Models of Corporate Fraud - Model 5: The 7 Signs of Ethical Collapse by Marianne Jennings

Here are the seven signs of ethical collapse:

1. Pressure to meet numbers 2. Fear and Silence 3. Sycophantic executives and an iconic CEO 4. A weak board 5. Conflict of interest 6. Over-confidence 7. Social Responsibility.

Recognising and remedying the seven signs of ethical collapse is the next step in corporate governance beyond the ethics codes, the ethics training, and the checklist processes.
These gualitative factors may well be more important than the financial analysis of a company; the numbers are only as good as the culture of the company that put those numbers together.

Sign 1: Pressure to Meet Numbers

All companies and organizations have goals and numbers that they have established as targets.
But a company headed towards ethical collapse has graduated the numbers pressure and incentive systems into a zone of perversity.
"Meet the numbers" gradually morphs into a meaningless exercise to get the desired numbers, even if destruction of the company is the result
CEO Bernie Ebbers described his high-pressure strategy for WorldCom in 1997: "Our goal is not to capture market share or be global. Our goal is to be the number one stock on Wall Street"
The Marsh McLennan (MMC) price-fixing scandal yielded the same type of numbers pressure. As MMC's profitability increased, it became more and more difficult to meet past numbers, let alone increase them. Roger Egan, the president and COO of MMC, explained the culture and the fear in this statement to his direct reports in a meeting: "Each time I see Jeff [Greenberg, CEO of MMC at that time] I feel like I have a bull's eye on my forehead"
The too-trite response from many is that the market places unbearable pressure on them and that their behaviors are simply responses to that pressure. But market pressure has always been there; succumbing to deceit as a response to pressure has not.
Another antidote for numbers pressure is emphasizing that finding a loophole, whether in the law or accounting, is not a means for achieving numbers. The ultimate question in all financial releases and reports is whether the information gives a fair and accurate picture of the company's current status and expectations.

Sign 2: Fear and silence

Enron employees were circulating via email a "top ten" list called Top Ten Reasons Enron Restructures so Frequently. Number seven on the list was: "The basic business model is to keep the outside investment analysts so confused that they will not be able to figure out that we don't know what we're doing"
As Steve Priest, the head of the Ethical Leadership Group, has heard in his interviews with employees in troubled companies, their reticence in a culture of ethical collapse is metaphorically explained as "the first whale to the surface gets harpooned".
paint a picture of an executive who ruled by top-down fear, threatened critics with reprisals and paid his loyal subordinates well"
Diana Henze, vice-president for finance at HealthSouth, refused to certify the company's financial statements in 1999 because the numbers had been changed so many times and she suspected fraud.
Henze's punishment was that she was passed over for a promotion that had been hers. When a less qualified person got the job, she confronted the CFO, who responded: "You have made it clear that you won't do what we ask" (New York Times, February 23, 2005).
There are three antidotes for the culture of fear and silence. The first one is straightforward: tell employees to speak up and give them the avenues for doing so. In other words, get your compliance hotline, reporting lines and anonymous reporting lines in place
The second antidote is to avoid the signals of silence: don't fire employees for speaking up, don't transfer, reassign, trample and/or malign employees for speaking up.
The third and final antidote to fear and silence is to include ethical behavior in annual performance reviews. One company has a ten per cent weight on "forthrightness" in employee annual reviews.

Sign 3: Sycophantic executives and an iconic CEO

Part one of this two-part factor is the presence of an iconic CEO who is adored by the community, the media and just about anyone at a distance.
The second part of this factor is that the iconic CEO, who already enjoys great deference, ensures agreement and lack of challenge by surrounding himself or herself with a sycophantic management team.
Even when they are not related to the CEO, senior executives don't always have enough experience or wisdom to challenge the boss. They become enamored with the prestige that comes with astronomical financial success at a young age. They fail to realize that they play the role of "useful idiots"
Former Tyco CEO Dennis Kozlowski was asked in 2001 how he chose his executive team and his response was a classic one: "I hire them just like me: smart, young, wants to be rich" (Business Week, May 28, 2001).
The antidotes should be obvious: beware of the iconic CEO. The "plodding" CEO should enjoy a resurgence thanks to these collapsed companies. Hire and keep a CEO who spends his or her time at the company with the employees, not on stage, screen and television.
Another antidote for this management structure is questioning the icon. Media deference to the rock-star CEO should not translate into board deference. Board members should also begin to worry when the CEO dabbles in questionable personal conduct.
A final antidote is making sure that wisdom, knowledge and experience surround the CEO. You need direct reports who are peers of the CEO; this will increase the likelihood of a challenge. Experience, knowledge and a bit of selfishness about reputation are the traits of direct reports over 50. A few more mature people are needed among the innovative young executives.

Sign 4: A weak board

The boards of companies at risk for ethical collapse are weak and ineffectual. Tolstoy's adage on happy families can be modified and applied: just as all happy families are alike and all unhappy families are different in their misery, all effective boards are alike and all weak boards are weak for different reasons
Some of the boards in ethically collapsed companies were weak because members were inexperienced.
Others were weak because of the presence of friends of management who would do whatever management wanted.
Still others were weak because of conflicts of interest.
Some boards were weak because they had qualms about reining in that autocratic CEO.
In other cases, board members failed to attend meetings, or the board-meeting structure itself was flawed. Many of the boards had a combination of these factors.
The boards of these collapsed companies are not necessarily boards of the incompetent, but they are boards with members who do not devote the thinking, time and detached input necessary for strategic oversight.
The antidote, always more easily said than done, is to get a strong board. Digging deeper into board conflicts of interest is helpful. It is important to look not just for intertwined compensation committee members and contracts with the company, but also for philanthropic arrangements, donations and other relationships that do not trigger statutory reporting provisions or even the traditional notions of conflicts under corporate governance standards.

Sign 5: Conflicts of interest

Organizations at risk of ethical collapse have a distinct atmosphere of nepotism and back-scratching. Independent judgment in the award of contracts, recruitment and even discipline becomes clouded with self-interest.
The dotcom industry was destined to self-destruct. When the dot-com companies went public during the internet bubble, stock for their IPOs was doled out to suppliers, customers, family, lawyers who drafted the prospect for the stock offerings, and anyone else the founders wanted to reward.
At Enron, CEO Ken Lay's son Mark, with his father's help, created two privately held technology firms. A few months after the companies were created, both signed up Enron as a customer. Enron even invested in one of them.
In addition, Enron hired Mark Lay as a consultant at a salary of 1m for a three-year contract, along with 20,000 options for Enron stock (New York Times, February 2, 2002). Enron also used a travel agency that was co-owned by Lay's sister, Sharon Lay. Her agency booked more than 10m in travel for Enron and its employees
The antidote is effective management. There are two ways to manage a conflict of interest once it happens: disclose it, or don't. In the case of board members, avoiding conflicts of interest in the first place is the best route.
In the case of executives, the same advice holds. Companies should create and enforce strong policies around hiring employees and awarding contracts.

Sign 6: Over-confidence

Companies heading towards ethical collapse often fancy themselves as being above the fray, not subject to either the laws of economics or gravity.
A certain arrogance comes from their unique and singular achievements. They no longer subscribe to the mundane Newtonian theory of what goes up must eventually come down. They find new ways of keeping things up, including fraud when circumstances warrant.
The innovators behind these companies were brilliant business people with good ideas, who were gradually consumed by hubris, until they found they were doing whatever it took to maintain their unique and revered status in the marketplace. They reached a point where they began to believe the hype about themselves.
The antidotes are again rather simple. Economic cycles apply to everyone. If something sounds too good to be true, then it is too good to be true. Innovators need the checks and balances of wisdom and business experience to get them through the inflated-ego stage that comes from setting the world afire with the power of invention.

Sign 7: Social responsibility is the only measure of goodness

This factor is a difficult one for us to grapple with in this era of moral relativism. On both an individual and a company basis, the fallen ones in these ethical collapses all perceived themselves and, indeed, were perceived as good citizens.
These companies and their officers used a balancing scale. So long as they were good to the environment, strong on diversity, involved in the community and generous with charitable donations, their schemes and frauds at work were not a problem. There was an odd sort of rationalisation and justification that consumed these business leaders.
It was their belief that they were "doing well by doing good". Philanthropic and social goodness became the salve for consciences grappling with cooked books, fraud and insider trading; all the usual activities of ethical collapse.
The antidote for this factor is quite simple: you should not automatically equate socially responsible behavior with good governance and corporate ethics.
We should not assume that just because companies and executives have answered what we perceive to be the higher calling of generosity, they have conquered the basics of avoiding fraud. Dedication to environmentalism, the community, diversity and other socially responsible goals do not necessarily translate into solid accounting practices.
Be very cynical about corporate generosity and social responsibility.