How a Mirror Can Help in the Crisis

// By Alexander F. Brigham & Stefan Linssen

“In the arrogant culture of one institution, those with oversight responsibility were at the bottom of the barrel–called “pollution” that would slow down everyday business–and viewed as an unnecessary nuisance.”

Shoo. You can’t attend this meeting. We are going to discuss things here that you will tell me I shouldn’t do. I don’t want that on the record and you can’t stop me.

And so it went. Joseph Cassano, the head of the most profitable division of one of the world’s largest and most admired companies stonewalled Joseph W. St. Denis and deliberately excluded him from a company meeting.

St. Denis, Vice President of Accounting Policy, had been hired to oversee the division’s transactions. Cassano, who obviously didn’t want St. Denis’s official input, had the power to exclude him in such a dismissive manner without retribution. In the arrogant culture of this institution, those with oversight responsibility were at the bottom of the barrel—called “pollution” that would slow down everyday business— and viewed as an unnecessary nuisance.

Enron circa 2001? No. Think AIG in 2006, a company that has now cost American taxpayers over $100 billion in bailouts, capital injections and guarantees—all thanks to the trades of one individual who was allowed to refuse oversight.

Seven Years

It has been seven years since the shocking implosion of Enron over off-balance sheet liabilities. Outrage was feigned, blue-ribbon commissions were created producing lofty recommendations, laws and regulations were passed and CEOs, including Jeff Skilling of Enron and Dennis Kozlowski of Tyco, were sent to prison.

Problem solved? Obviously not.

The hallmark Sarbanes-Oxley Act was hastily passed on the heels of the 2001 crisis. Legions of accountants descended on corporations, applying the various sections of the law to ensure controls were in place to track assets and require that attestations from management and whistleblowing hotlines be put in place in hopes that a subsequent crisis would be averted.

It wasn’t.

In an interview that followed the passing of SOX, Paul Sarbanes told a reporter about the hearings that Congress held on the issue of corporate fraud and the accounting scandals that had occurred in 2001 and beyond. He told the reporter that those hearings had “produced remarkable consensus on the nature of the problems: inadequate oversight of accountants, lack of auditor independence, weak corporate governance procedures, stock analysts’ conflict of interests, inadequate disclosure provisions, and grossly inadequate funding of the Securities and Exchange Commission.”

Today, corporations, mainly financial institutions, have begun reenacting the same shenanigans that caused the 2001 fiasco—moving liabilities off the balance sheets and convincing accounting firms to bless these maneuvers, as well as holding assets at inflated values versus market pricing. The fact that many of these institutions were later required to return those assets back onto their balance sheets underscores the fraudulent and misleading original intent of these firms.

Even deposed Tyco CEO Kozlowski, locked up in prison in upstate New York, is outraged, fulminating about how this scandal is so much worse than anything he did at Tyco. In a November interview with FOX business news, Kozlowski said, “I sit here and I read about a $150 billion bailout of AIG. I compare it to a $6,000 shower curtain. It’s hard to reconcile the two…You couldn’t even closely draw a comparison, at all.”

Apparently Kozlowski is right.

Despite his wife’s penchant for $6,000 shower curtains, ultimately Tyco’s investors did not suffer on nearly the same par as the shareholders of delinquent organizations involved in the more recent financial crisis. In comparison with those who owned stock in Citigroup, which erased $140 billion in shareholder value in a mere 18 months during the 2008 financial crisis, Tyco’s 2004 investors didn’t do quite that badly. In the aftermath of the Kozlowski/Tyco scandal, the company broke up into three sub-groups: Covidien (healthcare provider), Tyco Electronics (network electronics) and Tyco International (various industries). Tyco was ordered to pay over $2 billion to affected shareholders, but by 2006 its revenues matched the levels of 2004 when the scandal hit, and the change in stock price during that time period was relatively negligible.

The “Lynch” Pin

Some of the key players from the Enron debacle stayed on and contributed to our current financial crisis. In 2003, Merrill Lynch was charged by the SEC with aiding and abetting Enron Corp’s securities fraud. The investment bank/brokerage was accused by the SEC of participating in a few fraudulent transactions with Enron in order to improve the energy company’s annual earnings reports. Merrill never admitted or denied the allegations, but they did agree to an $80 million settlement and two of their senior executives, including their then-head of investment banking, were sentenced to several years in prison.

Merrill Lynch was one of the linchpins in the current crisis, too. The firm was the world’s largest issuer of collateralized debt obligations (CDOs), which were essentially bundles of subprime mortgages sold to investors as investment-grade securities. Some of the worst securities were held on their own books and not written down to market value when the housing market began to deteriorate. As ABAlert pointed out on August 3, 2007, well before the massive financial writedowns began to occur, Merrill Lynch reported second quarter 2007 earnings of $2.1 billion, likely by transferring its bad investments within its brokerage unit to render them no longer available for sale, and to indicate instead that they would be held until maturity. An unethical and misleading move, to say the least.

“I Sit Here and I Read About a $150 Billion Bailout of Aig. I Compare It to a $6,000 Shower Curtain. It’s Hard to Reconcile the Two… You Couldn’t Even Closely Draw a Comparison, at All.”

The unraveling came just a few months later, as Merrill Lynch was forced to reverse itself and write-off $9.4 billion of its CDO holdings in October 2007, leading to the firing of CEO Stan O’Neal, who presided over the debacle. By mid 2008, another $10 billion had been written off. Mr. O’Neal, however, received a severance package in excess of $120 million, in addition to the more than $60 million he was paid in the previous years.

As it stands, AIG hasn’t learned any lessons from the various corporate scandals of the fledgling 21st century, either. AIG should have had their eye on Joseph Cassano, the executive that kicked the Vice President of Accounting Policy out of a meeting, a long time ago. Or, more appropriately, they should have fired him in 2004. That year, Cassano’s department entered into a deferred prosecution agreement with the Department of Justice (DOJ) over aiding and abetting securities fraud.

This raises the question, at what point does a company say “enough is enough?” “Enough” probably occurs when one of your execs is busted for securities fraud and enters a deferred prosecution agreement with the DOJ. At the very least, at that point the leaders of a company should take a look at the division involved and think, “Maybe we should fire the guy responsible for that.”

Of course, AIG didn’t just hold off on firing Cassano, but also continued to pay him an exorbitant amount of money. In the eight years that Cassano worked for AIG, he was rewarded over $280 million. Even after he left the company in March of 2008, he received $1 million a month in consultancy fees (though eventually he lost that salary—a day before the U.S. Congress held a hearing on the company’s financial implosion.)

What’s the Difference Today?

As Ben Heineman, the highly-respected former general counsel of General Electric pointed out to Ethisphere, this year’s breakdown was systemic.“Enron and WorldCom, that set of scandals came from bad CEOs who knew what they were doing—they committed financial fraud and blew through the systems,” Heineman said. “The problem with this set of scandals and issues is that management didn’t know what they were doing. All systems failed: accounting failed, finance failed, legal failed, risk failed, human resources failed, operational leadership failed, the boards failed, CEOs failed. It’s a massive failure inside the company.”

This ingrained culture of bad behavior is twice as hard to swallow after hearing a similar remark Paul Sarbanes made about the earlier corporate scandals. “There were problems in the market—problems that were broad, deep, systemic, and structural. News stories at the time made this clear,” Sarbanes told a reporter in 2004. “A number of very major, highly-regarded public companies, along with their auditors, were relying upon convoluted and often fraudulent accounting devices to inflate earnings, hide losses, and drive up stock prices.”

So, did the Sarbanes-Oxley Act fail us? Not entirely. In some ways it worked as intended, as it resulted in an early warning on the financial meltdown issued back in June of 2007. Deloitte & Touche, the auditor for two Bear Stearns hedge funds focused on the mortgage industry, warned that the two failing hedge funds were assigning asset values that couldn’t be confirmed by the market. The hedge funds collapsed within days, and billions of investor dollars were lost.

So what was the shortfall in SarbanesOxley or other regulations that could have prevented additional financial collapses and frauds? Would a new rule limiting executive compensation have made a difference? Perhaps a law requiring greater disclosure? Perhaps rotating boards of directors more frequently? Perhaps assigning more “financial experts” to boards?

The answer to each of these questions is “no.”

What’s missing is not a law or regulation, but rather an emphasis on compliance and feature ethics, and a willingness to self-examine business practices routinely to make sure that they are transparent, of sufficient ethical intent and sustainable in the long run.

No incremental guidance or federal rule would have made a difference. Why is this? The individuals at the heart of the scandals behind today’s economic ruin knew the rules, but only obeyed their letter, not their spirit.

Ethics, morality, common sense, business conscience—whatever terms one might use to such an ethos—were absent, having been replaced by greed, fear, and simple willful incompetence and blindness.

“I Knew It was Wrong at the Time”

When scandals occur across such a broad swath of corporations, it’s important to ask, “Who was aware this was happening?” The answer usually is JOE. JOE (Just One Employee) exists in virtually every organization. He or she is the employee that witnesses or experiences significant fraud or moral meltdown, but doesn’t speak up about it. Corporations should operate under the assumption that employees at all levels know if improper and unethical behavior is occurring.

The best companies recognize this prevalence and enact systems whereby JOE can speak up and raise a concern without fear of being retaliated against. Those companies can nip any potential problem in the bud.

Richard Gugliada, former Managing Director of the rating agency Standard & Poor’s (S&P), was a JOE. S&P, along with competitor Moody’s, significantly abetted fraud in many financial institutions by assigning AAA ratings (sterling investment grade scores) to high-risk asset classes overseen by poor due diligence, which then allowed these institutions to resell them to unwitting investors.

“I knew it was wrong at the time,” Gugliada told Bloomberg News earlier this fall. “It was either [do it] that [way] or skip the business. That wasn’t my mandate. My mandate was to find a way—find the way.”

This was one way that S&P kept its business with clients, as companies would have limited cash flow if their ratings went down.

But S&P is hardly alone in having a JOE.

Consider government-backed mortgage securities company Fannie Mae and its sibling, Freddie Mac. Only now is it leaking out that executives had been fighting with one another years before the fallout over the internal risk controls of the two companies. Records from Congressional investigations and testimony show that executives at the two mortgage firms began to get nervous as they started taking on more and more of the junk mortgages that have become so infamous today. Fannie’s chief risk officer, Enrico Dallavecchia, wrote to the company’s chief operating officer, Michael Williams, “[Fannie] has one of the weakest control processes I ever witness [sic] in my career.”

This kind of internal debate had been occurring in both Fannie and Freddie. Such debates even tied back to the ratings agencies—it turns out they had been suspect for a long time, but no one bothered to take a hard look at what they were doing.

One former risk officer at Fannie Mae wrote an email as early as 2005 warning that if home values dropped, the mortgages would become huge financial burdens on the company. On top of that, the risk officer said, there was “concern that the rating agencies may not be properly assessing the risk.”

Of course, there is no shortage on “whistleblowers,” reporting looming dangers that often turn out to be baseless or ill-intentioned. Nevertheless, it’s hard to excuse the lack of due diligence on statements of concern.

In fact, the Ethisphere Institute raised the issue of fraud early on, back in 2005, when it highlighted the Ameriquest settlement over allegations of unfair lending practices. That issue involved a $325 million settlement with the DOJ, paid by Ameriquest Mortgage Co., as well as attorneys general from 49 states. Ameriquest fought the settlement for quite some time, but in early 2006 finally settled and resolved the charges that the company mislead and defrauded customers.

Of course, neither Ameriquest nor its billionaire CEO Roland Arnall admitted or denied guilt in the whole affair. This turned out to be a wise decision on their part, as the U.S. government ended up rewarding Mr. Arnall for settling his case of fraud before the real estate market began its catastrophic meltdown. In fact, just under three weeks after the settlement, Mr. Arnall was confirmed by the U.S. Congress as the next U.S. ambassador to The Netherlands.

In 2007, Ameriquest was purchased by Citigroup. Later, Citigroup would be part of the $700 billion Troubled Assets Relief Program (TARP), accepting over $40 billion in federal funding altogether.

We should consider the allegations of fraud against IndyMac Federal Bank as well, which is also involved in the housing mess and also based in California. In this case, unethical behavior allegedly wasn’t limited to improperly valuing CDO’s—there was a problem at the origination level, as well. A former chief commercial appraiser for IndyMac Bank (IMB) recounted his 2001 experiences at the company, in which he delineated a number of violations committed by employees. The most interesting section of the report is his description of a field review of an appraisal for a subdivision near Sacramento. There, the appraiser, Vernon Martin, discovered that a residential subdivision under construction and marked as “80 percent complete” was actually closer to being 15 percent complete. Martin soon found out that the two construction inspectors for that region were none other than the father and father-in-law of IMB’s CEO, Mike Perry.

From Martin’s report:

“The Problem With This Set of Scandals and Issues Is That Management Didn’t Know What They Were Doing. All Systems Failed: Accounting Failed, Finance Failed, Legal Failed, Risk Failed, Human Resources Failed, Operational Leadership Failed, the Boards Failed, Ceos Failed. It’s a Massive Failure Inside the Company.

“I reported my Sacramento findings in a private memo to the chief credit officer, who then distributed it to the senior managers at the construction lending subsidiary known as the Construction Lending Corporation of America (CLCA). The senior credit officer from CLCA, the manager who most resembled Tony Soprano, was the one to call me. He asked ‘Are you sure you saw what you said you saw?’ in a rather chilling manner. He said he had been on site with Roger Perry and had seen things differently. After that call, I asked the chief credit officer why CLCA’s senior credit officer would want me to recant my report. He told me that the senior credit officer received sales commissions for every loan made, which seemed to me like a blatant conflict of interest.”

Later, Vernon Martin was fired for “communication problems.” Afterwards, he reported his concerns to the OTS, which resulted in a number of audits of IMB. IMB followed the OTS’s suggested changes in personnel and ousted the president and senior credit officer of CLCA. The chairman of the board, David Loeb (founder of Countrywide), abruptly resigned during that time, as well.

This brings to light another rule companies should live by: if an employee at a highly profitable division gets fired, an exit interview is essential to see what’s going on.

“Don’t Kill the Golden Goose”

AIG kept a hands-off approach to Cassano’s department, presumably because it made a lot of money. But, when the credit crisis began to hit and money started getting tight, his department began hemorrhaging funds. By February 2008, Cassano’s department had racked up $11 billion in losses.

Ironically, oftentimes the most profitable and highest margin division, or even the highest performing individual, requires the greatest scrutiny, as opposed to the common willful turning of a blind eye to potential problems. Are these divisions and individuals earning their profits legally and with a straight ethical compass? If not, the profits probably won’t be sustainable. By failing to ask these crucial questions, companies lose the opportunity to put in place the controls and transparency that might have allowed that division or individual to continue to perform strongly and profitably without “going over the line.” Case in point is AIG, where the downfall of the entire organization can be attributed to the highly paid Cassano, who oversaw a division that delivered substantial profits at the highest of margins… profits that later proved to be a mirage.

Richard Gugliada, the former managing director at S&P who “knew it was wrong at the time,” also said that whenever the issue of making S&P’s criteria for ratings more stringent was discussed, the co-director of CDO ratings, David Tesher, said, “Don’t kill the golden goose.’’

By 2007, despite a deteriorating housing market, S&P accounted for 75 percent of McGraw-Hill Corporation’s entire profit, with $1.35 billion in revenue and an astounding 45 percent operating profit margin for the division (versus 15 percent in McGraw-Hill’s substantially large Educations division and a mere three percent in the Information and Media divisions). In just seven years, S&P had grown its operating profits nearly four times over from back in 2000, when it only contributed a more balanced 43 percent of the entire profit of the corporation and had net operating margins of 30 percent.

“The Senior Credit Officer from Clca, the Manager Who Most Resembled Tony Soprano, Was the One to Call Me. He Asked ‘Are You Sure You Saw What You Said You Saw?’ in a Rather Chilling Manner.”

The “golden goose” that Tesher referred to ended up biting back in a big way. The negative fallout of the relaxed ratings standards made news around the world.

McGraw-Hill was not alone in ignoring potential problems with its biggest profit contributor. Bear Stearns’ and Lehman Brothers’ top profit centers in recent years were CDOs as well—and neither of those firms continue to exist as independent entities.

Peter Drucker’s View

Several years ago, the executive director of Ethisphere asked legendary business management guru Peter Drucker if he would ever teach a Fortune 500 company about ethics. Drucker responded by saying that his class on ethics would be the shortest one in the world: “If you can’t look yourself in the mirror for something you’re about to do, don’t do it.”

Ethics are not taught, he says, but learned. Without the best intent in mind, failures will occur. Failures happen when there is a culture of less than best reasonable intent.

Or to put it even more simply, “rotten culture = rotten outcomes.” Is it any surprise the legendary Jack Welch, under whom the highly regarded GE compliance and ethics system (built by General Counsel Ben Heineman), was a long-time admirer and customer of Drucker?

Reflections for Improvement

You can be angry and complain about the financial crisis—or you can discuss what should change, and help to effect that change. The following list highlights some of the recommended steps that should be taken by companies, regulators and the investment community as a whole to improve the ethical culture of the business climate in which we operate and to prevent yet another financial meltdown.

For Companies:
Good companies invest in systems, policies and activities that aim to improve internal institutional ethical culture. This is not nearly as expensive as it sounds, and normally saves organizations a significant amount of money in the long run. Here are four key steps:

1. Increase Internal Transparency.
The best companies promote internal transparency by assessing employees’ opinions about their own ethical practices, the ethical culture of the organization and any ethical or legal misconduct they have witnessed. In so doing, organizations are able to “look in the mirror.” These companies also facilitate the usage of internal or third-party reporting mechanisms, as they know that it is far better to promote a culture in which employees want to blow-the-whistle privately, in the hopes that the issue will be reviewed and/or resolved internally. This way, employees will be more likely to keep potential legal and ethical concerns within the company, as opposed to feeling that their only recourse is to blow a whistle publicly on a problem that has festered because it was not addressed in time.

2. Pigs Get Fed, But Hogs Get Slaughtered.
Does your company have a tremendously profitable division, or even a few individual employees who singlehandedly generate outsized (or even obscene) profits? While this, of course, should be lauded, you cannot turn a blind eye to the “how’s” and “whys” of highprofit margins. Secondly, you shouldn’t be afraid to ensure that that profit is truly sustainable. After all, don’t you want this success to continue? Too frequently, an organization will shy away from questioning success in fear of destroying it. That is a misguided approach. If you express that you are interested in helping a division head or individual ensure that his or her large profits continue, he or she will most likely welcome your input. If they rebuff your approach, that is a significant warning sign that something could be amiss (e.g., bribery, conflicts of interest, violations of contract terms).

3. Leaders Must Talk About Ethics.
Strong companies have leaders who aren’t afraid to talk about ethics. This must go beyond a mere introductory letter in the Code of Conduct. Effective leaders build the discussion into regular employee interactions, and they do it in a way that makes employees believe in ethical behavior and inspires them to live and breathe the leader’s message (as opposed to a “wink wink, nudge nudge” approach of “be ethical but don’t lose the contract”). While we’re the first to acknowledge that no one is ethically or morally perfect, this fact shouldn’t prevent a leader from encouraging behavior that is healthy for the organization. The less-than-perfect leader who shirks that responsibility becomes an burden who cannot communicate core values to employees, which is not the type of person who should be running an organization in times of crisis.

4. Include Ethics and Compliance as “Risk Areas” to Self-Assess.
In far too many companies, the concept of conducting a risk assessment has been hijacked by the finance department as an exercise in finding problems that can be ‘insured’ against (e.g., currency risk and data insecurity). But, that leaves organizations entirely exposed when it comes to ethical risk areas. What about the risk of someone breaking a law or acting unethically? Colluding or cooking the books? If an organization doesn’t proactively look for those types of ethics and compliance risks, they dramatically increase the chance of a major adverse reputational and economic event occurring.

For Regulators/Government:

The preference for paperwork and rules, as well as internal politics run amok, has created a culture in which regulators are largely hindered. The current economic crisis environment provides an ideal backdrop against which improvements can be made. Here are steps in the right direction:

1. Require Ethics for 500+ Employee Companies.
All sorts of regulations kick in for companies once they reach 15 (Title VII), 20 (ADEA), 35 or 50 (FMLA) employees in size. How about requiring employers to have an effective ethics and compliance program, as set forth in the U.S. Federal Sentencing Guidelines? To make it less onerous, this stipulation could be limited to companies with at least 500 employees, whether public or private, who receive federal government funding, contract with the federal government, or have publicly listed securities on an exchange located in the United States. Would this have a big impact? It most certainly would.

2. Claw backs for Illusionary Profit Comp.
Spoiler alert: the executive compensation system in America is broken. While this has been common knowledge for years, nobody has fixed it and peer pressure and public shame alone will not remedy it. Public shareholders should have the same type of rights as the IRS when it comes to “looking back” and adjusting tax payments to account for over(or under-) payments made in years past. Executives should be exposed to claw backs if they are paid glorious sums of money on current year profits that are later proven to be illusionary due to questionable (even if nominally legal) accounting gimmicks or even simply due to windfall bubble market economics. If executives know that shareholders have greater legal rights, they will structure more meaningful long-term incentive plans to bring compensation into proportion with longer-term performance.

3. Fix the Regulators’ Internal Ethics Culture.
Government agencies can learn from leading private corporations in terms of building a culture of greater internal transparency and ethics. Insiders tell Ethisphere that, in some of these organizations, state or federal, there are few channels for employees to raise concerns short of becoming a whistle-blower, at which point the raised issue becomes a point of contention and the opportunity to improve procedures internally has been lost forever. This is a fixable issue, but needs firm commitment from leadership in major federal agencies.

Conclusion
In February 2006, a Wall Street Journal editorial concluded, “Since 2002 [when SOX first appeared], there have been more than 700 federal corporate fraud convictions, and some $266 million in restitution, fines and forfeitures. The mad rush to pass Sarbox in 2002 was less about keeping business honest than it was about keeping Congressmen in office.”

Perhaps The Wall Street Journal is onto something. And a new rash of regulations and legislation will inevitably come out of the current financial crisis, with much of it likely being wrong-headed.

Why? Because it is virtually impossible to legislate that companies must conduct their own “sniff tests” on their businesses to ensure that they are indeed following both the letter and the spirit of the law.

“Unfortunately, in this time of economic crisis, we see signs of companies cutting back on their compliance and ethics efforts. Chief ethics officers are being terminated and complinace programs scaled back due to budgetary concerns. That is entirely the wrong approach.”

Unfortunately, in this time of economic crisis, we see signs of companies cutting back on their compliance and ethics efforts. Chief ethics officers are being terminated and compliance programs scaled back due to budgetary concerns. That is entirely the wrong approach.

Fortunately, other companies are taking the exact opposite path and placing an increased emphasis on ethics and compliance during the market downturn. Smart companies know that the temptation and pressure to violate the law in order to achieve a financial goal (or, on a personal level, out of fear of losing one’s job) is far greater during economic crisis than in boom times.

One example comes from the companies that joined together in November 2008 to form the Business Ethics Leadership Alliance (BELA). These companies represent nearly $1 trillion in global commerce and recognize that standing up and being counted for acting ethically is more important than ever.

As SEC Director Lori Richards implores, “Now more than ever, companies need to take a long-term view on compliance and realize that their fiduciary responsibility requires a constant commitment to investors. This means sustaining their support for compliance during this market turmoil and beyond it.”

Companies that take ethics seriously in this downturn will likely survive, and perhaps even thrive. Companies that don’t will be the poster children for the next generation of scandals.

Which sort of company do you work for? You might be able to tell simply by looking in the mirror.