In the past two decades, a parade of companies has imploded in the wake of unethical and fraudulent business practices, leaving investors shaken and scorched. Enron Corp. is perhaps most notorious. Executives embezzled funds from investors, and as Enron teetered on bankruptcy, it misrepresented its financials and may have even created a false energy crisis. Investors lost more than $70 billion.
The charismatic Bernie Madoff, who was a well regarded and trusted financial investor and philanthropist to boot, fooled investors and got the best of the Securities & Exchange Commission, which has reportedly since tightened up. Madoff operated legal and illegal operations. His illegal entity ran a Ponzi scheme, using revenue from new investors to pay existing clients. Shareholder losses from Madoff’s actions amounted to $20 billion.
WorldCom and Tyco International have become synonymous with white-collar crime, thanks to unscrupulous behavior by a select few business executives within those companies. Bad executive behavior can lead to sales declines and tanking stock prices, and sometimes, a company’s demise. Enron brought down itself and a former “big five” accounting firm, Arthur Andersen.
Companies not in any danger of collapsing, but recently shown to have ethical lapses that could signal bigger problems within the company include Chesapeake Energy Corp. (NYSE: CHK), Wal-Mart Stores Inc. (NYSE: WMT), and News Corp. (Nasdaq: NWS).
The SEC is investigating Aubrey McClendon, chief executive and cofounder of natural gas company Chesapeake Energy, for borrowing as much as $1.1 billion in undisclosed loans to boost his financial stake in Chesapeake’s oil and gas wells. The board now says it will end McClendon’s eligibility for the company’s Founder Well Participation Program. The company is also replacing McClendon as chairman.
Wal-Mart’s Mexican subsidiary allegedly bribed foreign officials to more quickly get building permits for new stores, which is illegal under the US Foreign Corrupt Practices Act. Wal-Mart isn't the only company being investigated for unethical behavior in foreign countries. The federal government is investigating 81 public companies. (Meanwhile, business trade groups who are no fan of the Foreign Corrupt Practices Act are calling for amendments and clarifications as to what constitutes improper behavior under the law.)
The scandal also brings up a question for US companies operating globally: Should companies have different ethical standards depending on the country they’re operating in, or should they always be guided by one standard? The fallout of the scandal has been immediate, affecting Wal-Mart’s ability to open new stores in the US, which could eventually hurt business and shareholders.
Nearly a year after London-based News International’s phone-hacking scandal, its parent, News Corp., is still mired in muck. News Corp.’s leader, Rupert Murdoch, was deemed unfit to run his company by a group of British lawmakers. The company has been accused of trying to cover up unethical behavior instead of tackling the problem head on, which can make matters worse.
“I would actually prefer a company that has had fraud, has had problems, and then you want to see how they clean it up,” said Joan Pastor, chief executive and managing partner of JPA International Inc., which consults on preventing white-collar crime and other business issues. If a company swiftly addresses ethical issues, it can mitigate the damage, even put the company in a favorable light.
Sometimes it seems unethical behavior is commonplace in business, especially considering the subprime housing collapse, when an entire industry appeared to conspire to make a profit, without any ethical considerations. In the wake of the subprime meltdown in 2008, MBA students took to signing "The M.B.A. Oath" -- pledges that they would be ethical once they began their careers in business.
What causes executives to become shareholder nightmares? Psychologists say most of us are capable of ethical lapses, and people in business are no different. Pastor, a licensed organizational and clinical psychologist, classifies white-collar criminals as one of two types: the normal person, with a moral conscience and a sense of empathy, who under certain circumstances might act unethically, and the person who has no moral conscience or empathy and is prone to be deceitful.
The people who lack a conscience are the people who can do the most damage. Often motivated by money, they’re attracted to business and will seek out companies that are easy to exploit, ones with weak internal controls, says Pastor. “They have a compulsion to gain for themselves,” she says.
Other characteristics of white-collar criminals include a lack of remorse, a tendency to blame their victims, and a sense of entitlement. They can be brilliant and charismatic. “These people can be very charming,” Pastor says. “Some of these people are so bright, they’re just bored.”
It’s not only the people at the top of the corporate ladder who can have ethical lapses. It can happen at any rung in business. But ethical lapses at the top can result in lax ethics throughout the company.
Investors can look to a company’s management team and corporate culture for warning signs. Does the company make ethics a priority? Do executives act swiftly when an ethical problem arises? Does the company have tight fiscal controls? Does the company have a lot of turnover? Does the company have a good corporate culture -- do people like working for it?
Red flags can also be spotted in company financials, especially the footnotes, where crucial information often is buried. Footnoted.com is perhaps one of the best sources to check out before investing in a company. In 2009, Footnoted signaled Chesapeake Energy’s current problem with its post on the "worst footnote of the year." (Chesapeake spent $12.1 million to purchase McClendon’s antique map collection.
Founded by Michelle Leder, and now part of Morningstar Inc. (Nasdaq: MORN), Footnoted explores the footnotes of companies’ earnings releases, 10-Ks (annual reports), 10-Qs (quarterly reports), and other financial filings, for signs that a company’s financial outlook might not be as rosy as it appears. Company financial filings can be found in several places, including the most comprehensive site, the SEC’s Edgar.