted away from loyalty to an employer to loyalty ideals with old values cast aside. The major ethical issues were environmental, increased employer-employee tension dominated by civil rights issues, and escalated drug use. The birth of social responsibility began with companies establishing codes of conduct and values.

By the 1970s, defense contractors and other major industries were riddled by scandal, and the economy suffered a recession. The public began pushing for businesses to be accountable. Ethical dilemmas continued with human rights issues of forced labor, unsafe practices, and low wages. Some corporations chose to cover up rather than correct ethical dilemmas. The value movement began to move ethics from compliance oriented to values centered.

The 1980s saw corporate downsizing and employee loyalty change. The social contract between employers and employees was redefined and defense contractors were required to conform to stringent rules. The ethical dilemmas faced were increased bribes and illegal contracting practices, influence peddling, deceptive advertising, and the savings and loan scandal.

Global expansion brought new ethical challenges in the 1990s. Major concerns were child labor, bribery, and the environment. The cultural collision of Internet challenges began. Ethical dilemmas of the era were unsafe work practices in third-world countries under the control of American corporations. An increase occurred in corporate liability with class action suits. Financial mismanagement and fraud began to rise. In 1991 the U.S. Federal Sentencing Guidelines were established.

The new millennium brought unprecedented economic growth followed by financial failures. Ethics issues destroyed some high profile firms. Personal information was collected and sold openly on the Internet to data thieves, and computer hackers caused problems with business and corporate agencies. Terrorism hit American soil. Ethical dilemmas of the era included cyber crime, privacy issues, financial mismanagement, international corruption, and intellectual property theft. The Sarbanes-Oxley Act of 2002 was enacted to mandate stronger ethical standards. A shift emphasizing corporate social responsibility and international ethics centers occurred, which served global business needs (Ethics Resource Center, 2003).

Securities and Mutual Funds Fraud

What happened at Enron will be remembered in history, legal, accounting, and ethics books as a classic case of corporate corruption. An entire organizational culture was dominated by greed at the cost of individual personal value systems. Established and respected accounting firms were brought down along with executives, yet no lawyer was. How is it that Enron was able to go through its manipulation of business entities and monies without legal advice when numerous law firms were involved?

Enron made money and assets go around in circles in order to inflate profits. J.P. Morgan set up a special purpose entity (SPE), Mahonia, controlled by them, with its goal to engage in money-go-round deals. J.P. Morgan would arrange to prepay Mahonia for oil or gas; Mahonia would arrange to prepay Enron for a designated commodity. Finally, Enron would arrange to buy the commodity from J.P. Morgan in the future for a price that appeared to be the amount J.P. Morgan originally paid out, plus interest. In other words, J.P. Morgan was lending Enron money through Mahonia and calling it something else so that Enron would not have to disclose this debt on its balance sheets. Instead, Enron would book as trading profit the money transferred to it from Mahonia and list as a trading liability the money it was due to pay back to J.P. Morgan. Accountants cannot book such circles as sales instead of loans without two legal opinions: a true sale opinion, and a no consolidation opinion (Koniak, 2003).

Mutual funds are also called open-end investment companies and come in three main types: stock funds, bond funds, and money market funds. They are considered open-end as they are required to redeem outstanding shares at any time upon a shareholder’s request, and at a price based on the current value of the funds’ net assets. Although not required, virtually all funds continuously offer new fund shares to the public (Investment Company Institute, 2003).

Various mutual fund groups including Invesco Funds Group, Inc., Strong Capital Management, Inc., and Canary Capital Partners LLC are being charged with civil fraud by the SEC, as well as individual states, for after-market trades, rapid-fire trades, or short-term trades called market timing. Market timing is legal but is limited by fund companies because it can skim profits from long-term shareholders and does increase transaction fees. The director of the SEC enforcement division, Stephen Cutler, (as sited in Labaton, 2003, ¶ 7) says, “By granting special trading privileges to selected customers, they readily violated fiduciary duty they owed to all shareholders and rendered meaningless the funds prospectus disclosures on market timing.” The mutual fund industry is a $7.1 trillion industry. The mutual fund industry is currently undergoing scandals similar to the securities abuse of Enron and World Com, and of note is the Sarbanes-Oxley Act, which was modified to give greater leeway to the mutual fund industry at the advice of Investment Company Institute, its guru.

Investment Company Institute

The Investment Company Institute (ICI) serves the mutual fund industry and investors as representative before Congress, the SEC, and other regulatory agencies as well as state and foreign regulators. Its purpose is to ensure regulation and legislation continue to provide effective investor protection. It also seeks to enhance public understanding and serve public interest by encouraging adherence to the highest ethical standards by all segments of the fund industry (Investment Company Institute, 2003a).

ICI has guided investors, Congress, and the SEC on all issues related to mutual funds. The SEC is known to hold weekly meetings with the input of the ICI. The ICI’s influence as a provider of statistics and advice on mutual funds has tremendous clout as was evident in the drafting of the Sarbanes-Oxley Act of 2002. At ICI’s urging, drafters granted the mutual fund industry significant exemptions from important provisions. Those provisions enacted stringent conflict-of-interest rules, required greater disclosure of transactions between management and large shareholders, and imposed tougher requirements on management to monitor internal controls (Labaton, 2003).

The United States Securities Exchange Commission

The primary mission of the U.S. Securities Exchange Commission (SEC) is to protect investors and maintain the integrity of the securities market. Both federal and state laws regulate securities with federal security laws usually administered by the SEC. Any dealer or broker must be registered with the SEC. Rule 10b-5 of the 1934 Act protects against insider trading (Labaton, 2003).

The SEC has had difficulties of ineffectiveness due to politics and communication problems within the divisions of the agency. There are regulatory divisions within the SEC that are responsible for monitoring mutual fund companies, broker banks, and insurers that are isolated silos, making it difficult to monitor trading patterns. As of 2003 there have been only 350 examiners and support staff to monitor an industry of 13,000 mutual funds and investment advisors, meaning they are understaffed and under funded. Firms are inspected every five years and only as recently as last year have larger firms been inspected every two years. The commission is considering the creation of a new office of risk assessment, which would coordinate officials in various divisions who would be charged with anticipating new problems (Labaton, 2003).

Sarbanes-Oxley Act

The United States Securities Exchange Commission governs the Sarbanes-Oxley Act of 2002. It redesigns federal regulation of public corporate governance and reporting obligations and tightens accountability for directors and officers, auditors, accounting firms, legal counsels, and security analysts. While many companies have codes of ethics, the Commission’s code pertains only to employees of public companies who have financial-disclosure-related responsibilities.

Many organizations recognize that being legal is not the same as being right and urge their employees and others covered by their codes to seek the higher standard (the spirit or intent of the law rather than simply the letter). These codes reflect the notion that legality is a necessary but insufficient standard of ethical conduct. Decision makers are expected to apply law, regulation, policy, procedure, company values, personal values, and societal expectations as the criteria for determining what is “right” or appropriate for the company. (Navran & Pittman, 2003) Recently, there has been a push to expand the scope of ethics codes to include boards of directors. Both the New York Stock Exchange and NASDAQ proposals would require this broad application as part of their listing requirements. When there is one code for employees, another for senior financial officers or principal executive officers, and potentially one more for board members and committees, the waters are muddied and too complex. The resulting confusion can lead to complications and perceived double standards within an organization that may undermine the integrity of the codes. Policy statements accompanying a single company-wide code can address practical differences between board and employee activities (Navran & Pittman, 2003).

American Bar Association

The American Bar Association (ABA), currently 400,000 strong, adopted its Canon of Professional Ethics in 1908. Its code of ethics is to maintain public confidence and create self-regulation among its members, disciplining among its own ranks. The Sarbanes-Oxley Act angered the legal profession, with lawyers across the land voicing opinions about their code of client confidentiality being at risk.

The SEC is an independent agency, and yet it is rule maker, prosecutor, and judge as well as police. While private citizens are supposed to be advocated by the SEC, private citizens, such as CEOs, CFOs, accountants, and boards of directors under investigation from the SEC must turn to lawyers to represent them in matters with the SEC. There is a conflict of interest. Sarbanes-Oxley in essence is making the corporate lawyer answerable to the government, investing public, and regulators. This form of deputizing corporate lawyers acting as agents to the federal government, and with their clients, will certainly alter communication from client to lawyer and back. On the other hand, corporations should not hire lawyers to break the law by manipulating the stock market or mutual fund industry. Forty two states have adopted the measures on their own with no adverse problems on client confidentiality.

In response to Sarbanes-Oxley, the American Bar Association (ABA) created a Corporate Responsibility Task Force. On June 30, 2003, the task force urged amendments to the Model Rules to allow lawyers to more easily disclose wrongdoing by corporations they represent. They further recommended that corporate audit committees or other independent directors of the board meet regularly with general counsel in executive sessions. It was further recommended that outside counsel should establish a direct line of communication with general counsel, with an exception that outside counsel will inform the general counsel of violations or potential violations of law. In concluding that outside directors, outside auditors, and outside lawyers have fallen short in providing active and informed stewardship of the best interests of the corporation, the task force’s agenda is to modify and strengthen the current body of ethical rules guiding lawyer conduct (American Bar Association, 2003).

Rule 1.13 of the Model Rules of Professional Conduct states that a lawyer’s allegiance is to the corporation as an entity and not the constituents comprising the corporation. In September 2003, the ABA voted by a narrow margin to allow lawyers to disclose confidential client information if the client is using their services to commit a crime or fraud that would harm other parties (American Bar Association, 2003). The interpretation is open for discussion. Opponents of the change argue that it undermines the immunity that forms the basis of client-lawyer relations. Without it, they say, lawyers will be placed in an impossible situation of having to choose between their codes of conduct and ruining their business. They also argue that clients will withhold information from their legal advisors for fear of it being used against them, making lawyers less effective as advisors and less able to protect the company and its shareholders against malpractice (International Financial Law Review, 2003).

There are two perspectives from the ABA and the state about ethics rules. The ethics rules acknowledge the centrality and superiority of state law by insisting lawyers not aid clients in unlawful activity. From the bar’s perspective, ethical precepts that require lawyers to obey the law and to refrain from helping clients to break it are contingent on obligations, not constitutional norms. Corporate lawyers should practice law with corporate social responsibility. The ethics rules of Sarbanes-Oxley prohibit knowing assistance of illegality (Koniak, 2003).

Why Ethics?

Researchers studying U.S. companies have found that firms convicted of wrongdoing usually experience a decrease in profits and employee morale, as well as customer defection. In a review of 95 academic studies of mainly U.S. companies on the relationship between corporate financial and social performance, only four of the 95 studies found a negative relationship between social and financial performance. Fifty-five studies found a positive correlation between better financial performance and better social performance. The studies looked at 70 diverse measures of financial performance, product safety, and community investment. Eighty of the 95 studies sought to determine whether ethics pays or whether better social performance was a predictor of better financial performance (Paine, 2003).

There is a definite link between corporate and personal values and the success of a corporation. Case studies show commitment to truth, reliability, fairness, and respect will enhance management and group efficiency. (Paine, 2003) At the opposite end of the spectrum, communication becomes problematic and credibility at all levels is lost. Companies that incorporate ethics codes into their culture spend less time on problems and have more time devoted to productive activities, serving customers and developing new business (Paine, 2003).

Effective Ethics

When effective organizational ethics are fully integrated into the organization, application of the organization’s ethics code, must be ongoing. Leadership support is essential to the success of effective ethics, meaning that the code of ethics applies to everyone in the organization.

An ethics committee separate from the corporation best serves all employees. An outside hotline is also well served, as it gives employees freedom to speak about ethical dilemmas they might face, without possible repercussions from management. Ethics training programs are important to the success of corporate social responsibility.

The keys to an ethical climate are leadership, consistency, fairness, open talk about ethics, and employee perception that ethical behavior is rewarded. Of the types of ethics programs, a compliance- and values-based ethics program works the best. Being compliance based includes adherence to company policies, rules, and law, while being value based includes an emphasis on people and companies core value systems.

Conclusion: Corporate Social Responsibility

Corporate social responsibility is the integration of business operations and values whereby the interests of all stakeholders, including customers, employees, investors, and the environment, are reflected in the organization’s policies and actions. Good corporate social responsibility is seen through community involvement and support, contribution to local community growth and development, compliance with U.S. and international laws, and exemplary employee practices. By practicing CSR the company is positively affected, as are the community and the stockholders, and employee loyalty grows. Higher profitability is a benefit shown in statistics.

As stated by United States Securities and Exchange Commission Chairman William O. Douglas, on January 7, 1938 (cited in Atkins, 2003),

By and large, government can operate satisfactorily only by proscription that leaves untouched large areas of conduct and activity, some of it susceptible of government regulation but in fact too minute for satisfactory control; some of it lying beyond periphery of law in the realm of ethics and morality. Into these areas self-government, and self-government alone, can effectively reach. (¶ 26)

Biography

Zeta Angelich currently works as Director of Marketing for Micro-Bac International, Inc. in Round Rock, Texas as well as an Adjunct Professor at St. Edward's University in Austin, Texas. Her interest in leadership and ethics has been lifelong, and she will continue to write, publish, and teach on "things that matter."

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