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Handout 02 Managerial Ethics - Module 01A:

The Ethics of Market Abuse: Fraud, Corruption and
Bribery

Fr. Oswald A. J. Mascarenhas S.J., Ph.D.
JRD Tata Chair Professor of Executive Ethics, XLRI, Jamshedpur
July 10, 2014

Case 2.1: The Enron Corporate Fraud

Incorporated in 1930 and re-incorporated in 1997, Enron, a multinational company that specializes in
electricity, natural gas and energy markets and other physical commodities, was re-established in 1985 from the
merger of Houston Natural Gas and Inter North of Omaha, Nebraska. In the year 2000, Enron employed 61,000,
operated in over 40 countries, and reported revenues of $101 billion, thus wining the seventh rank among Fortune
500 that year.

By October 2000, however, Enron became the pioneer and trendsetter of energy sector corporate aggressive
accounting and insider trading irregularities. Among accounting scandals were the numerous round-trips it
engaged in, and which soon became the industry norm for similar scams. For instance, Denver-based Qwest
Communications used bandwidth to manufacture illusory revenue streams in its recent deal with Enron. According
to investigators, Qwest agreed to pay Enron $308 million for the use of dark fiber (or unused fiber optic) capacity.
In exchange, Enron agreed to pay Qwest between $86-195 million for access to active sections of Qwests network.
Both deals turned out to be fake allowing both companies to record fat revenues for the period, and particularly
helping Enron avoid reporting a loss for that period (Pizzo, 2002).

Andrew Fastow, a Harvard Business School graduate and chief financial officer (CFO) at Enron, wore two hats.
As CFO, he negotiated and set up outside partnerships to conduct Enron business. As the principal in these
partnerships, however, Fastow also negotiated with Enron on behalf of the partnerships. This is obviously conflict
of interest: which entity did Fastow favor in these deals? Enrons policies prohibited employees from wearing two
hats, but Enrons Board of Directors exempted Fastow from this rule. The result was a series of money-losing
transactions for Enron, and consequently, Enrons stockholders, creditors and employees all emerged as heavy
losers.

A series of fake transactions between Enron and investment partnerships executed by Andrew Fastow, led to its
filing for Chapter 11 bankruptcy protection in June 2001. In October 2001 Enron was suspected of a massive
financial statement fraud. Chairman Kenneth Lay, former President Jeffrey Skilling, and former Chief Financial
Officer Andrew Fastow, among others, were accused of shielding debt from public view, and overstating revenues
and earnings, thus giving the impression of rapid profit growth. The same year, Enron declared bankruptcy, then the
largest corporate failure in U. S. history. Its stock price plummeted from $90 in 2000 to $ 0.26 per share, just a few
days before fling the bankruptcy petition.

Enron had such a strong following on Wall Street that its CEO Jeffrey Skilling could bluff his way around
tough questions about the companys operations. Yet what happened to force this giant icon to come down in 2001
when its stock plummeted to $0.26 and the company faced almost extinction?

The Company boosted profits and hid debts totaling over $1 billion by improperly using off-the-books
partnerships, it bribed foreign governments to win contracts abroad, and it manipulated the California energy
market. Ex-Enron executive, Michael Kopper, pled guilty to two felony charges; acting CEO Stephen Cooper said
Enron might face $100 billion in claims and liabilities. Enrons former energy trader, Timothy Belden, pleaded
guilty on Thursday, October 17, 2002, to criminal fraud charges admitting he was part of a conspiracy to artificially
boost power prices during Californias devastating power crisis (Anderson, 2002). Belden is the first member of the
companys trading team to face such charges. Enron, ranked 7 on the Fortune 500 list two years ago, filed Chapter
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11 protection on December 2, 2002 after revealing a $618 million loss and eliminating $1.2 billion of shareholder
equity (Hays, 2002). Its auditor, Arthur Andersen, was convicted of obstruction of justice for destroying Enrons
documents.

One of the reasons that Enron's implosion was so destructive was that it had managed to hide its problems
through complex round trip transactions, a scale that even WorldCom couldn't match. By co-opting Arthur
Anderson, formerly one of the world's top five accounting firms, Enron was able to spin out shell companies and
special purpose vehicles/entities (SPVs) to hide its fatally wounded core.

Later in October-November 2001, Enrons Board of Directors scrutinized these transactions. Among the
securities scams investigated were associated with Enrons former Division Head, former CEO, and two former
Division Heads, each cashed in stock to mint $270 million, $108 million, $80 million and $74 million respectively;
two other directors each cashed in $68 million worth of Enron stock. The companys stock once peaked at $65; by
November 2001 it traded for less than 50 cents. The retirement funds (401K) of more than 45,000 of its American
employees forced invested in Enron stock have virtually evaporated since (Fortune 2002; Forbes 2002).

The meltdown of Enron Corporation was one of the largest corporate bankruptcies in history, and certainly
represented the biggest accounting scandal ever, and possibly, the largest cash crisis in corporate business. Once a
stodgy focused gas pipeline company, Enron redefined itself into the nations leading marketer of natural gas,
electric power, and bandwidth capacity. It struck hundreds of joint venture deals with domestic and foreign partners
alike in projects that diffused its original focus. Revenues soared from $20 billion in 1997 to $31 billion in 1998 to
$40 billion in 1999 until it jumped to $100 billion in 2000. Its NYSE annual-high stock price rose from $22.5625 in
1997 to $29.375 in 1998 to $44.875 in 1999, until it peaked at $90.5626 in 2000. Profits increased almost tenfold
from $105 million in 1997 to $979 million in 2000. Its total assets expanded from $22.5 billion in 1997 to $65.50
billion in 2000.

Investors have sued Enron ever since, with the accumulated damage to them estimated at over $25 billion. New
York-based Amalgamated Bank, which lost millions in the Enron fraud, sued 29 top Enron executives. Enron
restated its financial statements, citing accounting errors, and cut profitability for the past three years by about 20
percent, or by around $586 million. Lawsuits against Enron claimed that its top executives reaped enormous
personal gains from off-the-book partnerships. Meanwhile, Enrons auditor, Arthur Andersen, allegedly
instructed employees to shred critical documents involving fraud. Enron fired Fastow; he was later prosecuted, and
later (September 26, 2006) served a six-year prison sentence. Kenneth Lay is dead, and Jeffrey Skilling is currently
serving a two-year prison sentence. This tragedy of enormous human, social, economic and monetary losses could
have been prevented had Enron applied strict internal cash and accounting controls (Harrison and Horngren 2004).

Vice president Sherron Watkins, CPA at Enron, understood what was going on in the company. She had three
alternatives each loaded with high risk: a) report her concerns about Fastows deals to Kenneth Lay, CEO of Enron;
b) discuss these concerns with her boss, Andrew Fastow, CFO of Enron, or c) do nothing. Under (a) and (b), there
was a high chance that Watkins could be ignored or resisted and penalized for blowing the whistle, but there was
also a small chance that she could be heard and corrective action taken immediately. Under (c), Watkins would
avoid confrontation with Lay or Fastow, but the public (investors, creditors, employees, customers) would suffer if
they relied on faulty data. Watkins blew the whistle, reported the matter to the CEO and was severely penalized, but
enough damage had already been done to Enron that the company filed for Chapter 11 bankruptcy protection from
its creditors in September 2001.

Ethical Questions:

1. Andy Fastow masterminded the Enron fraud. How would you identify and assess the economics and
ethics of this fraud?
2. Among accounting scandals, Fastow was known to pioneer round-trip sales that apparently did not
violate the GAAP codes of those days. Today, it violates the Sarbanes-Oxley Act of 2002 that USA
promulgated to prevent such scams. Explain the unethicality and immorality of round-trip sales, and
their dangerous economic harm.
3. The retirement funds (401K) of more than 45,000 of Enrons American employees that were forced to be
invested in Enrons stock have been wiped away. Explore the ethics of injustice in this deal.
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4. Among other things, Andy Fastow wore two executive hats that implied serious conflict of interest.
Explain the ethical implications of such conflict situations.
5. Insider trading irregularities date from the origin of stock markets. But they took a dangerous scale at
Enron. Explain the unethicality and immorality of such irregularities, and their dangerous economic
harm.
6. By co-opting Arthur Anderson, an accounting firm that also provided consulting services, an obvious of
conflict of interests, Enron was able to spin out shell companies and special purpose vehicles (SPVs) to
hide its fatally positioned business. Argue the economic, financial and ethical violations of Arthur
Anderson, and the shell companies and SPVs that it spun for Enron.
7. Was Sharron Watkins right in whistle blowing? Even though whistle blowing is legal in the USA, and
now in India, when and how is it ethically and morally justified and imperative?


Case 2.3: Satyam Computer Services Ltd

Satyam Computer Services Ltd (popularly called as Satyam) proposed on December 16, 2008 that the 20-year old
company would spread risk by diversifying into the infrastructure and real estate business by acquiring two family-run firms:
a) a listed Maytas Infra Ltd where the Raju brothers had a stake of 35%, and b) an unlisted Maytas Properties Ltd where the
family ownership was about 36% (Maytas is Satyam spelt backwards!). Surprisingly, such a proposal to acquire two totally
unrelated companies was readily approved by its eminent board. However, the spontaneous and immediate uproar of Satyam
investors against the merger proposal led the board to call it off by December 17, 2009. Subsequently, B. Ramalinga Raju,
Satyam Chairman, revealed that, especially in the wake of the dot.com bubble bust and subsequent loss of IT business from
several Fortune 500 companies, the company had been reporting inflated profits, understating debts, and doctoring other
financial parameters to fight its market share erosion vis a vis domestic competitors such as Infosys, Wipro and Tata IT
Services. Such self-motivated whistle blowing stunned investors, perplexed government regulators such as SEBI and the CII
(Confederation of Indian Industry), intrigued accounting companies, leading to the dismissal of the Satyam board and
installing a board of government nominees. The board of directors of Satyam as of December 16, 2008 was as follows:

Name Designation
B. Ramalinga Raju Chairman
B. Rama Raju Managing Director
Ram Mynampadi Whole-time director
Mangalam Srinivasan Non-executive independent director
Krishna Palepu Non-executive director
Vinod Dham Non-executive independent director
M. Ram Mohan Rao Non-executive independent director
T. R. Prasad Non-executive independent director
V. S. Raju Non-executive independent director

Satyam is a watershed event for the institution of independent directors, wrote Prithvi Haldea (2009), chairman and
managing director, Prime Database, in Economic Times. It has demonstrated that even highly credible, qualified, and
educated persons are no insurance for corporate governance, that they are no watchdogs of the minority shareholders whose
interests they are supposed to serve. In fact boards can serve a negative purpose, that of providing a false sense of security to
the minority shareholders. In general, promoters want to enrich themselves and their institutions; the independent directors,
on the contrary, should be preventing this from happening. But this is the core of the problem: what if promoters also seek
positions of independent directors on boards? When this happens, the promoters as directors may not even recognize or
resolve conflict they could exploit it, as it happened with Satyam. Often, several independent directors may not be aware of
some promoter-driven initiatives as they attend only a few meetings a year.

Ethical Questions:

a) To what extent did the Satyam episode bring to light the deficiencies in the corporate governance system in India?
b) To restore investor confidence in corporate governance systems in India, an ethical mandate, how would you redefine the
role of the board, the independent directors, the internal auditors, the external auditors, the audit committees, and
government regulatory bodies?
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c) To what extent can corporate governance failures be attributed to factors such as short-term quick fix solutions?
d) To what extent can corporate governance ethical failures be attributed to factors such as corporate greed of managers,
chief executives, and even of boards and investors?
e) To what extent can corporate governance and ethical failures be attributed to more critical factors such as the lack of a
questioning culture and critical thinking in corporate boardrooms?
f) To what extent can corporate governance ethical failures be attributed to lack of effective separation between governance
and management, especially given the fact that several corporations have the CEO (management) as also Chairman
(governance) of the board?

Case 2.3: Sherron Watkins and Whistle Blowing at Enron

In summer of 2001, Sherron Watkins switched jobs within Enron to work for Andy Fastow, CFO. In this new back office
role, a non-commercial one, Watkins examined assets that Enron had for sale. Basically she examined a spread sheet that had
book values with estimated gains or losses on sales. It is here that she stumbled upon what she thought was an accounting
fraud. Fastow hedged a number of assets with several entities called the raptors, apparently fraudulent structures or shell
companies. Millions of dollars of losses that should have been borne by the raptors were fed back to Enron instead. The
interesting part of the story is not the pseudo raptors but the real person behind this game plan.

In 1999, the BOD of Enron made an unprecedented move of waiving the companys Code of Conduct to allow Fastow to
start his own investment partnership, named LJM (named after his wife and children, Lea, Jeffrey and Mathew). Fastow
raised $600 million from Enron for this limited partnership. This entity worked exclusively with Enron to buy assets, and
on hedging contracts. All losses of LJM came back to Enron but not its profits. The CEO, Jeff Skilling, concurred with
Watkins that LJM was a shady deal; he resigned on August 14, 2001, barely six months on the job. Meanwhile, Enrons cash
flow had dried up by May 2001 as the government regulators stepped in and put price caps. Also, Enron Broadband tanked
and the telecom sector was in real trouble. Watkins wrote an anonymous letter to Ken Lay, the new CEO of Enron. Ken,
however, did not hire independent inspectors to investigate the allegations of Watkins about LJM and other creative
accounting structures at Enron. Instead, Ken began to unwind these structures and forced a write down (non-recurring
expenditures) of a billion dollars in the third quarter of 2001, completely wiping previous years net income of $979 million.

Much of this loss could be attributed to Enrons foray into unrelated businesses, especially water business, and
broadband business. Moreover, the trading customers got very skittish. Enron had about $18 billion of energy contracts as
receivables and $16 billion as trade payables. Within 6 weeks, Enron lost $4 billion in receivables as some of its trading
customers went in for closures. On the other hand, most of its $16 billion dollar creditors demanded to be paid during the
same time. Enron had no option but to file for bankruptcy by September 2001. [For more details, see Singh 2005: 239-47].

Ethical Questions:

1. What is whistle blowing? Is it legally, ethically and morally justified?
2. When is whistle blowing ethical and ethically mandating, and why?
3. When is it moral and a moral imperative, and why?
4. Will business in general, and young entrepreneurs in particular, be discouraged by whistle blowing?
5. How is whistle blowing different from ones fiduciary duty to the company, and why?
6. Why is whistle blowing legal and legally protected in the USA or in India, and with what results?
7. How does whistle blowing help society, especially, shareholders, employees, customers and local communities?
8. Hence, was Sherron Watkins justified in whistle blowing at Enron?


The Ethics of Fraud as Market Abuse

Fraud has existed since the dawn of humanity and will continue until the end of times. Given human
nature and its weaknesses, ones avarice and greed for money, power and popularity has been the major
stimulus for fraudulent crime. The landmark case of fraud is McKesson Robinson, a corporation involved
in a 1937 financial statement balance fraud that reported $10 million of non-existent inventories and
accounts receivable. This case marked the beginning of required generally accepted auditing standards
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(GAAS) for independent public auditors.

Fraud exists even today and can occur anytime in an organization. At the same time, there is no
special recipe or checklist for detecting and preventing corporate or personal fraud at all times. No such
thing exists and no such thing is truly capable of being developed to monitor and control all forms of
fraud (Silverstone and Davis 2005: 5-6). Managers should be aware of fraud, deal with the human factors
that generate fraud by hiring honest people and keep them honest by instituting strong deterrents of fraud,
and deal with the environmental factors that cause crime by enforcing adequate monitors, controls,
policies and procedures.

The corporate world is failing in its fiduciary duty and loyalty to its stakeholders. During the last
decade, the media has been reporting hundreds of corporate frauds either in the form of accounting
misdeeds or insider trading security scandals. Led by Enron in 2001, the list of giant corporate
malfeasance grew steadily in 2002 and thereafter. In fact, there is a great fear that we have just scraped
the tip of corporate deviant behavioral iceberg.

In the wake of these extraordinary scandals, discussions about the executive virtues of honesty and
integrity are no longer academic or esoteric, but critically urgent and challenging. As representatives of
the corporation, its products and services, corporate executives in general, and production, accounting,
finance, and marketing executives in particular, must be the frontline public relations and good will
ambassadors for their firms, products and services. As academicians of business education, we must
analyze these corporate wrongdoings as objectively and ethically as possible. What is wrong must be
declared and condemned as wrong, what is right must be affirmed and acknowledged as right. We owe it
to our students, our profession, and to the business world. This chapter deals with corporate fraud,
particularly in terms of its origination and proliferation. Detecting fraudulent accounting practices and
insider securities trading irregularities in time, and preventing or forestalling them is an important duty of
managers and corporate executives today.

Losing investors confidence in the securities market can be disastrous. Thousands of shareholders
were shell-shocked and numbed when premium blue chip stock prices trading at the $100 and more levels
suddenly plummeted to a few cents a share within a year. What happened? Did the stock market crash?
Was it rigged? Neither. In reality, creative accountants fooled the markets they cleverly inflated
reported cash flow from operations by reclassifying items among the operating, investing and financing
sections of the statement of cash flows all this, presumably, well within the boundaries of the then
generally accepted accounting principles (GAAP). For instance, in acquisitions, cash paid for working
capital could be shifted to the investment section rather than shown as a reduction in cash flow from
operations (Mulford and Comiskey 2005: xi).

In an era of questionable and fraudulent accounting, cash flow is the only trustworthy measure of
financial performance available. It is almost impossible for accountants to manipulate cash flow. The
balance in cash and the total change in cash from one period to the next are generally not prone to
misstatement. The balance in cash is readily verifiable from banks and other institutions holding reported
balances. Hence, cash is a fact, while profit (which accountants can easily manipulate) is an opinion.
Cash flow is real and is not easily subject to the vagaries of GAAP. Most investors rely more on cash
flow statements than on reported annual statements such as the balance sheet and the profit and loss
statements.

Regardless of whether corporate scams have peaked or not, their intensity, frequency, and magnitude
over the last eight to twelve years since 2000, should be a moral and ethical wake-up call for all and must
be seriously scrutinized, objectively analyzed, effectively monitored, and expeditiously controlled. This
Chapter is a step in this direction. For all practical purposes, corporate scandals represent the level of
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corporate greed that left unchecked will destroy firms, industries, markets and our business system in
general.

The Incidence of Corporate Fraud and Corporate Damages

The top giant five fraudulent companies, Enron, WorldCom, Tyco, Qwest, and Global Crossings,
destroyed a combined capital of $460 billion in shareholder value while moving inexorably toward
bankruptcy (Stoller 2002; USA Today, October 10, 2002). The cascade of corporate accounting and
securities scandals has rocked major security markets of the world, especially the New York Stock
Exchange (NYSE) and the NASDAQ markets. The United States of America is the economic engine of
world commerce and the cornerstone of the world economy, and therefore, American corporate frauds
and scams have affected the stock markets around the world. However, not all of the stock associated
with the offending companies has suffered in other markets the way it has in the United States.

According to the 2002 Report of the Association of Certified Fraud Examiners (ACFE) on
Occupational Fraud and Abuse, on average, U. S. organizations lose about six percent of revenues owing
to dishonesty from within. When adjusted to U. S. Gross Domestic Product, the cost of occupational
fraud and abuse amounts to over $600 billion annually. The ACFE had conducted a similar study in the
mid-1990s based on voluntary reports of over 2,600 frauds, estimating losses to $400 billion annually, or
about $9 per day per employee (ACFE 1996). Such abuses may include everything from disorders in the
mailroom to the boardroom, from employee theft, purchasing managers kickbacks to corporate
embezzlement, but corporate fraud takes the lions share of organizational fraud and abuse (Albrecht and
Albrecht (2004: viii). These numbers understate the real damage, as it is impossible to know what
percentage of fraud is really discovered, and what percentage of fraud perpetrators are eventually caught
and brought to justice. In addition, many frauds that are discovered are handled out of court and
clandestinely and never made public (Albrecht and Albrecht (2004: 3).

Each dollar lost in fraud is a dollar loss of net income, and hence, it takes significantly more sales
revenue to recover the effect of fraud loss on net income. For example, a fraud loss of $100 million to an
automobile manufacturer whose profit margin (i.e., net income divided by revenues) is ten percent would
necessitate the manufacturer to generate additionally ten times the fraud loss, that is, $1billion in revenue
to recover the effect on the net income. If the average ticket price of a car were $20,000, this would imply
that the auto manufacturer would have to make and sell an additional 50,000 cars ($1 billion/$20,000) to
counterbalance the fraud loss. Meanwhile, this loss could be easily passed on to the consumer via higher
ticket prices. Alternately, if that amount is deducted from R&D, the opportunity loss of $1 billion could
affect the quality of cars.

Whereas most employee crimes in the past were theft of physical goods (e.g., stationery, money,
commodities) that were either in small amounts or infrequent, owing to fear of being caught, modern
crime is much more sophisticated and electronic in nature. Telecommunications, particularly the
computers and the Internet, have facilitated and stimulated corporate fraud. Employees now need only to
make a telephone call, misdirect purchase invoices, bribe a supplier, manipulate a computer program,
misplace company assets, and other fraudulent transactions by a mere push of a key on computer, PDA or
Blackberry keyboards. Most of them take years to be detected.
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Corporate fraud is a growing problem. The FBI (USA) has labeled fraud the fastest growing crime and hence, has
committed almost 24 percent of its resources to fighting fraud. At any given time, the FBI is investigating several hundreds of
cases of fraud and embezzlement, each averaging to over $100,000 in damages. These cases, however, relate just to FBI
jurisdiction. Secondly, insurance companies, that provide fidelity bonding or other types of coverage against employee and other
fraud, undertake regular investigations within their jurisdiction of employee bonding or similar insurance. Occasionally,
researchers conduct studies about particular types of fraud in specific industrial sectors. Fourthly, victims of fraud report crime.
All four sources of fraud, however, are incomplete, jurisdiction-specific, and periodical. They fail to provide a comprehensive
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Basic Definitions regarding Fraud

A fraud, in general, means deliberate misrepresentation. It implies a deliberate or willed and planned
misrepresentation of subjects, objects, properties, and/or events (SOPE) in a deviant behavior situation.

The Association of Corporate Fraud Examiners (ACFE) in 1996 defined an occupational fraud as
The use of ones occupation for personal enrichment through the deliberate misuse or misapplication of
the employing organizations resources or assets (ACFE 1996: 4). This definition has remained more or
less the same in 2004: an occupational fraud is the use of ones occupation for personal enrichment
through the deliberate misuse or misapplication of the employing organizations services or assets
(ACFE Report 2004).

The ACFE defines occupational fraud against ones organization. ACFE also defines fraud as an
activity that is: a) clandestine, b) which violates the employees fiduciary duties to the organization, c) is
committed for the purpose of direct or indirect financial benefit to the employee and d) which costs the
employing organization assets, revenues or reserves (ACFE 1996: 9). The term employee in this
definition includes employees of all categories: blue- and white-collar labor, managers, corporate
executives, including CEOs, CFOs, and presidents. Fraud can encompass any crime that uses deception
as its primary method or modus operandi.

Based on the Websters Dictionary (4
th
edition, 2002) we may identify the following fraud synonyms or
equivalents:

Deception: The act or practice of deceiving. The fact or condition of being deceived. Something that
deceives, as an illusion, or is meant to deceive, as a fraud. In marketing, the word deception has been
defined as those instances in which consumers change their behavior for reasons not grounded on
fact or reality but on beliefs and impressions made on them by the influencer (such as
advertising, marketers, sales representatives) (Gardner 1975). Often, consumers are influenced by
non-substantial attributes and features of a product (such as style, appearance, color, sheen, display)
at the expense of disregarding the intrinsic aspects of the product (Gardner 1975: 43).
Fraud: Deliberate deception in dishonestly depriving a person of property, rights, etc.
Mislead: To lead in a wrong direction, error of judgment or into wrongdoing. This may or may not
be intentional.
Subterfuge: An artifice or stratagem used to deceive others in order to evade something or gain some
end.
Trickery: Implies the use of tricks or ruses in deceiving others.
Chicanery: Implies the use of petty trickery and subterfuge, especially, in legal actions.
Beguile: To mislead people by ones charm or persuasion of cheating or tricking.
Seduction: (In a marketing context) means interactions between marketer and consumer that
transform the consumers initial resistance to a course of action into willing, even avid, compliance
(Deighton and Grayson 1995: 660). It is the enticement of a consumer into an exchange where
ambiguity is resolved by a private (non-institutionalized) social consensus that the consumer plays a
part in constructing (Ibid 668). Seduction is a strategy whereby consumers are induced to tolerate
overlook unsustainability, or even to connive in denying it. In this sense, seduction is more voluntary
than fraud and more collaborative than entertainment - a playful, game-like social form (Ibid 661).

Thus, deception is a broader term that applies to anything that deceives, whether by design (fraud), by
delusion (trickery or illusion) or by device (subterfuge and chicanery). A fraud is a deliberate
misrepresentation or nondisclosure of a material fact made with the intent that the other party will rely

and up-to-date picture of organizational fraud at the national level.

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upon it. If the party did in fact rely upon such a misrepresented statement, and if this causes injury, then
the person may bring an action to rescind the contract. Statements of opinion, however, may not be
usually used as a basis for fraud or misrepresentation. If the seller says, "This car is the best buy in
town," such a claim is treated as a statement of opinion or puffery, but not a statement of fact. However,
if the person making such a claim has "superior knowledge" having specific expertise in the field, and the
buyer relies on this expertise in the actual purchase, then such a claim may be equivalent to a
misrepresentation.
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The misrepresentation must be of a present or a past fact. False statements regarding
the future are not actionable. In addition, in general, silence or nondisclosure is not fraudulent, unless
nondisclosure relates to material facts regarding an inherently dangerous product. If the
manufacturers/sellers, however, choose to speak, they must tell the whole truth. Deceptive partial
disclosures often amount to fraudulence.

Corporate Frauds as Deceptive Trade Practices

Corporate frauds are deceptive trade practices. Traditionally, the concept of deceptive trade practices
included all transactions that have a "tendency or capacity" to mislead consumers. One did not have to
prove actual harm to any specific group of consumers. The courts have not changed the "tendency or
capacity standard". However, the Federal Trade Commission (FTC) of USA came with new guidelines for
deception. In the early 1970s, in the context of deceptive ads, the FTC used three tests to determine whether
to take action against trade practices: 1) the FTC must conclude that the ad is "likely to mislead consumers";
2) the misleading ad must be material to subsequent purchase, and 3) misled consumers must be "acting
reasonably in the circumstances." All three criteria apply to corporate frauds as deceptive trade practices.

A lie is not the same as deception or fraud. The Oxford English Dictionary defines: "A lie is a
deliberate false statement that is intended to deceive others". Deception does not always need a false
statement to deceive. A lie is a deliberate false statement that is either intended to deceive others or foreseen
to be likely to deceive others (Brandt and Preston 1977; Carney 1972). Most frauds in the form of creative
accounting practices are lies in this sense. From a legal perspective a lie is (a) a deliberate withdrawal of
(b) material information from (c) a person who has (d) a right for that information (e) at the time of the
withdrawal. The deliberate withdrawal of rightful information is a deliberate false statement. Thus, lie is
a form and subset of deception.

Embezzlement means to take willfully, or convert to ones own use, anothers money or property of
which the wrongdoer acquired possession lawfully, because of some office or employment or position of
trust. Embezzlement, therefore, implies three elements: a) fraudulent appropriation or conversion of
money, b) that the wrongdoer acquired because of his office or position, and c) that the said money
belongs to the employer or employing company. Thus, embezzlement is a special type of fraud.

Fraud is different from robbery. The latter uses physical force on someone to give the robber what he
wants. Fraud deceives or tricks you out of your assets. Robbery often involves force and violence. Fraud
involves surprise, cunning, deception and trickery by which one violates someones confidence, and gets
an advantage by false misrepresentation. Fraud betrays trust of ones customers or clients.


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The "Recovery Theory" in the U. S. Law is also based on the definitions of "fraud" and "misrepresentation." A
misrepresentation occurs when a person, by words or acts, creates in the mind of another person an impression not in accordance
with the facts. Example: If the seller of a passenger car expressly states that the auto has been rebuilt to meet tougher road
conditions, when it has not been, and if the buyer relies heavily upon this statement (hence a "material fact") in deciding the
purchase, then the latters decision was not freely and voluntarily made, but triggered by misrepresentation. A fact is "material"
if the person trying to avoid the contract will not have entered into it had he/she known of the misrepresentation. The buyer may
ask a court to free him/her of the contractual obligations of the purchase contract.

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Fraud is different from larceny, which is a form of stealing. The legal term for stealing is larceny.
According to Blacks Law Dictionary, larceny is felonious stealing, taking and carrying, leading, riding,
or driving way another persons personal property, with the intent to convert it or to deprive the owner
thereof (Black 1979: 792). Thus, the essential elements of a larceny are a) an actual or constructive
taking away of the goods of another, b) without the consent or against the will of the owner, and c) with a
felonious intent. Obtaining possession of property by fraud, trick or devise with preconceived design or
intent to appropriate, convert or steal is larceny. Thus, fraud is a subset of larceny.

Fraud is different from bribery or corruption. Bribery in the USA is giving or receiving of anything of
value by a subcontractor to a prime contractor. Blacks Law Dictionary (1979: 311) defines bribery or
corruption as an act done with intent to give some advantage inconsistent with official duty and the
rights of others. It is an act of an official or fiduciary person who unlawfully and wrongfully uses his
station or character to procure some benefit for himself or for another person, contrary to duty and rights
of others.
3


Fraud differs from skimming: a subtle practice of stealing a small portion of a resource (e.g., money,
commodity) that presumably will not be noticed. Skimming is a subset of larceny. [See Business
Executive Exercises 2.1].

Summarizing and synthesizing most of the above definitions of deviant behaviors, Table 2.1
characterizes major physical transactional abuses these include coercion, con games, theft by stealth,
theft by fraud and theft by force. Table 2.2 characterizes non-physical transactional abuses such as
verbal pressures via exaggerated financial statements, aggressive ads and other deceptive promotional
tools. Exhibit 2.1 is a simpler taxonomy of a wide variety of deviant behaviors. Exhibit 2.2 distinguishes
between fraud, corruption and bribery. This Exhibit assumes that corruption and bribery are subset of
frauds as deliberate misrepresentation.



Exhibit 2.1: A Simple Taxonomy of Business Deviant Behaviors

Task Execution Task Ambiguity
Low High
Non-Physical:
Persuasion,
Forced
consensus
Discrimination
Corruption
Bribery
Fraud
Theft by Fraud

Trickery, Beguile
Chicanery, Conning,
Seduction, Deception
Money-laundering;
Racketeering;
Theft by Stealth
Physical: Much
Force and
Undue Power-
pressure
Larceny
Stealing
Robbery
Theft by Force
Terrorism
Ethnic Cleansing
Genocide
Preemptive Wars
Aggressive wars




3
Bribery violates Title 18, US Code # 201; punishable by up to 15 years in prison + fines of 3 times the value of the bribe +
bribing officer is disqualified. Bribery also violates Foreign Corrupt Practices ACT (FCPA), Title 15, US Code # 78. Bribery in
the form of kickbacks violates Title 41, US Code #s 51-58; up to 10 years in prison.

10

Exhibit 2.2: Distinguishing between Fraud, Corruption, and Bribery

Fraud as
Deliberate
Misrepresentation
Regarding:

Deliberate Misrepresentation as:
Conspiracy-Abuse Factual-Abuse
Past and Current
Facts, Figures and
History
Corruption as Deception:
Deceptive accounting;
Income smoothing;
Ghost or shell companies;
Ghost employees or accounts;
Restating annual financial statements
Corruption as Accounting Bribery:
Kickbacks;
Wash Trading or Round Trip sales;
Accounting abuses (e.g., over-invoicing, under-
invoicing, dumping)
Hostile Takeovers;

Past, Current and
Future
Decisions,
Strategies and
Actions
Corruption as Deceptive
Advertising:
Lies, Cheating, Subterfuge;
Under- disclosure or Over-disclosure;
Planned buyer-seller information
asymmetry;
Promoting non-existent patents or
products/services;
Hyping IPOs;
Covering or disguising product/service
defects
Corruption as Financial Bribery:
Insider Trading;
Active or passive bribery;
Excessive executive compensation;
Seduction;
Market dominance;
Undue market entry barriers;
Exorbitant pricing or price wars;
Dishonoring warranties and guarantees

Corporate
Financial
Statements and
Annual Reports
Corruption as Deceptive
Reporting:
Understating Debt;
Overstating revenues;
Overvaluing tangibles/intangibles;
Massive write-downs
Corruption as Abusive Reporting:
Over-borrowing based on inflated collateral;
Tax Evasion gimmicks;
Inflating bad debts, theft, wastage and other
damages for tax exemptions and insurance
claims

Types of Corporate Fraud

Albrecht and Albrecht (2004) define and classify occupational frauds as using ones occupation to
cheat ones organization or for the benefit of ones organization. Table 2.3 lists commonest frauds by type,
perpetrators, and methods, victims, and costs of deception. The fraud types listed in Table 2.3 are in the
descending order of the magnitude of fraud losses in relation to money, market valuation, brand equity,
supplier goodwill and customer loyalty, cash crisis, insolvency and bankruptcy. Hence, our list heads
with management fraud followed by securities scams or insider trading, investment scams, tax fraud,
racketeering, vendor fraud, employee fraud, computer fraud, bribery, and customer fraud. Other things
being equal, historically, the magnitude of money and non-monetary damages of frauds could be
estimated along the rank order suggested in Table 2.3.

The most common occupational frauds on behalf of ones organization are those of the top
management that result in false financial reporting. Financial statement frauds occur in companies that
are experiencing net losses or have profits much less than forecasts or expectations. Such frauds make
corporate earnings look better and thus, increase the stocks price. Often, executives misstate corporate
earnings in order to draw larger year-end bonuses. [See Business Executive Exercise 2.2].

11


Basic Instruments of Corporate Frauds

Several types or patterns of corporate financial scandals are reported (e.g., See Yahoo! Finance,
various reports):

1. Unscrupulous brokers: sale of fictitious limited partnerships to boost revenues.
2. Wash Trades: sale of a product to another company with a simultaneous repurchase of the same
product at the same price; these swindles uniquely inflate sales by units and dollar volume without
recording any profits.
3. Oil and gas schemes (scammers speculate on oil shortages or a rise of natural gas prices).
4. Equipment leasing (scammers sell interest in pay phones, cash machines or Internet kiosks to seduce
thousands of investors).
5. Affinity frauds (scammers use their victims religious or ethnic identity to buy or gain their trust and
then steal their life savings).
6. Promissory notes (e.g., short-term debt instruments sold by independent insurance agents and issued
by little-known or non-existent companies promising no-risk high returns).
7. Prime-bank schemes (e.g., scammers promise investors triple-digit returns through access to the
investment portfolios of worlds elite banks such as Rothschild banking family or Saudi Royalty).
8. Aggressive accounting (e.g., converting long-term debts to assets, purchase intentions to actual
purchases, future orders to current ones).
9. Analyst research conflicts (e.g., Merrill Lynch issued misleading research reports, and had to pay
$100 million fine in May 2002, in New York, and had to institute several significant changes in the
way it does business). (See Berkenbilt 2002)

All nine corporate scam-types involve selling or buying under fraudulent conditions, and hence, fall
well within the domain of fraudulent marketing.

The U. S. Federal Energy Regulatory Commission (FERC) defines wash trading, also known as
round trip trading or sell/buyback trading, as the sale of a product to another company with a
simultaneous purchase of the same product at the same price. Essentially, wash trading is a false trading
because it boosts the companies' trading volume, or even sets benchmark prices, but shows no gains or
losses on the balance sheets. While this kind of trading may not be strictly illegal, (possibly, they are too
recent frauds to receive federal scrutiny), it can manipulate the power market, which is illegal and it is
downright unethical. An inflated balance sheet from round-trip trading misleads investors about the true
value and volume of the company's business. Misled investors may tend to invest more, thus jacking up
the corresponding stock price. Large volumes of "wash trades raise the revenues but have no effect on
earnings. For example, in the energy industry, round-trip trades involved the simultaneous purchases and
sales of energy at the same quantity between the same parties; they inflated revenues in both companies
but added no profit. For instance, in the energy trading market controlled by fraudulent energy
companies such as Enron, CMS Energy, Duke Energy, Dynergy, and Reliant Energy, each company
indulged in the same basic type of wash trading and thereby seriously affected market prices and
shortages (see Forbes.coms accounting tracker Internet service).

Wash trading also affects final consumers. For instance, wash energy trading created false
congestions and the perception of energy shortage in the Californian market in 2001, and the price of
electricity paid both by the industrial and home users skyrocketed (USA Today April 4, 12, 2002). Also,
on September 23, 2002, Allegheny Energy, a Maryland electric utility company, sued Merrill Lynch for
$605 million and more unspecified punitive damages in a New York state court. The charge stated that
Merrill inflated revenues of Global Energy Markets (GEM) through a series of round-trip trades with
former industry giant Enron, before selling it to Allegheny for $490 million in 2001. The lawsuit also
accused Merrill for misrepresenting the qualifications (e.g., age, experience) of Daniel Gordon, GEMs
12

head (Yahoo! News, Thursday, September 26, 2002, 9:25 am, EST).

Fraud versus Occupational Abuse

Occupational abuse is a form of fraud, presumably of smaller proportions. Nevertheless, abuses imply
some form of cheating and cost to the employers. Consider the following typical employee abuses:

1. Use sick leave when not sick.
2. Come to work late or leave work early.
3. Take a long lunch break without approval.
4. Indulge in slow and sloppy work.
5. Declare or punch more hours than worked for and get paid.
6. Work under the influence of alcohol or drugs.
7. Take products or stationery belonging to the organization (pilferage).
8. Pad your expense accounts. That is, collect more money than due on business expense
reimbursements.
9. Use employee discounts to purchase goods for relatives or friends.
10. Use companys computers during office hours to engage in personal email or securities exchange.

All of these behaviors are examples of occupational fraud. According to the Association of
Corporate Fraud Examiners (ACFE), an occupational fraud is the use of ones occupation for personal
enrichment through the deliberate misuse or misapplication of the employing organizations services or
assets (ACFE Report 2004). This definition is broad enough to include fraud schemes as simple as
pilferage to complex financial statement frauds. Each of these abuses implies: a) some clandestine
behavior, b) violation of perpetrators duties to the victim organization, c) some form of cheating the
employer, d) which costs the employer some money, revenues or assets, and e) some direct or indirect
financial benefit to the perpetrator.

The first five examples relate to cheating on time spent on work for which the employer must pay
extra. The sixth case of alcohol or drugs cheats on the quality of work that you owe to the company. The
next three abuses cheat on products and/or money. The tenth abuse cheats the company on everything:
time spent on work, quality of work and using companys products/services for ones private business.
All ten examples involve a corrupt practice, deception, and improper use of ones fiduciary trust.
Fiduciary duty implies that you are employed (entrusted with responsibilities) on the condition that you
are trustworthy and that you do not betray the trust your employer has in you.

In practice, how do you distinguish fraud from abuse? The difference is a matter of perspective.
Fraud implies more conspiracy and conspirators, more scheming, affects more people, involves greater
losses, and negatively affects large assets of the company. In contrast, abuses are often single-handed
actions that are ordinary and routine deceptions, which mostly benefit just the abuser, and involve smaller
corporate losses. [See Turnaround Executive Exercises 2.3].

Let us illustrate the difference between corporate fraud and corporate abuse by an example. Jane is a
bank-teller, and steals $100.00 each day for five different days of a quarter from her cash drawer. John is
also a teller who earns $500.00 a week, and calls in sick (when he was healthy) five different days during
the same period. Normally, the former crime would be called a fraud, and the latter action an abuse, even
though the damage to the bank in both cases is the same amount, namely $500.00. Each offense implies a
dishonest intent to benefit oneself at the expense of the company. Both violate their fiduciary duties to
the employer and betray the trust the employer had in them. Yet the punishment meted out in each will
be different. Jane would be fired for embezzlement and possibly prosecuted while John will be gently
reprimanded, and for repeated offense, his pay may be docked for a day or two. Jane stole money, but
13

John stole time (which is equivalent in money to Janes damage to the company). Janes action, however,
will be treated as a crime of embezzlement or stealing, while that of John would be treated as misconduct
or inappropriate behavior. It is a matter of perspective (Wells 2004: 4).

Based on Wells (2004: 46), Table 2.4 presents a detailed taxonomy of occupational fraud and abuse.
Table 2.4 traces occupational fraud to three major action-sources: a) corruption practices, b)
misappropriation of assets, and c) falsifying financial statements. Table 2.4 also includes several major
types and sub-types of occupational fraud under each of these three heads. Vigilant managers could use
this exhaustive list to check and identify occupational frauds in their companies.

Fraud has existed since the dawn of humanity and will continue until the end of times. Given human
nature and its weaknesses, ones avarice and greed for money, power and popularity has been the major
stimulus for fraudulent crime. The landmark case of fraud is McKesson Robinson, a corporation involved
in a 1937 financial statement balance fraud that reported $10 million of non-existent inventories and
accounts receivable. This case marked the beginning of required generally accepted auditing standards
(GAAS) for independent public auditors.

Fraud exists even today and can occur anytime in an organization. At the same time, there is no
special recipe or checklist for detecting and preventing corporate or personal fraud at all times. No such
thing exists and no such thing is truly capable of being developed to monitor and control all forms of
fraud (Silverstone and Davis 2005: 5-6). Managers should be aware of fraud, deal with the human factors
that generate fraud by hiring honest people and keep them honest by instituting strong deterrents of fraud,
and deal with the environmental factors that cause crime by enforcing adequate monitors, controls,
policies and procedures.

Corporate Financial Irregularities

Corporate financial irregularities include several deviant behaviors and data manipulations. Some
of these are: overselling shares to depress stock prices, overstating financial worth to boost stock prices,
overstating revenues by round-trip sales, understating debts, or, in general, cooking the books to
influence better SEC ratings. In general, financial irregularities are classified under two major heads: a)
Accounting Irregularities and b) Insider Trading Irregularities.

Most corporate accounting irregularities come under two heads: a) Fake transactions like round-
trip sales, and b) manipulation of debts and assets to overstate the value of the company. The U. S.
Federal Energy Regulatory Commission (FERC) defines wash trading, also known as "round trip" or
"sell/buyback" trading, as the sale of a product, e.g. electricity, to another company with a simultaneous
purchase of the same product at the same price.

Essentially, wash trading is false trading because it boosts the companies' trading volume, or even
sets benchmark prices, but shows no gains or losses on the balance sheets. While this kind of trading may
not be illegal as per then GAAP, it can manipulate the power market, which is illegal. Most of the large
scams recently uncovered were in the utility business (See Forbes 2002, July 25; Fortune 2002,
September 2). Several wholesale power traders revealed that they participated in the so called "round
trip" or "wash trading." For instance, wash-trading practices among some energy companies created false
congestion and generated the perception of an energy shortage in the troubled California energy market in
2001-2002. Some would even argue that this practice contributed to the bankruptcy of the two largest
California electric utilities and forced subsequent government support to keep power flowing there. The
price of electricity skyrocketed and in the end, it was the consumer who had to pay the price for corporate
accounting frauds. An inflated balance sheet from round-trip trading misleads investors about the true
14

nature and volume of the company's business. Large volumes of "wash" trades raise the revenues but have
no effect on earnings.

Recent Corporate Accounting Irregularities

Round-trip Sales:

1. Enron and Qwest Communications: Denver-based Qwest Communications used bandwidth to manufacture illusory
revenue streams in its recent deal with Enron. According to investigators, Qwest agreed to pay Enron $308 million
for the use of dark fiber (or unused fiber optic) capacity. In exchange, Enron agreed to pay Qwest between $86-
195 million for access to active sections of Qwests network. Both deals turned out to be fake allowing both
companies to record fat revenues for the period, and particularly helped Enron avoid reporting a loss for that period
(Pizzo 2002). Qwest admitted that an internal review found that it incorrectly accounted for $1.6 billion in sales.
It restated results for 2000, 2001, and 2002. It was planning to sell its phone director unity for $7.05 billion in
order to raise funds.

2. CMS Energy (May 2002): It executed several round-trip trades with Reliant Energy artificially to boost energy-
trading volume. Thomas Webb, former CFO of Kellogg, has been appointed as its new CFO since August 2002.
These companies have admitted that they have wash traded close to $6 Billion in sales revenues, either between
these two companies, or involving other energy companies involved in the fraud.

3. Dynergy (May 2002): also executed round-trip trades artificially to raise its energy trading volume and cash flow.
S&P cut Dynegys rating to junk, even though the company is conducting a re-audit.

4. El Paso (May 2002): Also executed round-trip trades artificially to enhance energy-trading volume. Oscar
Wyatt, a major shareholder and renowned wildcatter, may be engineering a management shake-up.

5. Duke Energy (July 2002): Duke engaged in 23 round-trip trades to boost trading volumes and revenue. Duke
claims that its round trip trades had no material impact on current or prior financial periods.

6. Global Crossing: February 2002, the company engaged in network capacity swaps with other carriers to inflate
revenue and shredded documents related to securities practices. Company filed Chapter 11 bankruptcy protection.
The Congress is investigating the role of its securities firms in its bankruptcy.

7. Homestore.com (January 2002): Inflated sales by booking barter transactions as revenue. The California State
Teachers pension fund, which lost $9 million on a Homestore investment, has filed suit against the company.

8. Merck (July 2002): Recorded $12.4 billion in consumer-to-pharmacy co-payments that Merck never collected.
Even though SEC approved Medcos IPO registration that would raise $1 billion, the company has withdrawn from
it.

Thus far, the FERC has demanded disclosure on wash trading from almost 150 energy companies
from all over the United Sates. Only when the investigation is complete and other wash trading
information is uncovered will we be able to assess how widespread this trading actually was.

Inflating or Restating Revenues:

9. Halliburton (May 2002): Improperly booked $100 million in annual cost overruns before customers agreed to
pay for them. The legal watchdog group Judicial Watch filed a securities fraud against Halliburton.

10. WorldCom: (March 2002): It overstated cash flow by booking $3.8 billion in operating expenses as capital
expenses. It gave founder, Bernard Ebbers, $400 million in off-the-book loans. By the end of 2002, the
WorldCom scam totaled $16 billion. The company found another $3.3 billion in bogus securities, and may have
to take a goodwill charge of $50 billion to write-off its debts. Former CFO Scott Sullivan and ex-controller
15

David Myers have been arrested and criminally charged. David Myers agreed to be guilty on September 26,
2002.

11. Peregrine Systems (May 2002): It overstated $100 million in sales by improperly recognizing revenue from
third-party resellers. It slashed nearly 50% of its workforce to cut costs. With a third auditor in 3 months, it has
yet to file its 10K for 2001; hence, it may be soon de-listed from the NASDAQ. Currently, it is restating
revenues from April 1999 to December 2001, during which John Moores, Chairman, dumped $530 million of
stock (Fortune, September 2, 2002).

12. Adelphia Communications (nations 6
th
largest cable TV company): April 2002, the founding Rigas family
collected $3.1 billion in off-balance sheet loans backed by Adelphia, and overstated results by inflating capital
expenses and hiding debt. The company filed for Chapter 11 bankruptcy on June 25, 2002. Three Rigas family
members and two other ex-executives were arrested for fraud on July 24, 2002. The company is suing the entire
Rigas family for $1 billion for breach of fiduciary duties, among other things (Forbes, July 2002).

13. AOL Time Warner: As the media market faltered and AOLs purchase of Time Warner loomed, AOL inflated
sales by booking barter deals and advertisements it sold on behalf of others as revenue to keep its growth rate up
and seal the deal. AOL also boosted sales via round-trip deals with advertisers and suppliers. The
Department of Justice (DOJ) has ordered AOL to preserve it documents. AOL confessed that it might have
overstated revenue by $49 million. New concerns are that AOL may take another goodwill writedown, after it
took a $54 billion charge in April (Forbes, July 2002). The scandal went public in July 2002.

14. Bristol-Myers Squibb: Inflated its 2001 revenue by $1.5 billion by channel stuffing (i.e., forcing wholesalers to
accept more inventory than they can sell to get it off manufacturers books). Efforts to get inventory back to
acceptable size will reduce Squibbs earnings by 61 cents per share through 2003 (Forbes, July 2002). The
scandal was disclosed in July 2002.

15. K-Mart (January 2002): Allegedly, its securities practices were intended to mislead investors about its financial
health. The company, then in a bankruptcy situation, was undertaking a stewardship review to be completed by
the end of 2002. February 26, 2003, two Kmart executives were indicted by a Detroit grand jury on federal
charges of fraud, conspiracy and making false statements over their recording of a $42 million payment that
resulted in an overstatement of Kmarts results (Hays 2003).

Ethical Implications

Deliberate accounting irregularities are failures of corporate accountability. In the wake of these
escalating corporate accounting scandals, several ethical and moral questions arise. As responsible
ambassadors and representatives of the corporation, and of its mission, products and services, corporate
executives in general, and accounting executives in particular, must represent integrity, honesty and
corporate responsibility to customers, shareholders and other stakeholders.

The Enron bankruptcy raised questions about the validity of the independent audits and of the
business practices of the accounting industry itself. It is clear that the auditors failed to pinpoint the
accounting irregularity problems with companies involved in corporate scams. Given the fact that the
accounting practices are relatively simple, it is hard to believe how easily the accounting firms disguised
the truth, presumably in collusion with the audit and accounting branches of the implicated firms. It is just
hard to accept that the accountants did not assess the magnitude of these frauds. Clearly, the accounting
principles and rules were not followed.

There were systems level failures at several points that allowed many corporate frauds and scams to
remain undetected until they were so large that they bankrupted large companies, with billions of dollars
of loss in shareholder equity. Some of the biggest and most prestigious U. S. accounting firms (e.g.,
Arthur Anderson, Deloitte & Touch, Ernst & Young, KPMG, and Price Waterhouse & Coopers) offered
16

consulting services to the same companies they also audited. This is gross conflict of interest. These firms
clearly compromised their credibility and independence when they had to audit their own work. The
Securities and Exchange Commission (SEC) failed to bar accountants from also being consultants for the
same company due to extensive pressure from the accounting lobbying groups. The same groups have
contributed millions of dollars to individuals, political activity campaigns (PACs), and soft money
contributions to fight any SEC rules change. Some of the largest scams recently uncovered were in the
utility business (see Appendix 2.1 and 2.2). Several wholesale power traders revealed that they
participated in the so-called "round trip" or "wash trading" practices.

Insider Trading Irregularities

Early 2000 marked the beginning of some of the worst corporate security irregularities in history.
Rapidly rising stock prices followed by the eventual market collapse might have led these executives to
unusual activities and practices in corporate transactions that were either questionable in terms of their
ethical and moral implications, or were outright violations of the law. For instance, Forbes (July 25,
2002) listed top 25 securities irregularities among top management executives, and little later, Fortune
(September 2, 2002) featured another list of 25 largest corporate irregularities in the form of corporate
accounting frauds and security scandals. The latter list of securities irregularities involved a total haul of
$23.074 billion dollars, averaging to $923 million per company. The list named 55 top executives
laundering $14.147 billion with over 257 million dollars per person. Incidentally, the Fortune 2002
report resulted from a research conducted during 2001 in conjunction with the University of Chicago,
School of Business. The current avalanche of security irregularities could represent just the tip of the
iceberg. Each business week of the last two years (2000-2002), the media has been featuring at least one
or other top corporate executives of the country confessing either accounting frauds or securities
irregularities or both.

Definitions and Discussion of some Key Terms

Insider Trader: The term insider is specially defined in Section 16b of the U. S, Securities Exchange Act of
1934 that limits short-term transactions by insider parties (Vagts 1979: 827). Section 16b of the 1934 SEC Act
imposes express liability upon insiders - directors, officers, and any person owning more than ten percent of the
stock of a corporation listed on a national stock exchange or registered with the SEC - for all profits resulting
from their short-swing trading in such stock. The insiders are assumed to have special access to insider
information concerning a corporation either because of financial interests and/or a managerial position. If any
insider sells such stock within six months from the date of its purchase or purchases such stock within six
months from the date of its sale, the corporation is entitled to recover any and all profit the insider realizes from
these transactions. The profit recoverable is calculated by matching the highest sale price against the lowest
purchase price within the relevant six-month period, and losses cannot be offset against profits (Mann and
Roberts 2000: 961). Individuals classified as insiders are subject to special restrictions in using such data in
trading in securities. Insider trading during a tender offer is prohibited by Rule 14e-3 of the 1934 SEC Act
(Mann and Roberts 2000: 963). A tender offer is a general invitation to shareholders to purchase their shares at
a specified price for a specified time. Section 14e imposes civil liability for false and material statements or
omissions or fraudulent, deceptive, or manipulated practices in connection with any tender offer.

Security: A security includes any note, stock, bond, pre-organization subscription, and investment contract. An
investment contract is an investment of money or property made in expectation of receiving a financial return
solely from the efforts of others. Securities not subject to the registration requirements of the 1933 SEC Act
are exempt securities which include short-term commercial paper, municipal bonds, and certain insurance
policies and annuity contracts. Non-exempt securities come under 1933 Act such as notes, stocks, bonds and
some investment contracts. Similarly exempt transactions are issuance of securities that do not come under the
registration requirements of the 1933 Act (e.g., limited offers, intrastate issues). Disclosure of accurate material
information is required in all public offerings of non-exempt securities unless offering is an exempt transaction.
17


Disclosure requirements: these are statements disclosing specified information that must be filed with the SEC
and furnished to each client. Insiders are liable under Rule 10b-5 for failing to disclose material, nonpublic
information to the SEC and each client before trading on the information.

Antifraud Provision: Rule 10b-5 makes it unlawful to 1) employ any device, scheme, or artifice to defraud; 2)
make any untrue statement of a material fact; 3) omit to state a material fact without which the information is
misleading; 4) engage in act, practice, or course of business that operates or would operate as a fraud or deceit
upon any person. Recovery of damages under Rule 10b-5 requires proof of: 1) a misstatement of omission; 2)
materiality; 3) scienter (intentional and knowing conduct), and 4) relied upon 5) in connection with the
purchase or sale of a security. In an action for damages under Rule 10b-5, it must be shown that the violation
was committed with scienter or intentional misconduct. Negligence is not sufficient.

Material: A misstatement or omission is material if there is a substantial likelihood that a reasonable investor
would consider it important in deciding whether to purchase or sell a security. Examples of material facts
include substantial changes in dividends or earnings, significant misstatements of asset value, and the fact that
the issuer is about to become a target of a tender offer.

Tippers These pass on insider information that they had a legal obligation to keep secret even though they do
not trade on it themselves. Correspondingly, a Tippee is someone who accepts insider information from a
person who should not have revealed it, and trades on it.

Insiders, for the purpose of SEC Rule 10b-5, include directors, officers, employees, and agents of the security
issuer, as well as those with whom the issuer has entrusted information solely for corporate purposes, such as
underwriters, accountants, lawyers, and consultants. In some instance, the rule also precludes persons (tippees)
who receive material, nonpublic information from insiders (tippers) from trading on that information. A tippee
who knows or should know that an insider has breached his fiduciary duty to the shareholders by disclosing
inside information to the tippee is under a duty not to trade on such information (Mann and Roberts 2000, p.
962).

I nsider Trading: SEC Rule 10b-5 applies to sales or purchases of securities made by an insider who
possesses material information that is not available to the public (Mann and Roberts 2000, p. 961). More
specifically, it is the attempt to benefit from stock market fluctuations by using unpublicized information gained
on the job (Mescon, Bove and Thill 2002, p. 58). An insider who fails to disclose the material, nonpublic
information before trading on the information will be liable under Rule 10b-5, unless he or she waits for the
information to become public. The U. S. Supreme Court has upheld the misappropriation theory as an
additional and complementary basis for imposing liability for insider trading. Under this theory, persons may
be held liable for insider trading under Rule 10b-5 if they trade in securities for personal profit using
confidential information misappropriated in breach of a fiduciary duty to the source of the information; this
liability applies even though the source of information is not the issuer of the securities that were traded (Mann
and Roberts 2000, p. 262).

I nsider I nformation: Insider information is data or news that has not been publicly released and that could
affect a shareholders decision to buy or sell stock in a publicly traded company utilizing material, nonpublic
information (Markon and Schmitt 2002). The law bars trading in a material nonpublic information. In terms of
defining just what kind of information fits this category, prosecutors have some leeway. The most clear-cut
examples include market-moving news such as an impending merger or bad earnings report before it is made
public. But, gray areas abound. Numerous other issues abound. For example, many companies attend
professional conferences each year and they may provide information about new products to attendees, while at
the same time bar members of the general public from any of the above information (Business Week, April 26,
2002). The American Society of Oncology (ASCO) is a case in point. At each of their annual conferences a
great deal of information is released to those attending these gatherings. This is akin to insider trading if the
attendees begin trading on the information provided to them.

18

Legal I nsider Trading: Insiders need to follow certain procedures when they wish to sell some or all of their
holdings. First, the potential inside trader needs to consult with legal consul so as to determine the
appropriateness of an insider purchase and/or sale at a given point in time such as a pending merger. Then a
Form 144 must be filed with the Securities Exchange Commission (SEC) indicating the number of as well as
the precise timing of the desired sale. Finally, an opinion letter must be sent from the appropriate legal counsel
and filed along with the above, to the Securities Exchange Commission (SEC). All these procedures are meant
to ensure that the corporate insiders do not trade on or tip others with insider information thus negatively
affecting the company and/or its shareholders.

Thus, although both Section 16b and Rule 10b-5 address the problem of insider trading and both
apply to the same transaction (i.e., trading securities), yet these two legal sources differ in many aspects:
1) Section 16b applies only to transactions involving registered equity securities, whereas Rule 10b-5
applies to all securities. 2) The insiders by Section 16b are only directors, officers, and those who own
more than 10% of the a companys stock, while the insiders by Rule 15b-5 extends to other categories
such as agents of the security issuer, underwriters, accountant, lawyers and consultants. 3) Section 16b
does not require that the insider possess material, nonpublic information; the liability is strict; whereas
Rule 10b-5 applies to insider trading only where such information is not disclosed. 4) Section 16b applies
only to transactions occurring within six months of each other, while Rule 10b-5 has no such limitation.
5) Under Section 16b, although shareholders may bring suit, any recovery of damages is on behalf of the
corporation; but under Rule 10b-5, injured investors may recover damages on their own behalf (Mann and
Roberts 2000, p. 962).

In 1988, the US Congress amended the 1934 Act by adding Section 20A that imposes express civil
liability upon any person who violates the Act by purchasing or selling a security while in possession of
material, nonpublic information. Any person who contemporaneously sold or purchased securities of the
same class as those improperly traded may bring a private action against the improper traders to recover
damages for the violation. The action must be filed within five years after the date of the last transaction
that is the subject of the violation. Tippers are jointly and severally liable with tippees who commit a
violation by trading on the insider information (Mann and Roberts 2000, p. 963).

Further, any person who distributes a materially false or misleading proxy statement may be liable to
a shareholder who relies upon the statement in purchasing or selling a security and thereby suffers a loss.
A misstatement or omission is material if there is a substantial likelihood that a reasonable shareholder
would consider it important in deciding how to vote or buy/sell shares, even if this misstatement or
omission occurred merely through negligence. Similarly, by Section 14e of the SEC Act of 1934, it is
unlawful for any person to make any untrue statement of material fact, to omit to state any material fact,
or to engage in any fraudulent, deceptive or manipulative practices in connection with any tender offer.
This provision applies even if the target company is not subject to the 1934 Acts reporting requirements.
Some courts maintain civil liability for violations of Section 14e; however, the requirements for such an
action are not entirely clear because relatively few cases have involved such violations. At present, the
target company may seek an injunction, and a shareholder of the target company may be able to recover
damages or obtain rescission (Mann and Roberts 2000, p. 963).

By legislations enacted in 1984 and 1988, the SEC is authorized to bring an action in a U. S. district
court to have a civil penalty imposed upon: 1) any person who purchases or sells securities while in
possession of material, nonpublic information; 2) any person who by communicating material, nonpublic
information aids and abets another in committing such a violation; 3) any person who directly or
indirectly controlled a person who ultimately committed a violation, even though the controlling person
knew or recklessly disregarded the fact that the controlled person was likely to commit a violation and
consequently failed to take appropriate steps to prevent the transgression. Violation in all three cases
must be on or through the facilities of a national security exchange or from a broker or dealer. Purchases
19

that are part of a public offering by an issuer of securities are not subject to this provision (Mann and
Roberts 2000, p. 963).

Corporate insiders for some time have been forbidden to trade while knowing about material,
nonpublic information such as earnings announcements or a possible merger. Currently, insiders need
only be aware of confidential market-moving information, as based on SEC Rule 10b-5. A second rule
(105b-2) extends liability for illegal insider trading to family members and other non-business
relationships that have agreed to keep secret the information they receive.

Further, as of August 2002, SEC has come up with newer rules requiring firms to report trades of
company stock by officers, directors and majority shareholders within two (2) days (Kristof 2002). This is
a vast improvement over past sales that allowed companies at least 10 days - and sometimes more than a
year - to reveal whether the top officers within the firm were buying or selling their equity or portions
thereof. Recently, the SEC is involved with more activities relative to insider trading cases: as a result, 57
insider trading related cases were filed in 1996, up from 38 in 1990 (Bryan-Low 2000).

Some Recent US Insider Trading Irregularities
(See Fortune, September 2, 2002).

Qwest Communications: As part of BellSouths deal to buy some of Qwest, Phil Anschutz, Director of Qwest, sold
his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion.

Gateway: Tedd Waitt, founder and CEO of Gateway, spent $9.36 million in June to buy back 2 million Gateway
trading around $4, when $82.5 was the stock peak price in November 1999: his haul was $1.00 billion.

Ariba.com: With an unusually short post-IPO lockup period, several corporate executives of Ariba.com began
selling their stock barely 4 months after Ariba went public in June 1999. Ron DeSantis, former EVP made 222
million, Keith Krach, Chairman hauled 191 million, Paul Heagarty, Director, Edward Kinsley, former CFO,
each laundered 127 million and 114 million, respectively.

I2Technologies: Founder, chairman and CEO of I2 Technologies, Sanjiv Siddhu, who still owns 27% of the
company, sold most of these shares after the stock peaked at $110 in March 2000. I2 Technologies stock now
trades at less than $1.0; his catch was 447 million; Ramesh Wadhwani, Vice-Chairman, and Sandeep Tungare,
former Director each did the same and made 160 million and 140 million, respectively.

Enron: Enrons Lou Pai, former Division Head, Ken Lay, former CEO, Rebecca Mark, former Division Head and
Ken Rice, former Division Head, each cashed stock to mint 270 million, 108 million, 80 million and 74
million dollars respectively; Jeff Skilling and Andy Fastow cashed $68 million each worth of Enron stock,
respectively.

Global Crossings: Gary Winnick, Chairman, Global Crossings, cashed stock worth $508 million; Winnick also sold
another $227 before January 1, 1999.

Cisco Systems: John Chambers, President, CEO, Cisco Systems, and Judith Estrin, former CIO, each cashed stock to
gain $239 million and $ 72 million respectively in 2000. Estrin also cashed $61 million of stock in February
2000, a month before it peaked at $80.06; she left Cisco that April.

Nextel Communications: Craig McCaw, Director, Nextel Communications, cashed stock to the tune of $343 million
in 2000. He also cashed $115 million from XO Communications, the Telecom he founded that went belly-up
June 2001.

Juniper Networks: Last May, with stock down 96% from its high of $243, executives of Juniper Networks, Scott
Kriens, Chairman, CEO, Pradeep Sindhu, Vice-chairman, and Peter Wexler, VP exchanged their booming
20

options for ones priced at $10.31! They bagged each 148 million, 108 million and 87 million dollars,
respectively.

Opportunism is rampant in every area of business, and corporate finance is no exception as the long
list of corporate securities irregularities (e.g., Fortune September 2, 2002) demonstrates. The risk of
opportunism can be very high, and considerable resources might have to be spent in controlling and
monitoring it, resources that could have deployed more productively elsewhere in the company.
Opportunism is hard to detect owing to information asymmetry between the party engaging in
opportunistic behavior and the other exchange partner, even harder to control, and strategies for
suppressing opportunistic behavior may undermine existing exchange relationships (Murry and Heide
1998) as well as forfeit valuable deals in the process. While several strategies of external control of
opportunism have been devised, tried, and often failed (e.g. reduction of information asymmetry, closer
monitoring, higher monetary incentives to discourage opportunism, higher contracted penalties for
opportunistic behavior), very few internal control mechanisms have been tried. A major internal
control such as selecting, contracting, and rewarding marketing or securities managers whose virtues of
honesty, prudence, commitment, and fiduciary responsibility have been tested and proven may help
control opportunism far more effectively than external monitors.

Corporate irregularities are bred by corporate greed that in turn is stimulated by the corporate
virtue of selfishness (Rand 1964). What we need at this juncture is a real return to virtue, specifically
the virtue of caring for others, specifically advocated by recent feminist ethical scholars (see Gilligan
1982; Noddings 1984). Unless corporate executives aim higher (see Bollier 1997), and incorporate
virtue in their corporate strategies (see Morris 1997), they will never appreciate the social contracts they
have implicitly signed with society by their corporate position (Donaldson and Dunfee 1995, 1999).

How do we Combat Corporate Fraud?

Our main argument is that ethics can combat corruption. Additionally, we believe that excessive
regulation and its complex interpretation/enforcement process breeds corruption. We also theorize that
there is a supply side versus demand side of corruption, especially in India.

However, how and under what circumstances can ethics reduce corruption? We suggest two
approaches:

1. Much of corruption thrives on uncertainty or ambiguity of the law, licenses, and other excessive regulation
and its enforcement mechanism. There is much information asymmetry between the buyer and the seller
of excessive regulation services. Ethics should focus on reducing uncertainty, ambiguity and asymmetry in
the entire corruption phenomenon wherever it occurs.

2. In order to do this, we breakdown the phenomenon of corruption into inputs, process, and outputs, and
distinguish the supply side and demand side under each. For a proper focus, we concentrate only on the
government as the supply side and business house as the demand side G2B domain.

Other things being equal, uncertainty/asymmetry in relation to inputs may be regarded as complexity,
uncertainty in the process may be construed as ambiguity, and uncertainty in the outputs as risk all this
both on the supply side and demand side. Table 2.5 is a representation of uncertainty involved in the
sources and sub-sources of corruption. When specifically applied to each cell, ethics can piecemeal
combat corruption. Additionally, Appendix 2.3 presents the essentials of the famed USAs Sarbanes-
Oxley Act of 2002 to Combat Corporate Frauds. [See Business Executive Exercises 2.4 to 2.8].

21

All businesses have a responsibility to the common good. Because corporate executives and
organizations are both economic and social institutional forces, their responsibilities to the public are
large and go beyond the sanctions of law and demands of competition. In serving each other, they must
strike at some unity that goes beyond a mere melding of self-interests to sharing of socially responsible
values and ideals. Howsoever defined, the social good of investors is very high, and the investing public
recognizes this good. Corporate irregularities of whatever form reduce this potential for social good by
depriving investors of necessary, objective and timely securities information to which they are entitled.
This goal is achieved in USA through existing organizations such as GAO, SEC, DOJ, and CFTC.

It is possible that corporate executives would justify their improper action under the guise of
situationism. The latter affirms that when confronted with conflicting rights or duties, it is usual to let the
situation with all its circumstances define whose rights should prevail. But this does not mean that the
rights of shareholders, investors, employees with 401K moneys invested in the company, and other
stakeholders should be totally disregarded, as seems to be the case with the corporate irregularities. In
fact, moralists (e.g., Rawls 1971) prescribe that under situationism one is obliged to give additional
protection to the rights of the disadvantaged.

Concluding Remarks

There are three dimensions to any corporate fraud: the human, the technology, and the legal
dimension. The most important one is the human. People will always try to find ways to get around any
regulatory system if it is to their advantage to do so. Any legal or technology system is only as good as
people that designed it. Consequently, there will always be someone smarter and more knowledgeable
that is willing to take the risk of exploiting the system for ones own benefit.

There are several issues that make it difficult to predict, uncover or control corporate corruption and
fraud. When the top-level business executives are corrupt, it is difficult for the mid-level managers to
detect or uncover the deceptive acts and the problems underlying them. Moreover, the mid-managers
would be worried about their jobs, especially if whistle blowing is punished in corporations.
Additionally, corporate executives involved in fraudulent activities that could launder billions of unearned
personal profit to them would not hesitate to pressurize and bribe subordinates into silence even if the
latter detected something irregular. Some subordinated could be could be easily seduced to keep quiet
"for the good of the company" or "only until the mess is straightened out." A sense of personal loyalty
may deter some from resigning their jobs under such strenuous situations.

As managers move from one place to another, it is possible they inherit an already messy
business from a previous executive, and would be reluctant to expose the situation for any number of
personal or professional reasons. Thus, many instances internal audits do not work and are just another
form of unnecessary nuisance in the bureaucracy. The Enron bankruptcy raised questions about the
validity of the independent audits and of the business practices of the accounting industry itself. It is clear
that the auditors failed to pinpoint the problems with companies involved in corporate scams. The
accounting practices are relatively simple. It is just hard to believe how easy it was for the accounting
firms to disguise the truth, without resorting to collusion between the audits and accounting branches of
the implicated firms as an explanation. It is just hard to believe that the accountants would miss the
magnitude of these frauds. Clearly, the Enron executives did not abide by the usual accounting principles
and rules.

There were systems level failures at several points that allowed many corporate frauds and scams
to remain undetected until they were so large and unredeemable. Some of the biggest accounting firms
such as Arthur Anderson, Deloitte & Touch, Ernst & Young, KPMG, and PriceWaterhouse Coopers
22

increased their earnings by offering consulting services to the same companies they audited. These firms
clearly compromised their credibility and independence when they had to audit their own work. The
Securities and Exchange Commission failed to bar accountants from also being consultants for the same
company due to extensive pressure from the accounting lobbying groups. The same groups have
contributed millions of dollars to individuals, PAC's, and soft money contributions to fight any SEC rules
change.

Whatever may be the underlying motivation for corporate scams, what we advocate is a corporate
ethical culture that is guided by some teleological rules and deontological imperatives. Some of these
have clear managerial implications, such as:

1. Corporate or personal good should not take primacy over social good of the stakeholders.
2. A corporate strategy should gratify the maximum number of people affected by that strategy (Rule
Hedonism).
3. The total sum of utilities generated by any strategy should exceed that of any comparable
alternative strategy (Rule Utilitarianism).
4. A corporate strategy should seek the happiness of the maximum number of people affected by that
strategy (Rule Eudemonism).
5. A corporate strategy should result in an action that can be the norm for all persons in such
situations (Rule Formalism: Universalizability).
6. A corporate strategy should result in an action that must be based on reasons that one would be
willing to have all others use to judge that corporations strategy (Rule Formalism: Reversibility).
7. A corporate strategy should fulfill the implied contractual duty to protect the rights and duties of all
stakeholders affected by that strategy (Rawls Contractualism).
8. A corporate strategy should fulfill the implied macro social contractual duty to protect the rights
and duties of all stakeholders affected by that strategy (I ntegrated Social Contracts Theory).
9. A corporate strategy must observe all legitimate laws that bind (Rule Legalism).

Subsequent handouts will clarify and discuss these rules in greater detail. Any corporate
strategy that fulfills one or more of these nine rules has lesser likelihood of corrupting into a corporate
scam or indulging in the corporate virtue of selfishness (Rand, 1964). What we need at this
juncture is a real pursuit of virtue, specifically the virtue of caring for others (see Gilligan 1982;
Noddings 1984), and a keen sense of corporate social responsibility (Mascarenhas 1995). Unless
corporate executives aim higher (Bollier 1997), and incorporate virtue in their corporate strategies
(see Morris, 1997), they will never appreciate the social contracts they have implicitly signed with
society by their corporate position and mission (Donaldson & Dunfee 1995, 1999).

23

Table 2.1: Characterizing Physical Transactional Abuses

Physical
Transaction
Abuse
Level of
Ambiguity
Inputs Process Outputs Remarks
Compelling
physical non-
violent
persuasions
Ambiguously
Fair
All transparent
products and
services
Perfect
information; full
awareness and
motivation to act;
no physical
inducements other
than puffery and
persuasions
Compelling but
fair tradewith
mutual gain.
There is much
scope for
marketing
here.

A Win-Win
bilateral exchange
in the standard
microeconomic
sense
Con Game Inherently
Ambiguous with
social consent
High
information
asymmetry; the
thief commands
but the victim
plays along.
The victims
response to the
evidence is not
simply to misread it
but go along with it.
Con Game: the
victim plays
along, but
suffers loss
without
knowing it.
Personal fraud
and scam one gets
involved in
consciously or
unconsciously.
Skimming,
Pilfering
Ambiguously
unfair
Belief you are
not noticed
Every day theft of
small items from
the organization
Could add up to
sizeable
amount over
many and
frequent
occurrences
Often, occult
compensation for
ones low wages
Theft by Stealth Unambiguously
Unfair and One-
sided
One-sided
intervention to
theft. The
victim is
unaware or
absent.
The victim is
physically absent or
psychologically
unaware of the
action of the thief.
Theft by
stealth: the
victim suffers
loss without
knowing it.
Thief is cunning,
contriving,
stalking,
scheming, and
vigilant for the
right occasion to
steal.
Theft by Fraud Inherently
Ambiguous with
no consent
High
information
asymmetry; the
thief commands.
The action is
noticed but
misinterpreted.
Pure embezzlement.
Theft by Fraud:
The victim
suffers loss by
misreading
evidence.
Corporate fraud,
corruption and
bribery are here
under various
forms.
Theft by Force Unambiguously
Unfair
Force, physical
or mental or
psychological;
threatening and
intimidating
elements; high
information
asymmetry;
Coercion is the only
reason why
transaction occurs;
parties no longer
Pareto informed;
the victim is
physically deterred
from responding.
Pure robbery.
Theft by force.
Transaction for
the thief; loss
for the others.
No marketing
needed here,
other than
bullying and
coercing to give
in.
The thief knows
more than others
in the forced
transaction. The
felons
overwhelming
superiority of
power accounts
for the victims
cooperation.
Larceny Unambiguously
Unfair
Larceny is
felonious
stealing using
tricks, frauds,
chicanery,
obfuscation, and
the like.
It is taking and
carrying, leading,
riding, or driving
way another
persons personal
property.
Larceny is a
cunning way of
taking goods
against the will
or consent of
the owner but
with a
felonious
intent.
It is a transaction
with minimal
consent from the
victim, who may
be silent and non-
resistant out of
fear of attack.
Fraud is a subset
of larceny.


24

Table 2.2: Characterizing Non-Physical Transactional Abuses

Type of
Verbal
Abuse
Level of
Ambiguity
Inputs Process Outputs Remarks
Promotional
Persuasion
Ambiguity is
moderate
Pre-existing
consensus. The
value of the
transaction can
be established
within it.
It works within the
logic of the prevailing
consensus, and defines
no new symbols or
signs.
Persuasion results
given enough prior
consensus between
buyer and seller.
Most advertising is
persuasive in this sense.
PR is also persuasive
when you fit news
material into a prior
consensus.
Trickery Ambiguity is
moderately
high
No pre-existing
social buyer-
seller consensus.
Implies the use of
tricks or ruses in
deceiving others.

You unconsciously
capitulate to the
wiles of advertising
Is a con game in
disguise where the
victim is drawn into a
social consensus
Chicanery Ambiguity is
high
No pre-existing
social buyer-
seller consensus.
Implies the use of
petty trickery and
subterfuge, especially,
in legal actions.

You are charmed
by glossy
brochures;
Is a con game in
disguise where the
victim is drawn into a
social consensus
Beguile Ambiguity is
very high
No pre-existing
social buyer-
seller consensus.
To mislead people by
ones charm or
persuasion of cheating
or tricking.

You unconsciously
capitulate to the
freebies and
charms that come
inside cartons.
Is a con game in
disguise where the
victim is drawn into a
social consensus
Seduction Ambiguity is
highest
Involves
construction of a
new consensus, a
deliberate and
stepwise process.
It is a strategy
whereby consumers
are induced to tolerate
or overlook
unsustainability, or
deny it. In this sense,
seduction is more
voluntary than fraud
and more
collaborative than
entertainment - a
playful game form
Enticement of a
consumer into an
exchange where
ambiguity is
resolved by a
private social
consensus that the
consumer plays a
part in
constructing.
The consumer must be
moved in stages from
old agreements to new.
Deception Ambiguity is
moderately
high
Involves
construction of a
new consensus, a
deliberate and
stepwise process.
Consumers are
influenced by non-
substantial attributes
and features of a
product or service.
Deception in when
consumers change
their behavior for
reasons not
objective but on
beliefs and
impressions made
on them by
promotions.
Often, consumers are
influenced by non-
substantial s of a
product at the expense
of disregarding its
intrinsic aspects
(Gardner 1975).

Cheating Ambiguity is
high for
trickery +
deception
No pre-existing
social buyer-
seller consensus.
Cheating is often
fraudulent and
dishonest exchanges

Cheating is
trickery +
deception
towards ones
clients
Consumers,
customers, clients
and buyers get often
tricked via
ambiguous marketing
promotions.


25

Table 2.3: Commonest Frauds by Type, Perpetrators, Methods, Victims, and
Costs of Deception
Type of
Fraud
Fraud
Perpetrators
Method of
Deception
Victims of
Deception
Costs of Deception
Management
Fraud
Top executives
such as CEO,
CFO and chief
accounting officer
(CAO)
Creative and
aggressive
accounting such as
earnings
management;
Income smoothing
Gain on sale and
Wash trading
Organization,
Investors,
Employees,
Suppliers,
Customers
Shareholders,
Creditors or lenders

Loss of market valuation, Tobins Q,
brand equity, supplier goodwill and
customer loyalty and investment
opportunity; loss of earnings, share
price, and corporate image
Possible bankruptcy
Loss in financial performance ratios
such as P/E, EPS, ROIC, RONA, ROI,
ROE & total shareholder return (TSR)
Securities
Fraud
Top executives
with insider
information
Illegal insider trading Public investors who
do not have access
to inside information
All of the above, plus violation of
insider trading laws with litigation
losses
Investment
Scams
Any individual
involved in such
scams
Tricking or conning
into worthless
investments
Telemarketing fraud
Unsuspecting
investors, especially
the elderly,
teenagers, the
marginalized
False prizes/sweepstakes
Unnecessary magazine sales
Worthless buyer club fees
Unrealized advance fee-loans
Work-at-home schemes
Deceptive travel/vacation packages
Tax Fraud
Corporate and
non-corporate tax
evaders
Failure to report
income from fraud or
bribes; filing false
returns
IRS State and local
tax authorities
Violation of Title 26, US Code # 7201
Bribes may not lawfully be deducted
as business expenses
Loss of tax money to governments
Racketeering
Racketeers
Corrupt
organizations
Criminal violations
of commercial
exchange laws and
ordinances;
Money laundering
Commercial
exchange partners
affected by
racketeering
Racketeer influenced and Corrupt
Organizations (RICO) statue violated;
Title 18, US Code # 1961
Vendor Fraud
Vendors
Suppliers
Brokers
Distributors
Retailers
Significant over-
charging either singly
or by collusion
Non-shipment of
goods paid for
Government with
defense contracts;
Innocent
corporations and
customers
Shipment of inferior or fake goods
Overcharge for purchased goods
Deprivation of goods paid for
Counterfeit goods
Employee
fraud or
embezzlement
Employees
At all non-
executive levels

Skimming, theft;
Cheating on time,
money, quality of
work
Employers,
Shareholders,
Customers,
Other employees
Losses in cash, kind, morale, work-
efficiency, sales and performance due
to occupational fraud
Computer
Fraud
Computer hackers,
code-breakers, and
classified data
destroyers
Illegal access to a
protected computer
vaulting or classified
data; hacking
The public, defense,
national security and
all governments
affected by
classified data
Violates Title 18, US Code # 1030
Bribery and
Kickbacks
All those engaged
in bribery,
kickbacks, and
foreign corrupt
practices
Bribery & kickbacks;
strategies
Suppliers
Prime contractors of
government projects
Bribery violates Title 18, US Code #
201, and the Foreign Corrupt Practices
ACT (FCPA), Title 15, US Code # 78.
Kickbacks violate Title 41, US Code
#s 51-58.
Customer
Fraud
Some customers
Some borrowers
Angered
customers getting
even with
employers
Not paying for goods
purchased; getting
something for
nothing; conning
banks to make loans
or transfer funds
The vendors
Retailers
Banks tricked into
granting loans or
funds transfers
Consumer theft costs
Bad debts; consumer credit abuse;
Violated loan covenants
Free rider costs; Unpaid interest
Non-amortized capital
26

Table 2.4: A Taxonomy of Occupational Fraud and Abuse
[See Wells (2004:46)].

Fraud
Action
Major
Types
Sub-types




Corruption
as Abuse
Conflict of
I nterest
Purchase
schemes
Sales schemes Joint venture
schemes
Strategic
alliance
schemes
Other
Bribery Invoice
kickbacks
Bid rigging Concealed perks Family
favors
Other
I llegal
gratuities
To self To subjects To other groups Gratuities in
kind
Gratuities in
stocks

Economic
extortion
Purchase
undercharges
Sales
surcharges

Extorting
commissions
Distorting
Sales
performance

Other











Asset
Misappro-
priation as
Fraud









Cash
related
Larceny Of cash on
hand
From the deposit

From
marketable
securities
Other






Fraudulent
Disbursements
Billing
schemes
Shell company Non-
accomplice
vendor
Personal
purchases
Payroll
schemes;
falsified wages
Ghost employees Commission
schemes
Workers
compensation
Expense
reimbursement
schemes
Mischaracterizing
expenses
Overstate
expenses
Fictitious
expenses;
multiple
reimbursements
Check
tampering
Forged maker or
endorsement
Altered
payee
Concealed
checks
Register
disbursements
False voids False
refunds
Other


Skimming
Sales Unrecorded Understated Other

Receivables Write-off schemes Lapping
schemes
Unconcealed
Refunds Used returns Tampered
returns
Stolen returns
I nventory
& All
Other
Assets
Misuse

Misuse of
inventories
Misuse of
payables
Misuse of
receivables
Misuse of other
liquid assets

Larceny
Asset
requisitions
and transfers

False sales &
shipping
Purchasing
& receiving
Unconcealed
larceny



Fraudulent
Statements


Financial
Asset/revenue
Overstatements
Timing
differences
Fictitious
revenues
Concealed
liabilities &
expenses
Improper
disclosures;
improper asset
valuations
Asset/revenue
Understatements
To make lean
years look
good
To provide for
future leaner
years
To
jeopardize
budgets
Other harms
Non-
financial
Employment
credentials
Fudging
Internal
documents

Doctoring
External
documents
Overstating
credentials
Understating
credentials

27

Table 2.5: The Supply and Demand Side of Fraud and Corruption:
An Input, Process and Output Analysis


Source of
Corruption

Sub-Source
of
Corruption
Structure of Corruption
Structured Inputs to
Corruption:
Complex People and
I nstruments
Structured Processes
of Corruption:
Ambiguous Exchange
Situations

Structured Outputs of
Corruption: Risk
Consequences




G2B
Supply
Side
(Laws &
Governments)




Corrupt
People


Corrupt G2B politicians;
Corrupt G2B government
officials;
Ministers with key G2B
portfolios;
Unfair G2B lawyers and
judges
G2B information asymmetry;
G2B Opaque transactions;
G2B Obfuscation and
chicanery;
G2B subtle bribery demand;

Information asymmetry
products;
G2B Seduction and Deception;
GEB Blackmail and beguile
set-up;
G2B Structured deception;
G2B Excessive bribery or
robbery;


Corrupt
Instruments
or Means
Excessive industry/market
regulation;
Complicated industry
excise/tax haven laws;
Complex mining licensing
systems;
Complex Public bidding
tenders;
Overbearing G2B
bureaucracy;
Ambiguous law interpretation;
Many G2B authorization
requirements;
Ambiguous G2B bid
process/selection;
Government market opacity;
Structured market injustices;
Loss to the government ex-
checker;
Lost business opportunities;
Tax Losses govt. deficit
budgets;
Consequent loss in GDP
growth;





B2G
Demand
Side
(Business
Houses)


Corrupt
People



Unethical/immoral
executives;
Overbearing middle
managers;
Unscrupulous accountants;
Corrupt internal auditors;
Corrupt external auditors;

Tax evasion; bribery-
proneness;
Export duty violation;
Import-quota violation;
Over-Maximizing profits;
Low ethical and moral
thinking;
Loss in taxes to the exchequer;
Loss in bribery payments to
the industry;
Loss in market capitalization;
Loss in brand image and
equity;




Corrupt
Instruments
or Means
Corrupt B2G distribution
and retail managers;
Corrupt B2G supply chain
managers;
Banking and credit opaque
B2G instruments;
Financial analyst (e.g., BSE)
pressurized demand;
Institutional Shareholder
demands;
Customer
demands/complaints;

Bribing government
distributors and retailers;
Bribing or pressurizing G2B
suppliers;
Bribing and buying G2B bank
credit;
Deceiving financial analyst by
fraud;
Silencing institutional
shareholders by promises;
Buying business licenses and
project approvals via B2G
bribes;

Weakened B2G creativity;
Delayed R&D and innovation
owing to corrupt B2G deals;
Stalled and stagnant business;
Losses due to G2B and B2G
delays;
Loss in sustainable competitive
advantage (SCA) to
governments and businesses;
Consequent loss in market
share;
Loss in RE & corporate
growth for the nation and
industries;
Loss in GDP, EBIT, EPS, ROI;



28

29

Turnaround Executive Exercises

2.1 In understanding and investigating the nature of corporate fraud and its related crimes in your company,
discuss the following:

a) What is fraud? What are its essential legal elements?
b) What is occupational fraud? How is it different from corporate fraud?
c) What is corporate fraud? What are its legally constitutive elements?
d) What is corporate abuse? What are its basic elements?
e) How is corporate fraud different from corporate abuse?
f) How is fraud different from deception?
g) How is fraud different from misleading?
h) How is fraud different from deliberate misrepresentation?
i) How is fraud different from unintentional errors?
j) How is fraud different from trickery?
k) How is fraud different from chicanery?
l) How is fraud different from larceny?
m) How is fraud different from robbery?
n) How is fraud different from embezzlement?
o) How is fraud different from stealing?
p) How is fraud different from skimming?


2.2 Investigate the following corporate frauds and estimate their impact in relation to: a) corporate cash flow
crisis, b) employee jobs and pensions, c) company stock prices, and d) social economic loss.

a) During 1998-2000, Andrew Fastow, CFO at Enron, negotiated and set up outside partnerships to conduct
Enron business. As the principal in these partnerships, however, Fastow also negotiated with Enron on
behalf of the partnerships.
b) During 1999-2001, Qwest Communications inflated revenue using network capacity swaps with Enron
and improper securities for long-term deals.
c) During 2001-2002, AOL inflated sales by booking barter deals and ads it sold on behalf of others as
revenue to keep its growth rate up and seal the deal. AOL also boosted sales via round-trip deals with
advertisers and suppliers.
d) In 2002, Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was
$39.44: his haul was $1.57 billion.
e) In February 2002, World Crossings engaged in network capacity swaps with other carriers to inflate
revenue.
f) In February 2002, Global Crossings engaged in similar network capacity swaps with other carriers to
inflate revenue. It also shredded documents related to securities practices.
g) In March 2002, WorldCom booked $3.8 billion in operating expenses as capital expenses.
h) In March 2002, WorldCom gave founder, Bernard Ebbers, $400 million in off-the-book loans.


2.3 Examine the following employee occupational abuses. In what way are they different from fraud? How are
they different from corrupt practices? How are they different from crimes? How are they economically
harmful to the employer? How are they morally harmful to the employees? How are they socially harmful
to the economy, society and the nation? What employees fiduciary duties to the organization do they
violate? How do they violate employees moral duties of honesty and self-esteem to themselves?

a) Use sick leave when not sick.
b) Come to work late or leave work early.
c) Take a long lunch or break without approval.
d) Indulge in slow and sloppy work.
e) Declare or punch more hours than worked for and be paid.
30

f) Work under the influence of alcohol or drugs.
g) Take products or stationery belonging to the organization (pilferage).
h) Pad your expense accounts. That is, collect more money than due on business expense reimbursements.
i) Use employee discounts to purchase goods for relatives or friends.


2.4 Consider the following case of accounts receivable fraud. The bookkeeper of a small but growing bread
company prepared bills to be sent to customers and was responsible for collecting payments. Recently, sales
have been increasing because of new customers and augmented sales revenue from existing customers. A
surprise internal audit, however, revealed that bank deposits were not growing proportionately to the
increasing sales revenues. On examining the customer copies of sales invoices, a fraud examiner found that
the amounts being billed were higher than the amounts being recorded in the cash receipts journal for the
same transaction. Office copies of the invoices had been altered to reflect the falsified journal entry. The
bookkeeper had stolen over $15,000 before the fraud was discovered. The bookkeeper was dismissed. He
agreed to pay back $15,000, however, lest he should be prosecuted (see Silverstone and Sheetz 2007: 28).

a) How do you classify this fraud?
b) Which of the five traditional accounting cycles is its source?
c) How do you identify exceptional and questionable account balances and variations?
d) Also, how could you detect it much earlier before the damage it created?
e) Which fundamental rule of accounting does this fraud violate, and why?
f) Hence, how would you prevent such frauds in the future?


2.5 Consider the following case of accounts payables fraud. An administrator of a school board in a small city
had full authority for all items payable from the boards annual budget. As an administrator, he traveled
frequently to education conventions and meetings of administrators in the state capitol and across the
country. An excellent CPA but a non-pleasant personality, he was not endeared to the board, and the board
was slow in approving his travel budgets. Frustrated and embittered, the administrator used his own signing
authority to approve personal expenditures and write checks to himself. He started padding the expense
accounts. For instance, he would charge mileage when using companys leased car. He used the boards
credit card to fill gas in his own private car. He submitted and approved several bills regarding meals and
entertainment on weekends and repairs to his car. His secretary blew the whistle on him, and forensic fraud
examiners found that invoices for many transactions did not exist. He was dismissed from the job, but no
specific charges were laid against him (see Silverstone and Sheetz 2007: 30).

a) How do you classify this fraud?
b) Which of the five traditional accounting cycles is its source?
c) Hence, how could you detect it much earlier before the damage it created?
d) How do you identify exceptional and questionable transactions?
e) Which fundamental rule of accounting does this fraud violate, and why?
f) Hence, how would you prevent such frauds in the future?


2.6 Consider the following case of payroll fraud. A suburban construction company employed several hundred
laborers at any given time. For an efficient lean operation management, the home-office included a one-
person accounting department, with a long-serving bookkeeper/controller who coordinated the weekly
payroll, printed the payroll checks, signed the checks with the owners stamp, and hand-delivered the checks
to the job sites, and reconciled the companys bank account. Owing to lack of any checks and balances, the
payroll clerk continued paying checks to several laborers long after they were gone, i.e., to ghost employees.
He would endorse the checks and deposit them in his own account. At the same time, he paid the
withholding taxes, union dues, and other deductions at source. An alert bank teller eventually noticed the
fraud, but only after several years and when the clerk had taken over $600,000 (see Silverstone and Sheetz
2007: 31).

a) How do you classify this fraud?
31

b) Which of the five traditional accounting cycles is its source?
c) Hence, how could you detect it much earlier before the damage it created?
d) How do you identify exceptional and questionable transactions?
e) Which fundamental rule of accounting does this fraud violate, and why?
f) Hence, how would you prevent such frauds in the future?


2.7 Consider the following case of inventory fraud. Suspecting some flow play, the board of directors of a gold
refiner company hired some forensic investigators to check the inventory of gold in the company. The
investigators discovered several brass bars of exactly the same weight as a gold bar on the inventory. An
interview with a smelter worker revealed that brass scrap had been melted down, cast into bars and added to
the inventory. There was no record of brass bars, however, on the inventory list. Instead, forty-five bars had
been valued at $8 million on the balance sheet. Another $5 million was classified as gold bars in transit.
The fraud had been going on for five years when it was discovered. On further investigation, it was found
that the CEO had perpetrated the crime together with his VP of Finance, in an attempt to hide operating
losses that would have jeopardized their positions and depressed the stock value of the company. The CEO
and the VP of Finance were both charged with fraud, convicted, and served a prison sentence (see
Silverstone and Sheetz 2007: 32-33).

a) How do you classify this fraud?
b) Which of the five traditional accounting cycles is its source?
c) Hence, how could you detect it much earlier before the damage it created?
d) How do you identify exceptional and questionable inventory evaluations?
e) Which fundamental rule of accounting does this fraud violate, and why?
f) Hence, how would you prevent such frauds in the future?


2.8 Consider the following case of capital expenditures fraud. By law, mortgage brokers are limited in their
business activities to specific mortgages, and investors to invest in them. For example, an investor would
give the broker $50,000 to be invested in a particular mortgage at the prevailing rate per annum to be paid
monthly. Often, certain brokers would violate their investment limits and issue other money instruments. A
government agency responsible for overseeing mortgage brokers was concerned that many brokers were
borrowing and lending money as if they were licensed as banks or trust companies. The agency hired some
forensic investigators to examine the books of a randomly selected group of mortgage brokers. The
investigators found that one broker had exceeded his authority by issuing so-called corporate notes secured
by the companys guarantee rather than by a mortgage. This broker used the money instead to purchase
property for himself, who then reduced his risk by selling partial interests to his family members or other
relatives. By the time the forensic investigators discovered this fraud, the broker had taken in more than $5
million by issuing corporate notes and invested in high-risk ventures that failed to pay rates of return
required to service the corporate notes. The broker, however, met his monthly obligations to his investors
through borrowing on a bank line of credit and was quickly overextended. The government agency revoked
the brokers license, and closed his operations with the help of several banks who took over the mortgages to
protect the investors (see Silverstone and Sheetz 2007: 33-34).

a) How do you classify this fraud?
b) Which of the five traditional accounting cycles is its source?
c) Hence, how could you detect it much earlier before the damage it created?
d) How do you identify such exceptional and questionable mortgage transactions?
e) Which fundamental rule of accounting does this fraud violate, and why?
f) Hence, how would you prevent such frauds in the future?


32

Appendix 2.1: Recent Insider Trading Irregularities
[Source: Fortune, September 2, 2002, pp. 64-74].

Company Total
Haul
($Billions)
Biggest Takers Individual
Haul
($Millions)
Remarks
Qwest
Communications
2,260 Phil Anschutz, Director,
Jo Pe Nacchio, former CEO
1,570
230
As part of BellSouths deal to buy some of
Qwest, Anschutz sold his Qwest stock of
33.228 million shares to BellSouth at
$47.25 for $1.57 billion when its market
price was $39.44.
Broadcom 2,080 Henry Samueli, CIO,
Henry Cicholas, CEO,
(both co-chairmen)
810
799
Nicolas boasts that he pays Broadcom
employees so little that they have to sell
their stock to pay their bills.
AOL Time Warner 1,790 Steve Case, Chairman,
Bob Pitman, former COO,
Jim Barksdale, Director
475
225
213
Ex CEO Gerald Levin, who masterminded
the AOL-Time Warner merger, and left it
May 2001, did not cash in single share
over this period.
Gateway 1,270 Ted Waitt, CEO 1,100 Founder Waitt spent $9.36 million in June
to buy back 2 million Gateway stock
trading around $4 in June 2002. The stock
peaked at $82.5 in November 1999.
Ariba 1,240 Ron DeSantis, former EVP,
Keith Krach, Chairman,
Paul Heagarty, Director,
Edward Kinsley, former CFO
222
191
127
114
With an unusually short post-IPO lockup
period, these executives began selling their
stock barely 4 months after Ariba went
public in June 1999.

JDS Uniphase 1,150 Kevin Kalkhoven, former CEO,
Danny Pettit, former CFO,
Josef Strauss, CEO & Co-Chair

246
206
175
I have made zero sales in 2002. says
Strauss, CEO since May 2000. Today all
my options are underwater. I need a
submarine to read them.
I2 Technologies 1,030 Sanjiv Siddhu, Chairman, CEO,
Ramesh Wadhwani, Vice-
Chairman,
Sandeep Tungare, former
Director
447

160

144
Founder Siddhu, who still owns 27% of
the company, sold most of these shares
after the stock peaked at $110 in March
2000. I2 Tech. now trades at less than
$1.0.
Sun Microsystems 1,030 Bill Joy, CTO,
Ed Zander, former President
103
100
Joy sold one million Sun shares in October
2000, 15% of his stake. He sold all his
other tech holdings around the same time.

Enron 994 Lou Pai, former Division Head,
Ken Lay, former CEO,
Rebecca Mark, former Div. Hd.
Ken Rice, former Division
Head
270
102
80
74
Jeff Skilling and Andy Fastow cashed $68
million each worth of Enron stock,
respectively.

Global Crossing 951 Gary Winnick, Chairman 508 Winnick also sold another $227 before
January 1, 1999.
Charles Schwab

951 Charles Schwab, Chairman,
CEO,
David Pottruck, President, CEO
353

188
Schwabs sales have never amounted to
more than a few percentage points of his
total holdings in any one year, says a
spokesperson.

Yahoo 901 Tim Koogle, former CEO,
Jeff Mallett, former COO,
Gary Valenzuela, former CFO
160
148
116
Co-founders Jerry Yang sold only $30
million during this period, while David
Filo sold none.

Cisco Systems 851 John Chambers, President,
CEO,
Judith Estrin, former CIO
239
72
Estrin also cashed $61 million of stock in
February 2000, a month before it peaked
at $80.06; she left Cisco that April.

33

Company Total
Haul
($Billions)
Biggest Takers Individual
Haul
($Millions)
Remarks
Peregrine Systems 818 John Moores, Chairman 646 Peregrine is restating revenues from April
1999 to December 2001, during which
Moores dumped $530 million of stock.
Sycamore
Networks
726 Gururaj Deshpande, Chairman,
Dan Smith, President, CEO,
Director,
Chi Kong Shue, EVP

137
129

122
BY the time main customer, Williams
Communications, went bankrupt last
April, these insiders had done most of
their selling.

Nextel
Communications
615 Craig McCaw, Director,
Daniel Akerson, former CEO
343
117
McCaw also cashed $115 million from
XO Communications, the Telecom he
founded that went belly-up June 2001.

Foundry Networks 582 Bobby Johnson, Chairman,
CEO
308 We are going to create shareholder wealth
the old fashioned way, said Bobby in
January 2000. Market cap has since fallen
95%!
Juniper Networks 557 Scott Kriens, Chairman, CEO,
Pradeep Sindhu, Vice-
chairman,
Peter Wexler, VP
148
108
87
Last May, with stock down 96% from its
high of $243, executives exchanged their
booming options for ones priced at
$10.31!

Infospace

541 Naveen Jain, Chairman, CEO 406 Jain claims he plowed much of this gain
into Net stocks; I lost $80-100 million
just on Inktomi and Verisign.

Commerce One 531 Thomas Gonzales, former
CTO,
Jay Tenenbaum, former
Director

115
75
Tenenbaum who got a chunk of
Commerce One stock when he sold Vio
Systems to the company in January 1999,
left last April. Gonzales died last fall.
AT&T 475 John Malone 348 AT&T bought Malones company, TCJ, in
a stock deal in March 1999. Malone left
his post as an AT&T director in 2001.
Network Appliance 470 David Hitz, EVP,
Thomas Mendoza, President,
Daniel Warmenhoven, CEO,
Director
111
58
48
Hitz says his selling is systematic: Its an
extremely consistent pattern of about 2.5%
of my remaining shares per quarter.
Inktomi 431 Paul Gauthier, former CTO,
David Peterschmidt, Chairman,
CEO
107
84
Peterschmidt hasnt sold any Inktomi
shares since February 2001. Investors
would flip if they found they did, says a
spokesperson.
Priceline 417 Jay Walker, former Vice-
chairman,
Timothy Brier, former EVP
276
45
Walker bought $125 million of Priceline
shares from Delta Airlines in November
1999, before the stock began falling.
Vignette 413 Ross Garber, former CEO,
Neil Webber, former CTO
98
92
Founders Garber and Webber did most of
their selling after they left Vignettes
Board in July 1999 and October 1999,
respectively.
Totals:
No. of Companies:

Sum
Mean
Std. Dev.


25

23, 074
923
502
Totals:
No. of Executives involved:

Sum:
Mean per executive:
Std. Dev.


55

14,147
257
262


34

Appendix 2.2: Recent Accounting Irregularities
[Source: Fortune, September 2, 2002, pp. 64-74].

Company Total
Haul
($Billions)
Biggest Takers Individual
Haul
($Millions)

Remarks
Qwest
Communications
2,260 Phil Anschutz, Director,
Jo Pe Nacchio, former CEO
1,570
230
As part of BellSouths deal to buy
some of Qwest, Anschutz sold his
Qwest stock of 33.228 million shares
to BellSouth at $47.25 for $1.57
billion when its market price was
$39.44.
Gateway 1,270 Ted Waitt, CEO 1,100 Founder Waitt spent $9.36 million in
June to buy back 2 million Gateway
stock trading around $4 in June 2002.
The stock peaked at $82.5 in
November 1999.
Ariba 1,240 Ron DeSantis, former EVP,
Keith Krach, Chairman,
Paul Heagarty, Director,
Edward Kinsley, former CFO
222
191
127
114
With an unusually short post-IPO
lockup period, these executives began
selling their stock barely 4 months
after Ariba went public in June 1999.
I2 Technologies 1,030 Sanjiv Siddhu, Chairman,
CEO,
Ramesh Wadhwani, Vice-
Chairman,
Sandeep Tungare, former
Director
447

160

144
Founder Siddhu, who still owns 27%
of the company, sold most of these
shares after the stock peaked at $110
in March 2000. I2 Tech. now trades at
less than $1.0.

Sun
Microsystems
1,030 Bill Joy, CTO,
Ed Zander, former President
103
100
Joy sold one million Sun shares in
October 2000, 15% of his stake. He
sold all his other tech holdings around
the same time.

Enron 994 Lou Pai, former Division
Head,
Ken Lay, former CEO,
Rebecca Mark, former Div.
Hd.
Ken Rice, former Division
Head
270

102

80

74
Jeff Skilling and Andy Fastow cashed
$68 million each worth of Enron
stock, respectively.

Global Crossing 951 Gary Winnick, Chairman 508 Winnick also sold another $227 before
January 1, 1999.
Cisco Systems 851 John Chambers, President,
CEO,
Judith Estrin, former CIO
239

72
Estrin also cashed $61 million of
stock in February 2000, a month
before it peaked at $80.06; she left
Cisco that April.

Sycamore
Networks
726 Gururaj Deshpande, Chairman,
Dan Smith, President, CEO,
Director,
Chi Kong Shue, EVP


137

129
122
By the time main customer, Williams
Communications, went bankrupt last
April, these insiders had done most of
their selling.

35

Company Total
Haul
($Billions)
Biggest Takers Individual
Haul
($Millions)

Remarks
Nextel
Communications
615 Craig McCaw, Director,
Daniel Akerson, former CEO
343
117
McCaw also cashed $115 million
from XO Communications, the
Telecom he founded that went belly-
up June 2001.

Juniper Networks 557 Scott Kriens, Chairman, CEO,
Pradeep Sindhu, Vice-
chairman,
Peter Wexler, VP
148

108
87
Last May, with stock down 96% from
its high of $243, executives
exchanged their booming options for
ones priced at $10.31!

Priceline 417 Jay Walker, former Vice-
chairman,
Timothy Brier, former EVP
276

45
Walker bought $125 million of
Priceline shares from Delta Airlines in
November 1999, before the stock
began falling.
Vignette 413 Ross Garber, former CEO,
Neil Webber, former CTO
98
92
Founders Garber and Webber did
most of their selling after they left
Vignettes Board in July 1999 and
October 1999, respectively.



36

Appendix 2.3: The Sarbanes-Oxley Act to Control Corporate Frauds

Hurriedly passed by the U. S. Congress in 2002 in the wake of Enron and other giant corporate scandals of
2000-2002, the Sarbanes-Oxley (SOX) Act
4
seeks to reduce the likelihood of fraud by making public company
CEOs and CFOs directly accountable for the internal disclosures and financial statement of their organizations.
Senior managers will also be subject to greater oversight from boards that are more independent, internal audit
committees and external audits. A major objective of SOX Act was to control and combat corporate fraud by: a)
developing better reliable information about companys operations to avoid making bad decisions, and thus, b)
improving the reliability of financial reporting, and c) restoring investor confidence. The ACT went into effect in
2002, and public CEOs and CFOs had to implement it by fiscal year 2004. The SOX, also known as Public
Company Accounting Reform and Investor Protection Act of 2002, was intended to provide a proper accounting
framework and rules for public companies by improving the accuracy and reliability of corporate financial
statements and disclosures made pursuant to the securities laws. The goal of SOX is for internal controls to be so
effective that degradation of the system through fraud is virtually impossible (Silverstone and Davis 2005: 23).

SOX seek to prevent and punish corporate corruption. SOX created a Public Company Accounting Oversight
Board (PCAOB) whose functions are to register, oversee, investigate and discipline all Public Accounting Firms
(PAF) that audit public companies. SOX require the creation of an audit committee comprising of independent
directors of the issuer company. The issuer companys PAF auditor will be under the control of the audit
committee. The CEO and the CFO of the issuer company will sign all its official financial statements and
disclosures.

Compliances with SOX are enshrined in three brief Sections: 302, 404 and 906.

Section 302 (Title I I I ): Corporate Responsibility for Financial Reports: Section 302 requires that
CEOs and CFOs personally certify:

1. The accuracy of financial statements and disclosures in the periodic reports issued by the
corporation,
2. That these statements fairly represent in all material aspects the results of operations and
financial condition of the company,
3. That the financial controls and procedures of sox have been implemented and evaluated, and
4. Any changes to the system of internal control since the previous quarter will have been
noted.

Section 404 (Title I V Enhanced Financial Disclosures): Management Assessment of I nternal
Controls: Reports filed with the SEC must include all material off-balance sheet transactions and
relationships that may have material effect on the financial status of an issuer. Additionally, Section
404 requires:

a) An annual statement of the issuer to contain an internal control report which shall state that
the management is responsible for establishing and maintaining an adequate internal control
structure and procedures for financial reporting;
b) CEOs and CFOs to periodically assess and vouch for their effectiveness, and
c) That no loans be extended to senior executives.

4
On June 18, 2002, the Senate Banking Committee passed a bill (#2673), a legislation crafted by Senator Paul Sarbanes (D-
MD), mostly in reaction to the confusion and distrust in the US financial markets caused by a series of gigantic corporate
scandals involving Enron, Global Crossing, Arthur Anderson etc., in late 2001. The bill was expected to die in the House owing
to its draconian implications, but got triggered on June 25, 2002 when WorldComs announced overstating earnings in their
previous five quarters by over $3.8 billion due to improper accounting procedures. On July 15, 2002, the Senate passed the
Sarbanes bill by a 97-0 vote. In the House, Michael Oxley (R-OH) made a few significant changes to the bill and sent it to the
House floor where it passed almost unanimously. Later, the new version of the bill (now called Sarbanes-Oxley) was passed by
the Senate 99-0 and in the House with a 423-3 vote. On July 30, 2002, President Bush signed the Sarbanes-Oxley Act of 2002 as
law, describing it as the most far-reaching reforms of American business since the time of Franklin Delano Roosevelt, (Whalen
2003).
37


Section 906 (Title I X White-Collar Crime and Penalty Enhancements): Corporate Responsibility for
Financial reports: Section 906 requires CEOs and CFOs to sign and certify the report containing
financial statements; they must confirm that the document complies with SEC reporting
requirements and fairly represents the companys financial condition and results. Willful failure to
comply with this requirement can result in fines up to $5 million and imprisonment from five to 20
years.

Moreover, Title VIII on Corporate Criminal Fraud and Accountability adds other injunctions:

a) It is a felony for knowingly destroying, concealing or falsifying a document to impede and
investigation;
b) All auditors should maintain audit work papers for five years;
c) The statute of limitations and securities fraud will be increased to five years;
d) Imprisonment for defrauding shareholders will increase to 25 years, and
e) All whistleblowers will be protected from management retaliation.

By Section 404, companies are also obliged to include an internal-control report as part of the annual report that
should minimally include the following:

a) A statement acknowledging responsibility for establishing and maintaining adequate internal
control over financial reporting.
b) A statement identifying and specifying the internal-control framework to evaluate the
effectiveness of internal control over financial reporting.
c) An assessment of the companys internal control over financial reporting as of the end of the
most recent fiscal year.
d) Disclosure of any material weakness in the companys internal control over financial reporting
(the latter is deemed ineffective if any material weakness exists).
e) A statement that the independent external auditor has issued a report on the companys
assessment of internal control over financial reporting, and
f) A statement that the companys external auditor has examined and reported his/her assessment
of requirements under (c) and (d) above.

The first step toward SOX compliance is the establishment of an audit committee composed of financially
experienced members of the board of directors, who are independent (in the sense, they perform no other corporate
duty, receive no compensation other than their directors fees). At least one member of the audit committee must be
a financial expert (the SEC will judge the level of expertise based on previous responsibilities, education, and
experience with internal controls and the preparation of financial statements). The audit committee will not have
members with close family ties among directors such that concentration of power in too few hands is avoided. The
audit committee is responsible for hiring and compensating both internal and external auditors and any other
consultant, and is thus, a logical body to oversee the entire SOX compliance process. Without meddling with
everyday company affairs, the audit committee must be able periodically to access all major financial and
accounting transactions to identify, monitor and question any unusual transactions and novel practices within the
company. [See Turnaround Executive Exercise 2.5].

By Section 406, titled Code of Ethics for Senior Financial Officers, corporations must have a Code of Ethics
applicable to its principal financial officer and comptrollers or principal accounting officer, or persons performing
similar functions. That is, the senior management together with the audit committee must devise a Code of Ethics
for the company that focuses on:

1. Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of
professional and personal interest;
2. Full, fair, accurate, timely and understandable disclosure of relevant matters in the companys
regular filings, and
3. Compliance with applicable government rules and regulations.

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The Code will also prevent improper insider trading. The senior management must explain the code of ethics to
all levels of employees, each of whom should receive a copy. The Code should provide for the segregation of
conflicting duties, periodic reconciling of accounts, and have these reconciliations reviewed by someone
independent of the reconciliation process. [See Turnaround Executive Exercise 2.6].

Costs and Benefits of Sarbanes-Oxley Act

SOXs benefits to the investor public are obvious (Yallapragada 2007: 69):

a) It has established an accounting industry watchdog;
b) It makes CEOs and CFOs responsible for all official financial statements, their procedures of
internal controls and their contents;
c) It mandates the companies and their auditors to assess the effectiveness of internal controls;
d) It strengthens the role of the board of directors, and
e) It forbids cozy relationships between accountants and executives.

The major problems with the SOX, however, relate to interpreting of and complying with Section 404. Audit
fees have skyrocketed average cost for a midsize company of implementing SOX, especially Section 404, have
been over $1 million. The costs may not justify the benefits of compliance. In fact, implementing SOX has been
minting money to accounting firms and trial lawyers (Powell 2005). In this regard, SOX particularly hurts smaller
and midsize public companies. SOX also places too much burden on CEOs and CFOs who must divert time from
business decisions to internal controls and their effectiveness. Hence, many companies have stopped dealing with
NYSE and, instead, chosen foreign stock exchanges, especially the London Stock Exchange (Factor 2006).
Whereas from the 1990s, when the vast majority of IPOs were made in the US financial markets, since 2002, there
has been a steady migration of IPOs to foreign stock exchanges (Murray 2006).

SOX, moreover, has many ethical challenges. Under SOX, if the company is indicted, the CEO and the board
must prove they are directly overseeing and monitoring an ongoing comprehensive ethics program that assures SOX
compliance throughout the company. SOX also implies that ethical guidance and reinforcement should come from
the top management (Galla, Cavico and Mujitaba 2007). Before SOX, business ethics was important; after SOX, it
is mandatory. SOX, however, does not provide clear ethical criteria, leaving the responsibility for ethical and moral
education within the company to each organization. SOX assumes that ethical behavior can be enjoined by laws and
rules, even though conventional thinking on moral development (e.g., Kohlberg 1969, 1984; Rest and Narvaez
1994) believes that people develop ethical behavior in response to social norms and organizational ethical climate in
the environment they work and live, and not from rules. The corporate frauds that plagued the companies were not
because existing laws and rules were inadequate. Corporate frauds were executive ethical failures. Corporate
executives with their concern for demonstrating high financial performance to shareholders and Wall Street analysts
devised creative accounting practices with the collaboration of their accountants, and hence, set a tone for unethical
behavior (Verschoor 2004). Can SOX change this unethical behavior through mere rules and penalties?

In 2006, year two of implementing SOX, many companies are still struggling setting effective internal control
systems that CEOs, CFOs, and the independent and external auditors can assess and vouch for (Wagner and Ditmar
2006). In this regard, the Public Company Accounting Oversight Board (PCAOB) has come up with various rules,
standards, and elaborations that may help companies with SOX compliance. If a company, however, can
demonstrate a strong control environment, then it can reduce the overall scope of its internal-control evaluation,
reduce in the sense that the company need not carry out as many internal tests and the auditors may do less
corroborating, resulting in lower compliance costs.