Imagine two neighboring farmers negotiating a trade. One farmer’s crop is being harvested now while the others will be harvested next season. Each farmer can agree to the amounts of the trade (the price if you will), but there is something extra needed in order for this trade to take place. What is needed is trust. The first farmer, whose crops are ready now, must trust that the second farmer will make due on their end of the bargain when next season rolls around. As with most economic transactions we make, trust that others will live up to their end of a deal, trade, or contract is essential. Without trust our transactions are limited only to what can be exchanged on hand in a secure environment.
Where does trust come from? There are at least two sources of trust which come to mind. First, trust derives from experience concerning the virtuous character of others. If you possess and express the virtues of honesty, integrity, and the like then your reputation warrants trust. Second, trust can derive from systems. If I know nothing about you except that you are part of a system which would swiftly, surely, and severely punish you for violations then I can trust that you will comply with the system out of self-interest if not good character. It is important to point out here the value of both sources of trust. We can’t count on everyone to be virtuous so we need a reliable system to encourage trust, but no system (even one based on self-interest) will work in every case so we also want to promote virtuous character in people.
In the case of the two farmers we can see how trust is essential and how both sources of trust are in play. Not only can you trust the second farmer based upon his good character, but you also know where he lives and if he doesn’t live up to his end your report will blacklist him from trading with any other neighboring farmers. Beyond a simple trading case we trust is critical in order for free markets to function. The free market system is built upon trust between all actors be they individuals, businesses, investors, brokers etc. In recent years the value of trust in one particular market actor has been most significant. That is the trust placed in accountants. Without trust in accounting the ability to trust the markets themselves can fail. How can I invest in something in which I can’t trust the numbers provided me? How can I do business with an entity that may collapse due to phony accounting numbers? While other players have been involved in the major corporate scandals, nearly all of them at the core involve accounting. From companies like Enron, to “the housing and banking crisis” we can find accounting practices at the core. While some had joked that “the numbers don’t lie but the accountants might” we now know that if we can’t trust the accountants then we can’t trust the numbers. Without trust in the numbers free markets can fail.
This is not to suggest that unethical accountants are the problem. In fact, most cases involve accountants as the ethical check on the CEO’s, investors, traders, or lenders. Many scandals involve market players finding a personal advantage if they can only get the accountants to “tweak the numbers” or some other euphemism. At Enron, for example, it was executives within the company who pressured the accountants to allow things which in turn lead to the collapse of the company. In other words, the accountants didn’t come up with some devious plan to cook the books, but they did not say “no” when pressured to do things. In fairness to those accountants Enron’s lawyers, traders, and executives didn’t say no either. However, accountants are the key group in our system who are supposed to be in a position to say “no” and uphold trust in the numbers. Given this, whether you are in accounting or not the importance of ethical accounting to anyone involved in a business enterprise (all of us) should be clear.
So what is needed to trust accountants? Employing people of good character is of course paramount. In addition, accounting systems need to be designed to promote two core features:
Transparency – Accountants must live, professionally speaking, in a fishbowl. What they are up to and why they are doing it needs to be visible not just within the company but also to the outside world. This is especially significant because most areas of business do not function with transparency in mind, but are designed to be opaque because we don’t want outsiders (especially competitors) knowing what we are doing. In order to have trust in the numbers transparency of the accounting is necessary.
Independence – Accountants must operate independently of the rest of the business organization. Without independence accountants are vulnerable to the pressures of whatever agent they become connected to which in turn can lead to skewed numbers. For example, the Arthur Andersen (AA) accountants working on the Enron account did not operate fully independently because Arthur Andersen also had a consulting contract with Enron. This allowed Enron executives to pressure AA consulting to in turn pressure AA accountants to alter their accounting practices to match what Enron executives wanted. In order to have trust in the numbers, accountants need to act independently of any other aspect of the business enterprise. In other words, independence requires that accountants operate free from (even the appearance of) any conflicts of interest beyond providing solid reliable numbers. Another support for independents is found in the difference in perception independent and non-independent entities. In any event be it independent auditors, independent judges, independent research or independent prosecutors, the perception of trust increases over those who are not seen as independent.
Another interesting feature of accounting ethics is the role of the independent auditor. In most every aspect of business our role and obligations are first to those who are paying for our efforts. An attorney’s obligation is to the client who hires her. An employees obligation is to the business employing her. Perhaps accountants alone acting as independent auditor’s break with this trend. The role of the independent auditor involves a primary duty to the user of the statement not the client paying for the audit. In several of the legal cases judges have affirmed that independent auditors have a responsibility to the public. This means there is a non-standard relationship with the client paying the bills. The independent auditor does not serve the client, but serves the public by auditing each client. In other words, the independent auditor’s role is a protector of the market at large by ensuring a fair and accurate audit of the companies who hire them. One consequence of this view is that accountants face an inherent, but perhaps necessary conflict between their responsibility and interest. They have a responsibility to the investing public and yet have an interest in pleasing the client hiring them for the audit. The alternative, to only have obligations to the firms that hire them for the audit has, perhaps, a greater risk that the audits be unduly influenced by the clients at the expense of the investing public. Serving the client can lead to the arrangement that we accountants will avoid telling the public how bad off your company is and we will guarantee that your financial (mis)-statements will not lead to charges of illegal behavior. Serving the public is the only way to preserve trust and preserving trust is the only way to preserve free markets.
Support for this can also be found within Kantian ethics concerning the universalizability of actions. You should recall that according to Kant if your action isn’t universalizable then you shouldn’t do it. Free market supports offer a similar point by arguing for a morality of the market in which all players have an obligation not to engage in behaviors which will damage the free market system. According to this “morality of the market” adaptation of Kantian ethics, we should not universalize behaviors which will damage the market. Inflating stock values leads to inefficiencies in the marketplace. Misleading financial statements causes a loss of trust in markets. In other words, “liars are free riders” in that they act for their own gain at the expense of the market system. The market pays the price for their misdeeds. In the fall of 2008 we saw just how much the financial system depends upon trust. When banks began to declare bankruptcy over bad debts (many tied to subprime mortgages) other banks worldwide lost trust in the financial solvency of each other and simply stopped lending money. Even solid businesses became unable to get loans causing some of them to close operations. It took the direct interventions of governments worldwide literally buying huge stakes in financial companies and backing companies up with public funds to begin restoring trust in the system. As I write this it is still unknown if these efforts succeed (you may know by now). What no one expected was just how quickly and easily trust can be lost and just how destructive the loss of trust could be to free markets worldwide. What I expect history may show of this current financial crises is that trust is much harder to regain than it is to loose.
Independent auditors are often said to be obligated to provide audits which are fair and use Generally Accepted Accounting Principles (GAAP). The legal cases make clear that fair presentation and GAAP are two separate duties and following the latter did not entail meeting the former. Thus, auditors cannot hide behind GAAP by allowing misrepresentation. This dual approach is significant because unethical behavior often starts by focusing only on the letter of the rules. You may recall the “I did nothing wrong because I broke no law” defense, which is not a sufficient defense at all because it ignores any misdeeds which are not technical violations of law. The same is true of GAAP where following the standard rules is important, but is not sufficient for ensuring wrongdoing isn’t occurring. Remember, much of the financial scandals occurred perfectly legally (which prompted changes in the laws). GAAP as with any system is not perfect and so it is important to remember the fairness requirement. Providing a fair presentation is an imprecise concept of course, but much of life relies upon imprecise judgments. An ethical financial professional should always remember the big general obligation lest they fall prey to doing wrong under the guise of loopholes in the rules.
The Structural Origins of Conflicts of Interest in the Accounting Profession – Colin Boyd
Boyd tells a fascinating tale of the evolution of the accounting profession from one of the most trusted and ethical professions to the damaged reputations seen in the first decade of this century. Below is a more focused version of his account. Of special note is how the ethical lapses are not placed on the poor character of accountants. Rather, Boyd places the blame squarely on the structure of the accounting business.
Accountants were small regional firms known for conservative ethical approaches to local businesses. By the 1960’s as businesses expanded from local, to regional, and then to be national in scopes the accounting firms followed suit. The consolidation of local accounting firms into national giants was made possible in part by the uniformity of accounting laws across state lines. This contrasts with law firms which were fairly restricted to particular states due to major variations in laws between the states. By the end of the 20th century there were only five big accounting firms (after the Enron collapse there were only four since Arthur Andersen did not survive the Enron scandal). In the late 1990’s the top six firms employed over 90% of accountants and earned more than 90% of accounting revenues. Thus, power became concentrated in a few firms rather than diffused throughout thousands of individual accountants. As these large firms competed with each other, it became common practice to branch out into more businesses than just auditing. As these other areas became more profitable and the firms more competitive auditing became a low profit service offered by the firms. The result was a lesser importance being placed upon the auditing part of the accounting business. Auditing was in a sense devalued within the firms from its status as the central service accounting firms provided.
To the business clients these structural changes also lead to shifts in how they approached audits. Rather than small businesses having relationships with individual accountants there were now national companies dealing with faceless accounting firms. Accounting firms shopped numerous accounting services, such as consulting, to the businesses and the businesses also began to view the audit as just another standard service offered by any auditing firm. This reduction of person-to-person relationships and the view that auditing was just another service, naturally led businesses to begin a new practice of shopping for auditors which furthered competition amongst accounting firms leading to reduced prices, profits and thereby the importance of auditing to the firms. The natural next move was from shopping for the lowest priced audit to shopping for a low priced audit with favorable opinions to the company. This is known as “opinion shopping.” By shopping opinions businesses could inquire how different firms interpreted and applied standards which allowed businesses to hire those firms who held opinions and practices yielding a more favorable audit depiction of the company.
With lesser importance on the audit side of the business, low profit margins on auditing, strong competition, audit shopping and now opinion shopping, the structures were in place to create a climate in which the financial interests of auditors was to now hold opinions, interpretations, and apply standards in ways that favored the businesses they audited in order to garner more business. The impact these structural changes had upon the reputation for conservative integrity cannot be ignored. Conflicts of interests arose not from “bad actors” but from structural changes. Such conflicts were institutionalized in the daily operations of firms and even the most ethical persons within the system could feel the newfound pressure.
The economic pressures on price continued to the point where auditing became a “loss leader” in many cases where firms sold audit services as a way to garner other business with a company. By bidding prices near, at, or below costs the firms needed to act to reduce the cost of providing an audit. This lead to the use of less senior employees to perform audits, having less oversight by senior firm managers, and partially automating the process with computers. In such an environment the quality and integrity of audits could not maintain their previous levels.
As firms employed cheaper, less experienced workers in order to save money there was another important trend occurring at the same time. Demand for accounting services in the business world increased at the same time leading to a trend where new accountants would begin working in firms auditing companies who were themselves hiring accountants at higher paying company jobs than they could expect at the firm. This resulted in cheap labor for accounting firms, a low cost audit for companies, a pool of accountants companies knew they could hire away from the firms, and a greater interconnectivity between employees at accounting firms and employees at the companies being audited. Such crossover would be another structural factor weakening the ethical integrity of audits. Three examples of how this impacted audit integrity are: First, the auditor may see a brighter future by pleasing clients who may offer them a better job. Second, the auditor may already know the company accountants from before they were hired away from the firm. Third, company accountants may very well know the auditor’s boss from their time at the firm (an intimidation for any new accountant sent in to perform an audit). The accounting firms were well aware of these relationships and made use of them to have their former employees steer business back to the firm which got them started in the business. We now know from the Enron collapse just how massive these employee transfers were between Arthur Andersen and Enron as well as the benefits these transfers had on Andersen gaining more Enron consulting business.
The practices of using auditing as a method to steer a consulting business to the firm or identify areas of a business which might be viable to pitch other accounting services to, was not without consequence for audits. While at first glance using audits to sell more profitable accounting services might be seen as a one way street, this street actually ran both ways. The way it ran back to auditing as was once more profitable accounting services were in place (often utilizing more seni0r accountants at the firm) the firm would then pressure auditors not to upset the client for fear of a loss of new business. As Arthur Andersen shredded most of it’s Enron records, we don’t have the direct evidence on this point. However, Enron does provide a comparable example from investment banking. Enron executives were unhappy with one banks financial analyst who correctly identified problems with Enron’s financial position. Enron executives told the bank in question that they need to get their analysts on board or Enron would find another bank to do business with. The banks’ response was clear and telling. The analyst in question was fired and replaced with an analyst who gave Enron a strong “buy” rating. This same dynamic existed in the accounting firms and it’s impact upon auditors is a key factor in the loss of audit integrity. This is a clear ethical conflict of interest between the auditing side and consulting side of accounting firms services. The firms were well aware of it, but it was a natural result of the structure of the accounting business. That structure which we see took decades to become what it was could not be easily changed by any firm alone and so it continued until the disastrous results were seen with the implosion of several major companies under accounting scandals.
Some other notable problems with the structure of the business were that the professional associations for accountants were dominated by the big five firms and therefore no action was taken to systemically remove the conflict of interest between consulting and auditing because it was so profitable for the big firms. A similar problem is found with regulators many of whom were themselves former employees of these firms and the firms heavily lobbied against any government or regulatory action on this conflict of interest. The firms always declared that there was no solid evidence of a conflict of interest causing any harm and that therefore they should be allowed to continue operating as they have been. This worked until the Enron collapse which became the “smoking gun” proving that a conflict of interest existed with very damaging effect.
As a result of the Enron collapse the Sarbanes-Oxley Act (SOX) was passed with one its goals being to systemically alter the audit business to avoid the conflict of interest problems and restore integrity to the process. Will SOX work? Colin Boyd doesn’t think so. While there are restrictions placed upon individual auditors to ensure that they do not have a conflict of interest Boyd finds the real source of the problem goes untouched. After all, is the source of the conflict caused by the auditor or the firm? Boyd thinks systemic change needs to address the firm as the source of the conflict not the individual. Specifically, Boyd favors a requirement splitting consulting services from auditing services which SOX does not do.
One important factor involved with finance is risk. We have already encountered what risk is and how it is always present. In the next sections we will see the connections between risk and responsibility.
Risk & Responsibility
One of the most relevant applications of risk in business involves responsibility for products and services when they result in harm. Certainly we are familiar with some of the more egregious uses of product liability lawsuits which are one legal instance of applying responsibility for the risks stemming from products. A few of the worst offenders include:
The woman who sued McDonalds for millions after she purchased hot coffee and drove off with it between her legs where it spilled and burned her. She won, and this is why McDonalds’ cups now say “Hot!” (even in multiple languages).
The man who decided to trim his hedges using a lawnmower. He held it up overhead and ended up trimming a few fingers. Now lawnmowers carry a warning label to prevent future liability suits.
The man who climbed atop a ladder and stood on the very top rung. He fell and sued such that ladders now carry warning labels.
Of course there are legitimate instances of product liability where the design, manufacture, or marketing of a product injures those who use it correctly. The car that exploded when hit in the rear at low speeds (the company saved money by putting an unprotected gas tank in the rear of the car), the child’s toy that was toxic when put in their mouth (what kid doesn’t put toys in their mouth?) and the tobacco company’s false advertising claims that tobacco did not cause health problems are all examples of justified liability in which companies are clearly responsible for the harm caused by risks related to their products.
The ability to manage risk and responsibility is important both in terms of ethics and prudence. One way businesses shield themselves from responsibility when risks become real problems is to disclose risk information up front. By providing proper instructions on use (and warnings against specific misuses), fault is shifted from the business to the consumer. This creates a powerful incentive for businesses to disclose potential risks as a way of shielding themselves from lawsuits. One common example of disclosure today are drug commercials where about fifty percent of the commercial presents a listing of possible side effects.
Disclosure of risks or warranty claims is not a complete liability shield. Simply having a consumer sign a document setting down conditions is not itself sufficient to exclude a business from responsibility. The case of Henningsen v. Bloomfield Motors, Inc. and Chrysler Corporation demonstrates this point. In the case, a car with 400 miles on it crashed due to mechanical defects in the steering. Chrysler claimed that it was not responsible because its responsibility ended when the car was sold to the dealer, Bloomfield Motors. The dealer who sold the car said it was not responsible because the sales contract included standard, small print wording that Chrysler required to appear on all sales. The wording basically gave both Chrysler and the dealer immunity for any liability claims for the product. During the sales process, no one pointed out this wording and it was admitted that one would have to concentrate even to read it. The courts did not accept either companies liability defense for several reasons:
The clear intent of this wording was to avoid responsibility for their product and in no way gave due consideration to the consumer.
The manufacturer could not hide behind the dealership by ending its obligation once the dealer takes possession of the car because manufacturers know the car is to be resold to consumers and the manufacturer even markets the car directly to consumers.
The contract itself was not the result of any bargain. In fact, consumers had no say in the matter as it was a take it or leave it transaction imposed upon consumers by the dealership. This is especially important because automobiles are an essential purchase and Chrysler (and other American companies who required similar wording) accounted for over 90% of the market. In other words, people need cars and can only get them from a couple companies each of which imposes wording which amounts to an abdication of any responsibility for product quality.
What this case demonstrates is that disclosures are an important shield against being held responsible so long as they maintain a balance between protecting the company from liability suits and protecting the interests of the consumer in obtaining a safe, reliable product. Companies must not use disclosures strictly to protect themselves at the cost of product safety and reliability.
Another ethical way businesses shield themselves against responsibility is increased product safety and quality control. By doing more testing and evaluating the sort of things (even the dumb ones) that people may do with a product, a business can better prevent harm by changes in design, manufacture, or disclosure. Certainly this method may increase upfront costs, but the consumer protection and the liability shield it creates are well worth the costs. Many businesses who did not adequately manage product safety, quality control, and disclosure of risks were bankrupted by the ensuing liability suits. In addition, when members of an industry fail to protect consumers, the result is often increased government regulation which generally raises the costs to all parties. This creates an incentive not only to police your own company, but to ensure that the competition does the same. This motive to police the competition follows not only from a desire to keep out government regulation and to protect consumers, but also to ensure that the competition isn’t cutting corners on safety in order to offer a lower priced product or service. Allowing a company to cut corners on safety is a form of “cheating” in which that company gains a competitive market advantage at the expense of safety. This is a case where both ethics and prudence are in alignment.
In addition to disclosures and quality control, responsibility also takes into account three other factors. First, what is the minimal standards for the industry? Second, did the company know or should they have known of the risks? Third, did the company exercise due care to make the product safe? If your product meets or exceeds the current minimal standards for the industry, you can demonstrate that due care for safety was exercised, and there was no covering up or ignoring a safety concern then you are less likely to be found responsible or your legal liability will be lessened. Let us examine how we might go about assigning responsibility.
Levels of Responsibility:
So what is the appropriate level of responsibility for consumers and manufacturers to bear? There are several answers to this question each ranging from putting the burden of responsibility entirely upon consumers to putting the burden primarily upon manufacturers. At least four theories deserve mention, beginning with the heaviest burden of responsibility on consumers and ending with the largest burden upon businesses.
Caveat Emptor – Or “buyer beware” places no responsibility upon businesses for the products or services they provide. The entire burden is on the buyer, who should know what he is buying. This is a classic standard employed in business. Though this standard was the historically accepted view of businesses around the world, it has given way in the last few centuries. This view is not taken seriously in contemporary society because of the negative incentives it provides businesses. If all the responsibility is placed upon the consumer, then manufacturers have little or no reason to provide quality safe products. Given some of the more egregious examples of manufacturers selling products they know are unsafe, we must employ another standard.
Social Contract Theory – Advances the notion of an unspoken agreement between consumers and businesses. When a consumer buys a product, they enter a contract in which they agree to pay a certain price for a product with certain features. The business in turn enters a contract to provide a product with those features. If a product is “defective” or “not what was advertised” then the social contract view holds that the business is responsible for not living up to its end of the contract. If the product was as described and functions as expected then the business has meet its responsibility leaving any other problem to the consumer. The contract view sets forth four duties for manufacturers.
Comply with the terms of sale (both expressed and implied).
Disclose the nature of the product.
Do not misrepresent the product.
Do not use undue influence (coercion) to make a sale.
So long as these conditions are met, a business has done its duty and is not liable for anything else. These conditions do require much. If a company fails to disclose the risks of a product, it can be found liable. To a large extent this requirement is the reason for warning labels to ensure that people are warned about the risks of the product. Due care however, must be taken in marketing a product. For instance, when Winthrop Labs claimed their drug was non-addictive, this claim was later used to find them liable when some users did in fact become addicted. This demonstrates not only the importance of warning, but also the importance of not overstating product claims. A company that claims its product is “totally safe” is only asking for a liability lawsuit for overstating a claim (even a pillow can be dangerous if used improperly).
Dieola Soft Drink
Suppose KevorkCo develops a new tasty soft drink called Dieola. The product tastes better than the competition, but is marketed with the following large warning (printed in multiple languages on every can): “Use of this product WILL cause cancer” and “KevorkCo is not responsible for any cancer caused by this product.” Years later, a class action suit is filed by Dieola drinkers seeking damages from KevorkCo for causing cancer. According to the social contract view who is responsible or liable? Do you agree?
Objections to the Contract Theory:
Several objections have been made against the contract theory of product liability. We will only look at three of the more serious objections.
Broken chain of agreement – The theory assumes that consumers buy directly from manufacturers, which in today’s economy is quite rare. Usually there are layers of middle men involved. A more likely instance is where the consumer purchases from a salesperson who works for a store, which buys from a wholesaler, who buys from a manufacturer or you invest with a broker who in turn invests in mutual funds run by others. Given the other links in this chain how can a business ensure that it meets its obligations to consumers? Or perhaps more to the point, how can a misrepresentation by a salesperson (or elsewhere in this chain) to the consumer be the responsibility of the business?
Computers: A Broken Chain?
All of you are using a computer and most of you have or will purchase a computer at some point. Did you purchase from a manufacturer? Those of you who purchased from a store certainly did not. Even those of you who purchased a computer from Dell, Gateway, or some other company whose logo appears on your computer, did not buy from a manufacturer. These companies may sell you computers, but they assemble those computers from a variety of components manufactured by other companies. To make matters worse, many companies (Nvidia video cards, for instance) design computer parts but then contract out the manufacturing of these parts to other companies (Visontek is one such company) who then sells these parts to computer companies like Dell for use in computer assembly. In other words, you may have a “Dell computer” with an “Nvidia” video card that was manufactured by “Visontek.” Given situations like this, it seems hard to say that a consumer has a “contract” with a manufacturer. At best there is an indirect relationship.
Disclaimers can be too broad – If a contract can be used to ensure products have certain qualities then it stands to reason that a contract can be used to exclude certain qualities. In other words, just as you buying a new lawnmower from me generates an obligation for me to ensure that lawnmower works, my stating to you that there is no warranty on the lawnmower if it breaks generates a shield for me once you walk out the door with it (and it breaks 10 minutes later). Allowing manufacturers to use disclaimers in this way can free them from virtually all liability (“This product may break at any time, may be dangerous, and we are not responsible for any problems or damages caused by its use”) The hypothetical case of KevorkCo is one example of how the contract theory allows disclaimers to serve as a liability shield in ways we would otherwise reject.
Assumption of equality – The contact theory also views the manufacturer and consumer as equals coming together and making an agreement. This is just not realistic as consumers cannot be as knowledgeable about a product as a manufacturer. Think about it, when you purchase a car, a computer, a stock portfolio, or a home can you truly evaluate the products as well as the sellers? Consumers often depend upon the seller for an accurate evaluation and lack the time or expertise to evaluate the quality of the information the seller provides. The assumption of equality is just not an adequate picture of the buyer-seller relationship.
Theory of Due Care – Instead of “buyer beware” this view is one of “seller take care.” Since sellers are not equal, the theory of due care places the burden of responsibility upon the seller or manufacturer to ensure that buyers are not harmed. This means that a company is required to live up to the express and implied claims about a product as well as take reasonable steps to ensure that consumers are not harmed by the product. Thus, even if a company disclaimer says “we are not responsible for any damages associated with the use of this product” the company is liable if it did not take reasonable precautions to prevent those damages from occurring. If there was a reasonable good faith effort to ensure safety and all the claims about the product were upheld then the company isn’t liable. Recall our hypothetical case of KevorkCo, where the contract theory would say that since the company warned consumers it isn’t liable for damages, the theory of due care would say that despite the disclaimer the company is liable because it did not exercise reasonable due care (it was negligent) when it decided to sell a cancer causing soft drink.
Due care does not hold manufacturers responsible for things “inherent to the nature of the product.” For instance, someone who is injured because they were in a head on collision at 60 mph does not have an automatic claim against the manufacturer because of the risk inherent to the nature of the automobile (when it crashes at high speeds, bad things happen). Nor would your stock broker be responsible for a general crash in the market as such risks are inherent in any stock investments. This would not help KevorkCo because cancer is not an inherent risk to soft drinks (it is just one that KevorkCo choose to allow which makes them responsible). Further, due care does not hold manufacturers responsible for things they could not have foreseen. For instance, if a lawnmower company took reasonable steps to survey how 10,000 customers used its product and ensured it was safe for that use (namely mowing the lawn by pushing the lawnmower), the due care theory would not find merit in a liability claim made by the person who picked up his lawnmower with his hands and used it to trim hedges (and a few fingers in the process). Clearly this was a use of the product that reasonable people would not have expected therefore shielding the company from responsibility.
Due care does require at least three specific responsibilities of manufacturers:
Design – Manufacturers must ensure that the product design is such that harms are minimized. In the auto industry this takes into account airbags, seat-belts, crash tests, rollover tests, as well as gas tank placement and protection. There is a duty to ensure that a design minimizes risk (designing a compact car with a gas tank placed right in front of the driver would likely fail this duty). Securitized subprime mortgages probably don’t meet this standard.
Production – Companies must make certain that care is taken during manufacturing to prevent defective materials or poor manufacture from increasing the risk of harm. A decision to use cheap aluminum gas tanks in cars to save money would be a failure of this duty (as this makes them more apt to puncture in accidents). The failure for rating agencies to properly rate risky investments such as credit default swaps or securitized mortgages are other examples.
Information – Labels and instructions should be prominently provided to ensure that users are able to protect themselves from potential harms. We see this on most products today where we are bombarded with warnings (many of which are obvious) to help us make safe decisions when using products. This is standard in finance where investment risk is to be disclosed by brokers and in prospectuses.
Objections to Due Care:
There are several objections that can be made to the due care theory of product liability. Of these, we will mention three.
Subjectivity – No objective standard is offered to determine when due care has been exercised. Instead, we are left to ponder what a reasonable person would do to ensure care. This leaves a lot of room for leeway as to what is required. This also leads to hard comparisons. For instance, is increasing the price of all new cars by $5,000 worth say a 5% gain in accident survivability? Is opting to make the cheaper car (so more people can own a car) ignoring due care because of the 5% increased fatality rate? These are difficult judgments to make.
Knowledge – A great many harms caused by products are simply not known until years later. For decades it was thought that asbestos was safe. The harm was discovered well after the product was used. If the company had no way of knowing the potential problem in advance, do we find them responsible under the due care theory or not? It seems hard to fault manufacturers under the due care theory for things they could not have known, but then are we to conclude that no one is responsible for the damages? This would be a hard conclusion to accept as it leaves many injured people without coverage.
Paternalism – The due care theory imposes a sort of paternalism where manufacturers are left to determine what is good and safe for you. Should they determine that you should pay 20% more for a 5% improvement in safety? Or, should you the consumer be given the choice between a safer, more expensive product and a cheaper, more risky product? The due care theory would likely not allow a company to manufacture a cheaper riskier product. In finance there are examples of this paternalism in practice where some segments of the market are restricted to the professionals so as to protect the uninformed investor from loosing big.
Social Cost – This view builds upon the contract theory and due care theory by incorporating their requirements and then adds a bit more. Not only must companies live up to the conditions of the contract and exercise due care, but they must also be held responsible for any injuries caused by defects in the product, even if no one could have foreseen those injuries. For example, the asbestos companies would be found liable here for harms done by asbestos even though no one at the time had any reason to suspect those harms would occur. This view is also referred to in legal language as “strict liability” as it holds any manufacturer responsible for any harm caused by a defect in the product. This theory is fairly utilitarian as it takes a consequentialist approach to product liability; it views harms to consumers (and harms to non-consumers) as another business externality which a business should be accountable for. In other words, since the harms caused by your product are a consequence of the benefits you gained for manufacturing the product, it is only right that you pay the costs. Otherwise, you are benefiting while pushing off part of the costs of your doing business on society. The greater good of all is served when every manufacturer pays the true costs associated with their products. This theory then provides the strongest incentive for companies to ensure safety and to build in the real risks of the product into the price in order to cover later costs. This of course does not apply to risks inherent in the nature of products (like the stock market going down).
Objections to the Social Cost View:
Although several objections to the social cost view are offered. There are three that deserve specific mention.
It is unfair – Justice requires compensation when you could have or should have prevented a harm. Yet, under the social cost theory manufacturers are forced to compensate even when they could not have prevented a harm. Note: this objection should not surprise us as we have already made reference to utilitarianism’s inability to fully fit with our conception of justice. In response some argue that you are causally responsible therefore liable.
Social cost theory will not reduce accidents – The assumption made in social cost theory is that by holding manufacturers responsible we create an incentive to create safer products. This may not bear out because by holding manufacturers responsible we would alleviate the consumer of responsibility which may lead to more risky behaviors by consumers and therefore more accidents. Or, what is often referred to as “moral hazard” why people take more risks because they don’t suffer responsibility.
Undue financial burden – Social cost theory and its legal counterpart, strict liability, have caused an explosion of lawsuits and a crisis in the insurance industry which ends up paying for these suits. Putting so much burden on manufacturers will put some out of business even when there was no way for them to prevent the harm. Also, it will significantly raise product costs as well as insurance costs imposing a serious financial burden on manufacturers. Further, if this is the operating theory of product liability, would you risk bring a new product to market? New technology or processes would be a serious risk for any business as if something unforeseen goes wrong you could be put out of business by the avalanche of lawsuits. As such, social cost theory seems to discourage technological advancement.
As we can see, each theory of responsibility has advantages and disadvantages yet leaves something unresolved. It may well be that we are deciding which “innocent” party (the consumer or manufacturer) should pay the costs, but the burden must be placed somewhere.
Thought Question: Segway
Lisa purchased a new Segway as a way to travel around town. The manufacturer claims that the product is safe. Before Lisa made the purchase, she asked the Segway dealer if there was a risk of tipping over? The dealer said “the Segway is designed such that it will prevent you from tipping it over.” After weeks of use Lisa found that the technology of the Segway always kept her balanced. So confident was Lisa in the stability of the Segway that she decides to take it bar hopping one Friday night. After a few too many drinks Lisa cruises down the street and plows through several pedestrians and crashes into a parked car. This results in several bystander injuries as well as Lisa being seriously hurt after being hurled from her Segway, which tips over during the collision. Lisa’s attorney later claims that the Segway manufacturer and dealership is responsible for all of the injuries since it made a product, claimed it couldn’t tip over, and failed to warn her of the dangers of using the Segway under the influence of alcohol.
Is the manufacturer liable? Is the dealership liable? What theory of product liability supports your answer?
Risk & Investors
Many investors use brokers and money managers to guide through the investment process. Yet, many brokers face conflicts of interest which may result in their advocating actions which increase their commissions rather than benefit the investors. Brokers have a fiduciary responsibility to advocate on the investors behalf. Yet brokers also have an incentive to maximize their commissions and maximize profit for their brokerage house. This creates a natural conflict of interests in which brokers have three different interests at stake – yours, the brokerage that employs them, and their own. It is easy to speculate upon which interests take a back seat in this situation. Clearly, this system as it is presently set up will increase the risks to investors. Current laws do little to change the situation.
Conflicts of Interest?
Given the very real broker conflict of interests (and the harms that can result), it is important to determine the broker’s proper role. Are brokers simply sellers or are they buyer’s agents? If they are just sellers, then they have no more obligation to investors than to provide full disclosure and accurate information (like the seller of any other product). If they are buyer’s agents, then they have an additional obligation to protect the interests of the investors they advise. Which is the proper way to view a broker? When considering this question think about the ways brokers present themselves to clients.
Another problem for investors is futures and securities markets where individual investors are duped for hundreds of millions each year. So much fraud and deception has occurred that the SEC suggested individual investors be barred from participating in these markets for their own protection. In other words, since these particular markets require sufficient knowledge and constant attention to avoid huge losses, only those qualified should be allowed to take part. This paternalistic approach is similar to driver’s licenses in which, rather than allow anyone to drive, we require that they pass certain tests before doing so. Analogously, certain markets might be restricted to those who meet required criteria as a way of reducing investor risk. There is also a non-paternalistic motive for restricting access to these markets. That is, when a person invests all that they own in risky markets and looses it, they not only harm themselves (and their dependents), but they typically impose costs on society as well. If Jones has his retirement wiped out in risky investments at age 65, then he is likely to require more state assistance to ensure his livelihood (we simply do not throw 65 year olds out on the street to starve; instead government programs will aid them). This cost is inevitably imposed upon us via the state.
Recent technological advances have changed the investing world. No longer do investors have to either be professional investors or work with professionals. Today you can do all of your own investing and trading right from a home PC. Some have hailed this as a good thing because it gives access to everyone. However, the evidence thus far is that day traders do much worse than other investors. Many day traders have lost everything due to bad decisions resulting from their lack of knowledge and experience. This leads to an interesting challenge: Should there be more restrictions this type of risky investing? Perhaps a license or test to ensure a minimal standard of knowledge before we permit people to take such financial risks?
Another risk posed to investors is that of false advertising. Of course lying and deception are things regulators will seek to prevent and practices brokers are obligated to avoid. But these constraints all depend upon what constitutes a false claim? There are a great many “shady” areas where information is factual, yet misleading. We lack the time to fully explore this issue but it is worth mentioning how current regulators determine false advertising in the realm of investing. Regulators look at three criteria:
Would a reasonable person conclude falsely based upon the claims? If not then no wrong has occurred. If a reasonable person would make false conclusions then regulators ask the next question.
Could the person easily have avoided reaching false conclusions? If so, then no wrong has occurred. If a reasonable person could not easily have avoided reaching false conclusions then a third question is asked.
How much harm did the false conclusions cause? Regulators will not find fault when little harm is caused.
For this reason when it involves finance, health care, or real estate the standards used are much higher than for small item purchases or credit card applications. A simple rule of thumb is the more money involved, the stricter standard for misleading claims is imposed by regulators. The “Conventions of Lying on Wall Street” case demonstrates just how routine deception is in the investing world.
Employee Investors & Enron
One of the ways companies have moved to save money and keep employees happy is to encourage large amounts of employees retirement to be in company stocks. By using a legal practice, Enron accountants were able to make the company appear more profitable that it actually was. These results were pointed out to employees who, out of a desire for profit as well as company loyalty, continued to invest their retirement plans heavily in company stocks. Employees of Enron only learned the true risks once the fraudulent accounting practices became known. With rare exception, (namely company executives), the employees saw their retirements wiped out when the stock collapsed. Company rules actually prohibited regular employees from selling their stock while it was declining, but this rule did not apply to executives. Is there an ethical conflict of interest for companies when they allow or encourage employees to heavily invest their retirements in company stock?
Ethical Issues in Financial Services – John R. Boatright
Boatright discusses several abusive sales practices in finance including:
1. Churning – advising clients in ways which generate fees for the advisor. Churning also includes the broker making trades on behalf of a client in order to generate fees for the broker without gains for the client. Churning violates the fiduciary obligation brokers have to their clients.
2. Twisting – selling clients a new insurance policy to replace an older one with no real benefit to the client but increased commissions for the seller.
3. Flipping – convincing clients to pay off an old loan with a new loan resulting in more fees paid by the client.
4. Unsuitability – advising products which are not suited to a client. For example, advising someone 5 years from retirement looking to keep his principle secure to invest in risky stocks rather than safe bonds. In most cases this advice does not fit the objectives of the client (but may generate more fees for the broker). The duty to provide suitable advice is commonplace in law, medicine, and other professional services.
5. Deception – in the Arvida investments retires were never told that 8 of 9 managers just resigned before the investment went public or that part of the payouts to investors came directly from the incoming capital of new investors.
We know that there are many ways to deceive people from withholding truth, shaping truth, or misdirection. Perhaps the best way to define deception is not in how it is done but in it’s effect. Deception occurs when a person cannot make rational choices as a result of holding false beliefs which were created by the claims of others. Boatright take a humorous, but important look at the use of deceptive language in finance. Some examples are provided in the chart below broken down into the accurate terms and the deceptive term which have replaced them.
Accurate
Deceptive
Broker
Financial Advisor
Selling to you
Help you select
Buying a product
Allocate your money
Tax deferred
Tax Free
Very Risky
High Yield
Nobody knows the return
Projected returns
Commissions
Front end or Back end loads
Life insurance premiums
Deposits
6. Insider trading – trading stock in public companies using non-public information. For example, when Texas Gulf Sulphur Co. found rich mineral deposits the top executives invested heavily in the company and only then publicly announced the find. The reverse occurred in Enron where executives knew the company was going under and quietly sold millions of their stock while publicly reassuring investors that everything was fine. Note: insider trading refers to the type of information used not the person. A company outsider who manages to obtain insider information can still be guilty of insider trading (see Martha Stewart). Legally two points determine if insider trading occurs when someone uses inside information to trade:
“The trader has violated some legal duty to a corporation and its shareholders”
“The source of the information has such a legal duty and the trader knows that the source is violating that duty”
This means that cases where outsiders happen to learn things from sources they have no reason to suspect are violating the law are free to use that information to trade. In general then insiders are prohibited from trading by #1 and outsiders are only prohibited from trading when #2 holds. Thus many people may use the same information to trade but only some of them would be legally guilty of insider trading depending upon who they were and what they knew about the source of their information.
O’Hagan Case
James O’Hagan was a partner in a law firm which was advising the buyer in a hostile takeover of Pillsbury. O’Hagan tricked a fellow partner into revealing the hostile takeover of Pillsbury. This insider information on the Pillsbury takeover allowed O’Hagan to make millions. The question was did he violate insider trading law? After all, he was not an employee of either the purchasing company or the company being purchased nor was he even working on behalf of either company. The source of his information was also not a member of either company. If anything O’Hagan had misappropriated his own law firms information about outside firms. The Supreme Court decided that O’Hagan was guilty of insider trading even though he wasn’t an insider because he misappropriated confidential information. This legal decision brought back the concept of misappropriation as a determining factor in finding illegal insider trading.
What’s wrong with insider trading? Two sorts of arguments are offered. First, insider trading involves property rights such that the trader is guilty of theft of corporation property (such property may simply be the information used). Second, a fairness argument that says insider traders have garnered an unfair advantage due to their access to non-public information about publicly traded companies. To have a level playing field for investors only public information should be used.
The property rights argument has two problems. First, if any use of inside information is a misuse or theft of property then any use of any knowledge from work could be a violation even if it has nothing to do with trading. Second, if the wrongness of insider trading is that it violates the property rights of the corporation then why can’t the corporation just give permission for employees to use that information to trade? If it is just a property right then certainly the corporation has the right to let employees use company property if it chooses. For these reasons the wrongness of insider trading must be found in the fairness argument.
Rather than make the case for the fairness argument it might be just as helpful to assume that it is fair to utilize insider trading. What would the result be? Once foreseeable result would be that investors do better based not on their ability to analyze public information but on their ability to acquire non-public information. If we allowed the use of such information in trading what would investors do to obtain it before other investors do? One obvious method would be to offer cash “incentives” (bribes) to employees for sharing information about their company. Another would be to hire people to spy on companies using whatever means available to try to find out inside information. While some of these efforts would be illegal we can expect that people will engage in them given the gains to be had for getting good information early compared to the risks that someone gets caught and that it could be proven that you hired them. Does this seem a more ethical or fair system for trading markets to work? It might be objected that the use of bribes or spies could be done now to gain inside information. The difference is that even if you gain inside information now it is much harder to use it given prohibitions on insider trading. If the use of insider trading itself were accepted then we should expect more people to use these methods to gain inside information. Another consequence of accepting insider trading is the loss of investment dollars by those who see the system as an unlevel playing field that they cannot compete on. Still another consequence would be within the corporation in which individual employees now view all information not as something to be shared within the organization for the good of the organization, but as something to be kept to themselves to benefit their own investment trading. In other words, legalized insider trading may reduce trust in the markets and within corporations.
Hypothetical Case: If Insider Trading were Legal…
Executives at company X know the company is in trouble. No one but these executives know and so they devise the following plan. Since insider trading has been made legal to promote “efficient flow of information” the executives know that market traders watch what executives do with their stock and then react immediately. Therefore the executives agree that on Monday they will all invest heavily in company stock and encourage all their close relatives and friends to do the same. After the insiders, their friends, and families make the mass Monday morning purchase the rest of the market follows in on the buy. They do this because obviously the insiders know the stock is going to jump so the traders all want in on the deal. The stock price soars all day Monday. Near the end of the day all of the insiders, friends, and family suddenly sell all of their stock cashing in on huge gains. By the next morning the stock crashes and it is revealed that company X is going under. Millions of investors dollars were lost, many ordinary workers and retirees loose money on the deal while the very managers who ran company X into the ground cash out with huge gains. Behold – the fair and just free market in action if only insider trading were legal.
Much more can be said about the risks investors face and the role the financial services industry plays in creating that risk. However, the more pressing issue is when we do find that a company is responsible for something which has gone wrong who exactly do we hold responsible? On one hand it could be the individuals whose actions and decisions led to the problem. On the other, it could be that the organization itself is held responsible.
Part 5: Individual Responsibility
When something bad happens who is responsible? When we encounter cases such as the Ford Pinto gas tank explosions or the Exxon Valdez oil spill or the more recent Firestone tires Ford/SUV rollover incidents, this question must be answered. With responsibility evaluations there are two sorts of approaches. One impulse is to find and punish individuals. Another option is to find fault with a “system” such that systemic failure was the cause and by fixing the system we can prevent like situations from occurring in future. In some cases we find that both systemic failure and individual misdeeds were the cause. How we assign responsibility has serious consequences for business. Focusing blame on the system is often a shield used by individuals to protect against their misdeeds. Conversely, focusing responsibility on individuals is used to shield a poor system. Let us briefly examine each of these two approaches.
The Individual Responsibility Approach
This approach holds that a corporation cannot be responsible because somewhere within the company an individual or individuals made decisions that caused the problem. They, and only they, are responsible. To often individuals hide behind their businesses, allow a company to bear responsibility for the decisions of the individual. For instance, at some point in time some individuals at Enron made the decision to “cook the books” leading to millions in losses to investors. In a case like this, responsibility can best be applied to those individuals.
Further, there are those such as Manuel Valasquez who argue that moral responsibility can only be applied to individuals and never to corporations. To help understand this argument we need to make a distinction between two types of responsibility.
Moral responsibility is ascribed to intentional agents because they intentionally allowed or took part in an action.
Natural responsibility is a term used for non-intentional agents and describes a causal fact.
A person stealing money from the cash register is acting with intention and therefore is morally responsible. A hurricane destroying a neighborhood is an example of naturally responsible (it was the cause) but not morally responsible (there is no intentional act by the hurricane). People can be ascribed both types of responsibility depending upon intentionality. Since corporations cannot act except through individual agents, they are like natural disasters and can only be ascribed natural responsibility. Corporations can be causal factors but cannot be intentional agents. When wrongdoing occurs moral responsibility can be traced to individuals not institutions. Let us consider the advantages of an individual approach by reviewing the National Semiconductor case.
National Semiconductor Case
Over a hundred employees and managers were involved in falsifying product testing records thereby defrauding the U.S. military. The military wanted to charge the individuals with fraud as punishment would dissuade them from committing any future fraud. National Semiconductor successfully argued that it was the company that was responsible, not the individuals. The company paid a fine and no individuals were held responsible.
This verdict is problematic for several reasons. First, this decision fails to deter future fraud as the individuals who committed fraud were not themselves punished and therefore have no reason not to continue fraudulent activities. Second, this decision punishes everyone in the company equally, whether or not they were part of the fraud. Since some employees refused to participate in the fraud, this solution means, in effect, that we punish the innocent as if they were the guilty rather than taking the time to punish only those who were guilty.
We can summarize the arguments for individual rather than corporate responsibility made by Valasquez and others as follows:
Corporations do not qualify for moral responsibility because they are not intentional agents.
Punishing corporations instead of individuals fails to deter the future actions of individuals.
Punishing corporations instead of individuals means punishing the innocent as if they were guilty.
Every corporate action is the result of individual decisions. As such, the moral responsibility applies to the individual not the corporation.
Even if it is a corporate policy that was causally responsible, there are individuals who, with intention, proposed, endorsed, or applied such a policy and those individuals are morally responsible for its effects. For instance, if I, with intention, program a machine and due to that programming the machine causes harm to someone, we find moral responsibility applies to me the programmer and not the machine.
Individual Responsibility Approach Criticisms
One criticism of the view that only individuals should be ascribed moral responsibility is the question of unintended harms. When no one acted intentionally to cause a harm, but a harm has resulted, then who is responsible? Isn’t this where “deep pockets” or utilitarian responsibility applies?
Hospital Cases
Lisa Belkin discusses several instances of how human errors do not warrant individual moral responsibility. Instead, in these cases, it is a system which is responsible. Yet, in many of these cases medical professionals have been sued or fired for things in which they bear no moral responsibility. Therefore, we should not seek to assign moral responsibility in these cases and instead we should focus on reevaluating the system to prevent future errors from costing human lives.
Valasquez would agree that in these cases no one is morally responsible. The hospital examples focus on accidents, which are not the same as immoral actions. Certainly a system can be causally responsible for accidents and, to the extent that it is, we should fix it. However, this does not entitle us to conclude, as Belkin implies, that moral responsibility in these cases is ascribed to systems or corporations. Moral responsibility applies only to immoral actions not to accidents.
For instance, suppose A designs a product, B chooses materials for construction, C manufactures it and then D markets that product. Each one has done his best to make a good product but it turns out, unforeseen by anyone, that the resulting product is unsafe. Upon examination no moral fault can be found with either A, B, C, or D due to a lack of intention. Certainly we might endorse “deep pockets” or identify utilitarian reasons why the company should pay the damages to product users, but these reasons are not motivated by any account of moral responsibility. Instead, they hold that since someone should compensate those harmed and the corporation is naturally responsible, then the corporation should pay those costs.
One case that involved the debate between blaming the system or individuals is the Challenger disaster. The results of the Challenger disaster was to blame a system rather than individuals. For those favoring the individual approach this result was wholly insufficient. Further, holding the system responsible did not seem to correct the problems at NASA, as years later the loss of the Columbia shuttle occurred despite similar safety warnings having been made. Yet in this second shuttle disaster the focus was on a “broken system” and not individuals. Thus, this case may lend support to the benefits of holding individuals, not systems, accountable for the decisions they make.
NASA Challenger Disaster Case
In the Challenger case, four executives knew their engineers objected to the launch for safety reasons and also knew that if they did not recommend to NASA that the launch should proceed, NASA would abort the launch. After “putting on management hats” they chose to overrule their engineers’ recommendation for a launch delay (yet, the engineers were correct). Certainly we can ensure a systemic change by requiring that engineers’ recommendations be passed up the chain, beyond the four executives. But how can we not hold these four executives accountable? They had the information; their call was the determining factor to launch or not; and they put the launch schedule above a serious safety concern. Shouldn’t these executives be charged with an ethical lapse in placing higher value on launch scheduling than mission safety? Aren’t these four individuals morally responsible?
Corporate Responsibility
Under this second approach, individuals can rarely be held responsible because the structure of the corporate system shields them from having complete knowledge or decision making power. This is what is meant by “diffusion of responsibility” where no individual had full knowledge or control due to the structure of the decision making process within a corporation. It may also be the case that no particular individual decision was the problem, but the design or the incentive structure of the corporate system lead to the problem. For instance, if a corporation has an incentive structure under which (as a matter of unintended fact) employees gain substantially by ignoring the law, then it seems the responsibility for lawbreaking must be, in large part, shared by the corporation that initiated and perpetuates such a system. There are at least two ways of assigning corporate responsibility.
Full Corporate Responsibility
With this view, anything that happens within a corporation is the responsibility of the corporation. Many versions of this position can be readily seen and argued for. From the military officer who is responsible for the actions of anyone under his command, to the ship captain who is responsible for the actions of those aboard ship, to the utilitarian claim that holding corporations fully responsible creates a large incentive for “policing the employees” and to deter/prevent wrongdoing. This view is often put forth in legal arguments, especially in cases where no individual can be held to account (someone must be held responsible which often defaults to the institution). However, this view is criticized as going too far in assigning responsibility. When an individual acts without the knowledge, consent, or encouragement of others (and managers were not negligent in their duties) then it seems a stretch to hold the corporation (or any other institution or individual) accountable. One example of holding corporations fully accountable for employee actions (without proving managerial negligence) is the case of South Dakota v. Hy Vee Food Stores.
Society has determined that liquor should not be obtained by minors. As a result, many states hold liquor store owners accountable for any sales made to minors by their stores. For instance, if an employee sells to minors the store owner may loose their liquor license. Several owners have complained that this practice is unfair; despite diligent efforts they cannot ensure their employees will sell only to adults. Owners argue that instead of holding them responsible, it is the employee who is responsible for the sale and therefore only the employee should be fined/punished by the government.
In the Hy Vee case an employee failed to I.D. the minor purchaser. The company had a policy warning employees that they, not the company, were liable for sales to minors. Despite this, the courts imposed a fine on the company and not the employee for the sale. Who should be held responsible here? If owners are taken off the hook, then do they have sufficient incentives to ensure employees abide by the law?
Of course not everyone in favor of corporate responsibility supports the full responsibility view. Instead, some offer a lighter approach which will still hold the corporate institution to be responsible rather than individuals, but does so less often than the full responsibility theory.
The Corporate Character Theory
This view recognizes that the organizational structure, management style, company policies, methods of decision-making, and disciplinary sanctions impact how employees act. This notion is often referred to as the “culture” of the corporation. Just about any institution will have a culture or character that influences its members. Recognizing this influence, the corporate character theory holds that corporate responsibility is warranted to the extent that the corporation’s character is implicated as a causal factor in wrongdoing. This method of assigning responsibility will hold corporations accountable for many wrongdoings but affords them protection when the acts were the work of a “rogue employee.” One case offered in the book which lends support to the corporate character theory is an “Auditor’s Dilemma.”
An Auditor’s Dilemma
Gem packing company has an auditor checking the records. The auditor discovers ACE glass invoices which are misdated or show the company being paid in full for deliveries which haven’t arrived. She talks with the head of purchasing who explains that managers earn one third of their salary from meeting quotas. Missing even one quota is considered a death blow to a managers career with Gem. So, managers regularly pay for things in one fiscal year which are actually received in the next in order to consistently meet their quotas. If an executive exceeds a quota by a significant amount HQ typically increases their quota to that amount plus 5% so managers try hard to meet every quota but not exceed any by very much. Falsifying delivery dates, prepaying or postdating purchases like those to ACE glass are methods for managers to meet the quota system and garner their incentive bonus. Suppliers like ACE glass know how the system works at Gem and have no problem playing along. Corporate HQ has not caught on to what managers are doing, but managers say that HQ created the system and have been happy with the results so there is no real harm in what managers are doing. The auditor knows that the sales and invoices do add up – only the dates are being shuffled around.
Is there anything wrong going on here?
What should the auditor do?
Suppose the fraud is discovered. Who is responsible? The individual managers or corporate character as displayed by the incentive plan? The managers blame the incentive system for the problem, are they right?
Perhaps the biggest supporter of corporate responsibility is our current legal system. The governing laws in these cases are the Federal Sentencing Guidelines. These guidelines support the corporate responsibility view by holding the organization, rather than individuals, responsible for wrongdoing. The guidelines are set up to provide adequate deterrence, just punishment, amends for harm caused, and incentives for preventing and reporting potential wrongful conduct. The guidelines punish more severely corporations with repeat offenses, that cover-up offenses, or that obstruct justice. In addition, punishment is tied to the pervasiveness of the wrongdoing. Was it just one low-level employee or was this a group of top managers? The guidelines also lessen punishment for cooperating with law enforcement and for having/creating systems in place to prevent or discourage law breaking. One case with serious implications for legal application of the Federal Sentencing Guidelines is the U.S. v. Bank of New England.
U.S. v. Bank of New England
In this case, a bank teller did not report repeated cash withdrawals that were over $10,000, which is required by law. The bank argued that it was not responsible because the employee committed the action and and also that the employee did not know of the requirement. The courts ruled against the bank holding the corporation responsible for the employee’s actions. Clearly, this sort of corporate responsibility provides an motivation for informing and monitoring employees to ensure they act properly. However, have the courts gone too far by ascribing moral responsibility to the corporation?
So what are we to conclude about individual vs. corporate responsibility? To hold a position of strict individual responsibility seems to ignore the effects corporate systems and corporate culture have on individual actions. Conversely, a strict corporate responsibility approach provides no disincentive for individuals to act immorally and then hide behind the corporation (Enron executives profited financially and most of them do not appear likely to face jail time). The natural response is to hold that both theories play a role in determining responsibility. Yet this “dualism” creates problems of its own. For instance, the case of the train wreck which was caused in part by an engineer running a red light and in part by the red light being placed in an abnormal and hard to see position. Some determination of shared responsibility between the individual and the organization responsible for the light placement seems in order, but how much? What is ethically important is to look at both individual as well as corporate structures as candidates for assigning responsibility whether it be moral or causal. One other viewpoint is put forth by Boatright.
“Individual Responsibility in the American Corporate System…” – John R. Boatright
Question, what is a corporation? Answer, “An ingenious device for obtaining individual profit without individual responsibility.” How does this answer work as a description? Boatright thinks this often used line demonstrates a sincere desire to bring individual responsibility back to the business world. Boatright does not share this desire as he finds the American corporate system requires a separation between corporate managers and individual responsibility. While Boatright thinks individuals acting wrongly outside their company role should be punished individually (such as those embezzling company funds), he thinks those operating within their designated company role should be shielding from personal responsibility.
Holding executives responsible (or accountable) for their actions can occur from several sources including: the business organization through internal controls or firing (by other executives or shareholders), the law through criminal prosecutions, other businesses by withholding business due to damaged reputation, or from customers who withhold their business in response to the executives actions. Boatright thinks it is important to recognize the ways that markets themselves can hold people responsible rather than place the full burden of responsibility as coming from the state in the form of law. In other words, the lack of legally enforced individual responsibility for some classes of actions does not mean there will not be individual responsibility derived from other sources.
Boatright indentifies several problems of assigning individual responsibility:
The burden of proof inside a black box – Assigning individual responsibility in the business world is often a case where we know something bad happened but no one in the room will admit who did it. How then are we to decide which individual to assign responsibility? This is often the case in the business world where decisions are made behind closed doors without any proof of exactly who did it (though we know at least some in management did it). Individual responsibility will not help here, so corporate responsibility will suffice.
Diffusion of decision making – In many cases there were many actors involved in events, some of whom may not have known what others are doing. In such cases how can we hold these individuals responsible? It may not be efficient or effective to do so compared to holding the corporation responsible.
Legal responsibility is driven by three different agendas: deterrence, compensation, and retribution. Each of these can yield different results for individual responsibility. The most efficient and effective method of meeting these three goals of legal responsibility is corporate responsibility. Otherwise we are looking at each individual player and forced to determine which of the three goals are we employing in this person’s case. Individual responsibility may be detrimental to business efficiency. Corporations have deeper pockets and therefore deterrence is more effective. Holding corporations responsible results in their setting internal oversight to deter individual wrongdoing. Holding individuals responsible is less of a deterrent and if individuals are held responsible they will demand higher salaries for this extra risk which decreases business efficiency. Corporate responsibility is simply more efficient than individual responsibility.
“Moral Hazard” – Often thought of as the problem where one acts in more risky ways because one knows they will avoid the consequences of their risky behaviors. For example, companies that know, or believe that they will be bailed out if they go bankrupt will take more risks because of the knowledge of even a possible bailout. In the context of individual responsibility the problem of moral hazard is found when companies know that individuals will take the fall for their wrongdoing while the company retains the benefits of the wrongdoing. This encourages companies to allow, overlook, or outright encourage wrongful behavior so the company can benefit. What happens if such wrongdoing is caught? The company can retain the benefits while hiding behind the “lone guilty person,” the “rogue employee” or the “bad apple.”
