History and Emergence of Ethics and Compliance

The past twenty years has seen an explosion of corporations, across the United States, creating new business programs that deal with ethics and compliance. One survey showed that eighty-three percent of corporations, that completed the survey, have developed a formal code of ethics or conduct (Deloitte and Corporate Board Member Magazine, 2003). It can be said that corporations generally don’t add extra personnel and undue expenses without justification. Why then are corporations creating these added expenses? Who, within the corporation, is developing these codes of ethics and compliance programs and why are they doing it? To answer these questions we must look at the history and emergence of the field of Ethics and Compliance.

Discovering the birthplace or emergence of “business ethics” is not an easy task. One reason for this lies deeply buried within the history of business ethics. Richard De George (2005) describes the history of business ethics as having three separate paths. The three separate paths or synergies of business ethics build upon each other in a way that makes the sum stronger than any other individual path.

Three Synergies of Business Ethics

The first path refers to “ethics in business,” which can be seen as “the application of everyday moral or ethical norms to business (De George, 2005).” Early examples of ethics in business can be seen in the Bible’s Ten Commandments, Plato’s Republic, and Aristotle’s Politic. As ethical philosophies took a more modern approach other views began to arise like that of Adam Smith and Karl Marx.

The second path refers to “business ethics” as it applies to the academic field. The 1960’s brought forth a new generation of social consciousness toward business. Viet Nam, Civil Rights, and Environmental Issues all became targets, for this new generation, to protest. Corporations looking to minimize public outcries formed social responsibility programs. Business schools began developing courses designed to address these social responsibilities. De George (2005) describes these courses as first having an emphasis on law with no systematic approach to ethical theory as empirical studies were the norm, as they developed or defended corporate actions. In the 1970’s the birth of “Business Ethics” as an academic field came into its own and by 1990 business ethics was deeply rooted in academia.

Ethics as a movement, the final path, shows how a business interweaves ethics into the structures of the organization through the creation of ethics codes, officers, committees and training. The business ethics movement began when new legislation was passed that targeted businesses. These laws included the Civil Rights Act of 1964, Occupational Safety and Health Act of 1970, and the Environmental Protection Act. Non-compliance with these laws could bring lawsuits upon organizations. Naturally, businesses wanting to mitigate their risks will need to comply with the laws. As more laws were passed, companies needed ways to keep abreast of each law.

Rise of the Corporate Ethics & Compliance Officer

The rise of the Corporate Ethics & Compliance Officer came in three phases (Swartz, 2003). The first phase came after scandles during the Reagan era. The next phase came in the early 1990’s after the Federal Sentencing Guidelines promised reduce fines for implementing an Effecive Compliance and Ethics Program (ECEP). The last phase came from a number of high profile corporate corruption case that include companies such as Enron, MCI/WorldCom, and Tyco.

Ethics and Compliance professionals come from vastly different backgrounds. Imagine each of the different types of organizations (businesses, corporations, partnerships, etc.) in the world and each one having their own view of what ethics and compliance means to their organization. The combinations are endless, making the path to becoming an ethics and compliance professional a daunting one. However, there are a number of key elements that play a role in determining what goes into the ethics and compliance program. How organizations interpret these key elements can shape what an organization looks for in an ethics and compliance professional, and with it, what the professional’s day-to-day activities will be.

One element lending a hand, in shaping “ethics and compliance” into a profession, is the Federal Sentencing Guidelines for Organizations (FSOG). In 1984 Congress established the U.S. Sentencing Commission. The commission set out to establish guidelines that federal judges could use when handing out convictions to criminals. It wasn’t until 1991 before chapter eight was added; creating sentencing standards for organizational defendants (Association of Corporate Counsel, 2005). The 1991 manual has undergone many changes over the years. Organizations can use the guidelines to decrease the amount of punishment by up to 95% (De George, 2005). One important element of the FSOG is instituting an “Effective Compliance and Ethics Program” (ECEP).

Companies now have guidelines to model their E&C programs after, within the ECEP seven element need to be addressed to mitigate an organization’s punishment, they are: (1) standards and procedures; (2) oversight by high-level personnel; (3) due care when delegating authority; (4) effective communication of standards and procedures; (5) auditing/monitoring systems and reporting mechanisms; (6) enforcement of disciplinary mechanisms; and (7) appropriate response after detection (Izraeli & Schwartz).

Compliance professionals interact with other departments within an organization. How compliance professionals interact with each department depends on what department is accountable for compliance within the organization. Some organizations place ethics and compliance responsibilities on the shoulder of the general counsel to ensure that, “[h]igh-level personnel of the organization shall ensure that the organization has an effective compliance and ethics program” and to stay compliant with the FSOG (Salmon-Byrne & Frederickson, 2010). However, Ethisphere (2010) builds the case that by placing the ethics and compliance function with the general counsel creates a conflict of interest.

Compliance professional’s interaction between departments is conducted through a variety of communication medians. Interaction can take place in work groups that help facilitate collaboration between different departments. Other obvious means of communication would include e-mail, phone, face-to-face conversations, text messages and even social media networks. Some E&C professionals act as a help-desk for ethical and compliant related issues, while other E&C professionals might facilitate training throughout the corporation.

A Corporate Ethics & Compliance Professional should also have a code of professional ethics; one such code was adopted by the Society of Corporate Compliance and Ethics (SCCE). The code of ethics has three main obligations, they are: (a) to the Public, (b) to the Employing Organization, and (c) to the Profession (Murphy, Walker, Anderson, Horowitz, Milano, & Doyle).

Summary

Over the last few decades the ethics and compliance profession has grown up from a philosophical idea to high-level personnel within corporate America. Guidelines, like the FSOG, have helped the E&C profession grow by leaps and bounds. Ethics and Compliance professionals must always be looking for new ways to reinvent their craft. Ethical values can change due to idealistic views perceived by the public; these changing views set the tone for acceptable values and standards in ethical thinking. As an ethics and compliance professional, the answer is not always found in the law books, it’s found when thinking beyond the words of law.

References

Association of Corporate Counsel. (2005, March). The New Federal Sentencing guidelines for Organizations: Great for Prosecutors, Tough on Organizations, Deadly for the Privilege. Retrieved August 20, 2010, from ACCA.com: http://www.acca.com/protected/article/attyclient/sentencing.pdf

De George, R. T. (2005, February 19). A History of Business Ethics. Retrieved August 13, 2010, from SCU.edu: http://www.scu.edu/ethics/practicing/focusareas/business/conference/presentations/business-ethics-history.html

Deloitte and Corporate Board Member Magazine. (2003, July). Business Ethics and Compliance in the Sarbanes-Oxley Era. Retrieved Auguest 20, 2010, from GlobalCompliance.com: http://www.globalcompliance.com/pdf/BusinessEthicsandComplianceSurvey.pdf

Izraeli, D., & Schwartz, M. S. (n.d.). Actrav.Itcilo.org. Retrieved August 22, 2010, from What Can We Learn From the U.S. Federal Sentencing Guidelines for Organizational Ethics?: http://actrav.itcilo.org/actrav-english/telearn/global/ilo/code/whatcan.htm

Murphy, J. E., Walker, R., Anderson, U., Horowitz, M., Milano, S., & Doyle, J. M. (n.d.). Code of Professional Ethics for Compliance and Ethics Professionals. Retrieved August 20, 2010, from CorporateCompliance.org: http://corporatecompliance.org/Content/NavigationMenu/Resources/ProfessionalCode/SCCECodeOfEthics_English.pdf

Salmon-Byrne, E., & Frederickson, J. (2010, May 25). The Business Case for Creating a Standalone Chief Compliance Officer Position. Retrieved August 21, 2010, from Ethisphere.com: http://ethisphere.com/the-business-case-for-creating-a-standalone-chief-compliance-officer-position/

Swartz, N. (2003, January 1). Rise of the corporate ethics officer. (Up front: news, trends & analysis). Retrieved August 19, 2010, from AllBusiness.com: http://www.allbusiness.com/human-resources/employee-development-employee-ethics/453806-1.html

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Violations of Reg O & the Federal Sentencing Guidelines

In 1973, the U.S. National Bank of San Diego went down in the history books as the first financial institution holding assets in excess of 1 billion dollars. Investigations into the U.S. National Bank discovered that over 400 million dollars in financial loans went to its chief executive officer and his related interests (Osborne, 1998). In the following years other banks began to fail with similar insider dealings being blamed. In 1977, the Safe Banking Act was introduced to deal with some of these cases. After repeated amendments and some eighteen new titles added, the Safe Banking Act of 1977 became known as the financial Institutions Regulatory and Interest Rate Control Act (FIRA). FIRA became a major upgrade to what is known as Regulation O (Reg O). More modifications to Reg O came with the passing of:

• The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA);
• The Housing and Community Development Act of 1992;
• The Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA).

The FDICIA requires that management of certain financial institutions must provide an assessment of their compliance with insider laws and regulations. Regulation O was designed to discourage insider’s from using their positions to secure self serving credit extensions (Osborne, 1998). Violations of Reg O can cost financial institutions a lot of money making non-compliance of Reg O not a suitable option.

Regulation O Violations

Section 215.11 of Regulation O, titled Civil Penalties, states, “Any member bank, or any officer, director, employee, agent, or other person participating in the conduct of the affairs of the bank, that violates and provision of the part (other than section 215.9) is subject to civil penalties as specified in section 29 of the Federal Reserve Act (12 U.S.C. 504) (Federal Register, 2010). Section 29, titled Civil Money Penalty, breaks down violations into three tiers and sets a maximum monetary penalty, per day, for each of the three tiers (Federal Reserve, 2008).

• Tier 1 - Any member bank which, and any institution-affiliated party with respect to such member bank who, violates any provision of section 22, 23A, or 23B, or any regulation issued pursuant thereto, shall forfeit and pay a civil penalty of not more than $5,000 for each day during which such violation continues.
• Tier 2 - any member bank who commits any violation that recklessly engages in an unsafe or unsound practice in conducting the affairs of such member bank; or breaches any fiduciary duty; which violation, practice, or breach is part of a pattern of misconduct; causes or is likely to cause more than a minimal loss to such member bank; or results in pecuniary gain or other benefit to such party, shall forfeit and pay a civil penalty of not more than $25,000 for each day during which such violation, practice, or breach continues.
• Tier 3 - any member bank that engages in any unsafe or unsound practice in conducting the affairs of such credit union; or breaches any fiduciary duty; and knowingly or recklessly causes a substantial loss to such credit union or a substantial pecuniary gain or other benefit to such party by reason of such violation, practice, or breach, shall forfeit and pay a civil penalty in an amount not to exceed the applicable maximum amount of $1,000,000.

Section 29 also sets a maximum fine of no more than 1 million dollars, per day, for any of the three tiers. Each of the three tiers can be used as a measurement of risk based assessments for non-compliance. If an employee within your financial institution knowing places your operations in violation to regulation O then the price for non-compliance can be a very expensive price to pay.

Federal Sentencing Guidelines Section 8

The Federal Sentencing Guidelines Section 8 has a similar structure to Section 29. However, Section 8 goes into much more detail than Section 29. While Section 29’s tiers show how much one has to pay, Section 8 helps determine what tier an organization should fall under buy using what is known as a culpability report. (United States Sentencing Commission, 2004) Section 8, titled Sentencing of Organizations, outlines how the Judicial System should review an organization in violation of law and then determines the level at which they are culpable. This can come in handy when someone within the organization commits a crime. If the organization placed into account internal controls that would have otherwise discovered the crime then the organization could be less culpable than if the organization didn’t show due diligence or due care.

Summary

Both Section 29 and Chapter 8 allow organizations the ability to measure their risk by allowing them to understand what the monetary penalties are and what they can do to ensure they are not culpable for non-compliance. These two pieces of legislation are far from perfect and a review should be performed. For now, as compliance officers, knowing the monetary risk for violations and addressing each issue to limit your culpability is a great asset to have and can save the organization a substantial amount of money if a crime was to occur.

References

Federal Register. (2010, July 1). Title 12: Banks and Banking. Retrieved July 6, 2010, from http://www.ecfr.gpoaccess.gov

Federal Reserve. (2008, August 13). Section 29. Civil Money Penalty. Retrieved July 6, 2010, from FederalReserve.gov: http://www.federalreserve.gov/aboutthefed/section29.htm

Osborne, P. R. (1998, June). Managing regulation O. Retrieved July 6, 2010, from findarticles.com: http://findarticles.com/p/articles/mi_qa5381/is_199806/ai_n21423220/?tag=content;col1

United States Sentencing Commission. (2004). 2004 Federal Sentencing Guidelines. Retrieved July 6, 2010, from ussc.gov: http://www.ussc.gov/2004guid/8b2_1.htm

By: Joseph Dustin

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Supervisory Powers over Financial Institutions

Since the onset of the housing market collapse, financial institutions have been failing at an astounding rate. As more banks begin to fail and taxpayer bailouts are passed by congress, one can only wonder if anyone is monitoring these institutions. How do we identify the causation of banking failure? Do we blame the financial institutions or the agencies that govern them for the failures? The answer may be somewhere in between and not easily defined by using current methods used in identifying failing financial institutions.

To help identify bank failures, regulatory agencies are provided with supervisory powers that allow them to examine financial institutions for safety and soundness. Are these supervisory powers that the agencies currently have adequate enough to identify a failing institution before its too late, or are the processes they use flawed? Furthermore, the examinations given to financial institution by their supervisory agency should be analyzed to further understand why the supervisory agencies fail to adequately predict banking failures.

An Increase in Bank Failures

In 2008, after years of relatively low numbers of bank failures (an average of just over 3 per year from 2000 to 2007), banks rapidly began failing. Twenty-five financial institutions failed in 2008 and this was only the tip of the iceberg (see Figure 1). In 2009, bank failures were up again, this time the industry had a total of 140 institutions that were closed. As of July 15, 2010, bank failures have reached a total of 90 for the year with no signs of stopping there. McIntyre (2010) and Scatigna (2010) are forecasting even higher numbers of bank failures this year. With high numbers of banking failures being forecasted in the near future, why could we not stop these failures from occurring and what are the supervisory agencies doing to prevent future failures from happening?

Banks generally fail for one of two reasons. First, banks can become insolvent, forcing the supervisory agency to step in a close the institution. Insolvent banks occur when the bank’s liabilities become greater than their total assets. The second reason banks fail is due to becoming illiquid. Banks that are illiquid generally have assets that equal the amount of their liabilities; however the bank has a hard time liquidating these assets to meet consumer deposit demands or withdrawals. Rather banks are failing due to being insolvent or illiquid, the supervisory agency over each institution has be able to adequately monitor banks in order to predict their failure.

Bank supervision and bank regulation are two terms that are often confused as being one and the same. The Federal Reserve (2005) defines the terms as being “distinct, but complementary, activities.” Bank supervision involves three distinct actions: monitoring, inspecting, and examination. Each action reflects a key component in assessing the overall condition of banking organizations. Organizations found violating the laws that fall within the regulatory agency’s jurisdiction can have formal or informal actions taken against them to rectify the problems. Bank regulation involves the creation of regulations and guidelines that cover the day to day activities of banking organizations.

Authority to Impose Regulatory Enforcement Action

Regulatory Agencies have a vast range of powers that enable them to deal with troubled institutions with the end result of catching problems early in an effort to minimize more costly supervisory measures further down the road (Malloy, 2003). Some of the regulatory agencies with powers over financial institutions are the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS).

Malloy (2003) states that the enforcement provisions of the Federal Deposit Insurance Act (FDIA) are “applicable regardless of the type of depository institution involved” and “is now a more or less unified body of federal enforcement provisions.” Figure 2 breaks down each supervisory agency’s enforcement actions over the last ten years.

The OCC has supervisory powers over national banks. The Comptroller is given the authority to examine these institutions through the Federal Deposit Insurance Act (FDIA). The FDIA allows the OCC a way to discover unlawful violations that are considered “unsafe and unsound practices” of national banks during examinations. Institutions under the supervision of the OCC may be required, but not limited to, pay “any deficiencies in capital” or increase the amount of capital that is required (Malloy, 2003). The OCC may also impose personal liabilities against management when violations under the National Bank Act occur.

The FRB has supervisory authority over state chartered banks that are members of the Federal Reserve System, Bank Holding Companies (BHC), Edge and agreement corporations, foreign branches of member banks, and other nonbanking activities of foreign banks (Federal Reserve's Publication Committee, 2005). The FRB, under the Federal Reserve Act, has the ability to impose civil money penalties upon the bank’s directors and officers.

The FDIC has supervisory authority over banks that are not members of the Federal Reserve System. The FDIC insures bank deposits up to a set amount and has special examination authority to determine the condition of an insured bank or savings association for insurance purposes (Federal Reserve's Publication Committee, 2005). The FDIC is the federally designated receiver which allows it to liquidate banks that become insolvent (Malloy, 2003).

The OTS has supervisory authority over savings associations that generally focus on residential mortgage lending (Federal Reserve's Publication Committee, 2005). The OTS also supervises federal savings associations along with companies that own or control other savings associations. Some of the enforcement provisions carried out by the OTS are administrative cease and desist orders, suspend or remove members of management, and impose civil money penalties (Malloy, 2003).

The regulatory agencies are further streamlined by the Uniform Financial Institutions Rating System (UFIRS). UFIRS was adopted by the Federal Financial Institutions Examination Council in 1979 and was introduced to create an evaluation and rating system for financial institutions. UFIRS is based on the evaluation and rating of six key indicators. The six components used are Capital adequacy, Asset quality, Management capability, Earning, Liquidity, and the Sensitivity to market risk; otherwise known as CAMELS (Rau, FDIC's Controls Over the CAMELS Rating Review Process (Report No. AUD-08-014), 2008). Even with the CAMELS ratings, supervisory agencies are not catching bank failures fast enough to prevent such an occurrence. This is evident when both the FDIC and the OTS examined IndyMac Federal Bank, FSB (IndyMac) of Pasadena, California.

IndyMac Federal Bank, FSB

The supervisory responsibility, over IndyMac, rested on the shoulders of the Office of Thrift Supervision (OTS). OTS closed IndyMac on July 11, 2008 and named the Federal Deposit Insurance Corporation as conservator (Office of Inspector General, 2009). According to the Audit Report published by the Department of the Treasury and conducted by the Office of Inspector General (OIG) states, “IndyMac’s failure [was] largely associated with its business strategy of originating and securitizing Alt-A loans on a large scale.” IndyMac had an aggressive strategy to increase profits, by using nontraditional loan products, insufficient underwriting, and borrowed heavily from costly sources. After 2007, in the mitts of the mortgage market decline, IndyMac was left holding $10.7 billion in loans. As the bank became illiquid, the situation took a turn for the worse when account holders created a “run” of $1.55 billion in deposits that left IndyMac with no way to liquidate their assets to cover their liabilities. The OIG made it clear that, “the underlying cause of the failure was the unsafe and unsound manner in which the thrift was operated.” If IndyMac’s business strategy is to blame for the closing of IndyMac, why didn’t the FDIC and OTS uncover this strategy before it was too late?

Rating the Banks

Each regulatory agency needs to be able to efficiently monitor the conditions of banking institutions that they supervise. Two ways agencies can achieve this goal is to conduct onsite and offsite examinations. The FDIC, under section 10(d) of the Federal Deposit Insurance Act (12 USC 1820(d)) mandates onsite examinations on an annual basis. This interval may be extended to 18 months for lower asset institutions and if the FDIC relies upon examinations conducted at the state level, then the process could be extended out to 3 years (Rau, 2002).

To better bridge the gap between onsite examinations, the FDIC uses several forms of offsite monitoring tools such as the Statistical CAMELS Offsite Rating (SCOR) review program, the Growth Monitoring System (GMS), and the Real Estate Stress Test (REST). In 2002, the Office of Inspector General conducted an audit titled, Statistical CAMELS Offsite Rating Review Program for FDIC-Supervised Banks; this audit was delivered to Michael J. Zamorski, Director of the Division of Supervision and Consumer Protection. The audit set out to determine the effectiveness of the SCOR review program. Upon completion of the audit several key factors began to emerge (Rau, 2002).

• A time lag of up to 4 ¼ months exists between the date of the Call Report and the subsequent offsite review;
• The SCOR system depends on the accuracy and integrity of Call Report information to serve as an early warning between examinations;
• The SCOR system cannot assess management quality and internal control or capture risks from non-financial factors such as market conditions, fraud, or insider abuse; and
• DSC case managers rarely initiate follow-up action to address probable downgrades indentified by SCOR outside of deferring to a past, present, or future examination.

The SCOR review program is dependent on the management’s ability to accurately submit the Call Report data (Rau, 2002) The FDIC’s assesses management’s ability through onsite examination and because onsite examinations can take place up to 3 years apart, management review is left to the integrity of the reporting financial institution’s integrity. Some of the comments from examinations over management quality were (Rau, 2002):

• Board oversight and executive officer performance
• Management supervision is unsatisfactory, and senior management’s ability to correct deficiencies in a timely manner is questionable
• President and senior management engaged in new and high-risk activities without sufficient Board supervision, due diligence, and adequate policies.
• Board supervision of the bank’s subprime lending is inadequate.

In 2008, another audit report was conducted by Zamorski titled, FDIC’s Controls Over the CAMELS Rating Review Process. The audit report states that, “the purpose of conducting a risk management examination is to assess an institution’s overall financial condition, review management practices and policies, monitor adherence with banking laws and regulations, review internal control systems, identify risks, and uncover fraud or insider abuse.” After the OIG audit was conducted, they concluded that the Division of Supervision and Consumer Protection (DSC) should revise the Case Manager Procedures Manual in order to better track changes in the CAMELS ratings. These changes are necessary in providing a more accurate evaluation and rating of an institution’s financial condition and operations (Rau, 2008). The OIG also believes that the CAMELS review process is still viable for detecting at risk banks.

Although onsite CAMELS ratings are said to be reliable, the rate at which the rating deteriorates varies. The DSC has also stated that, “that the SCOR system cannot assess management quality and internal control or capture risks from non-financial factors such as market conditions, fraud, or insider abuse (Rua, 2002).” If the lack of quality in a bank’s management staff are the leading causes of bank failures, then how can we improve upon an early prediction model’s ability to ferret out such moral hazards? Barr, Seiford, and Siems (1994) believe that by using the data envelopment analysis (DEA) as an early prediction model the accuracy of prediction is significantly increased. DEA is a management quality metric designed to give early prediction models the missing M in the CAMEL rating system. The past results from an analysis of 930 banks conducted over a 5 year time frame validates the metric and confirms that the quality of management is crucial to a bank’s failure (Barr, Seiford, & Siems, 1994) The research also revealed that the statistical data relating to the management’s quality could be seen “up to three years prior to failure.”

Summary

Regulatory agencies conducting supervisory and regulatory oversight over the financial industry must continue to improve upon the processes involved in predicting bank failures. Evidence indicates that the quality of a bank’s management is a leading indicator in predicting bank failures. Onsite evaluations are more reliable due to having a more accurate assessment over a bank’s management. Although offsite evaluations are not as reliable as onsite evaluations, they provide a way for supervisory agencies to fill in the gap between onsite evaluations. Evidence also indicates that early prediction models using a method that includes management quality will offer higher rates of predictability. Further analysis on improving the detection of moral hazard is warranted and should be conducted in order to improve the overall quality of our banking system.

Upon completion of this case study, another six banks failed on July 16^th 2010, bringing the total of failed institutions to 96 for the year. Three of these bank failures were in Florida, a state that has been hit particularly hard when it comes to bank failures. The future of our financial industry maybe uncertain and reform may be the only option for many financial institutions on the government’s watch list.

References

Barr, R. S., Seiford, L. M., & Siems, T. F. (1994, Dec 1). Forecasting Bank Failure : A Non-Parametric Frontier Estimation Approach. Retrieved July 15, 2010, from SMU.edu: http://faculty.smu.edu/barr/pubs/bss-core.pdf

FDIC. (2010, July 9). Failed Bank List. Retrieved July 15, 2010, from FDIC.gov: http://www.fdic.gov/bank/individual/failed/banklist.html

Federal Reserve's Publication Committee. (2005, July 5). The Federal Reserve - Purposes & Functions. Retrieved July 15, 2010, from FederalReserve.gov: http://www.federalreserve.gov/pf/pdf/pf_complete.pdf

Lee, S. J., & Rose, J. D. (2010, May). Profits and Balance Sheet Developments at U.S. Commercial Banks in 2009. Retrieved July 15, 2010, from FederalReserve.gov: http://www.federalreserve.gov/pubs/bulletin/2010/pdf/bankprofits10.pdf

Malloy, M. P. (2003). Principles of Bank Regulation second edition. St. Paul, MN: West Group.

McIntyre, D. A. (2010, February 6). Bank Failures In 2010 May Hit 200, Up More Than 40%. Retrieved July 15, 2010, from 247wallst.com: http://247wallst.com/2010/02/06/bank-failures-in-2010-may-hit-200-up-over-40/

Office of Inspector General. (2009). Material Loss Review of IndyMac Bank, FSB (OIG-09-032) Audit Report. Washington, DC: Department of the Treasury.

Rau, R. A. (2008). FDIC's Controls Over the CAMELS Rating Review Process (Report No. AUD-08-014). Arlington, VA: Office of Inspector General - FDIC.

Rau, R. A. (2002). Statistical CAMELS Offsite Rating Review Program for FDIC-Supervised Banks. Washington, D.C.: Office of Inspector General - FDIC.

Scatigna, L. (2010, January 2). Financial Physician’s 2010 Forecast. Retrieved July 15, 2010, from thefinancialphysician.com: http://www.thefinancialphysician.com/blog/?p=1467

By: Joseph Dustin

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Some Things Never Change: BP's Unethical Business Practices

British Petroleum (BP) is no stranger to being in the news for unethical practices. With the most recent being the explosion of the Gulf Coast Rig, the Deepwater Horizon, that killed 11 people, injured many more and produced one of the largest oil spills in history that occurred in U.S. Waters (Adelson, 2010). If this incident was BP’s first than I would say this could have been an accident. However, this incident doesn’t come close to being the first and only shows us a devastating trend that places profits over the value of human life. In fact, BP’s unethical practices have claimed the lives of 38 employees ending just after March, 23, 2005 (CSB, 2007). One of the accidents happened five years ago, when the BP Texas Refinery exploded killing 15 and injuring 180 more. To better understand what is going on at BP we will take a look at the Texas Refinery Explosion and the ethical considerations that contributed to the problems that lead to the death of those 15 workers.

The BP Texas City Refinery Explosion

March 23, 2005, the BP Texas City Refinery (BPTCR) exploded causing 43,000 people in the surrounding area to remain indoors after being issued a shelter-in-place order. The explosion also killed 15 contractors and injured another 180 workers, which caused an additional estimated $1.5 billion in financial losses (CSB, 2007). The Final Investigation Report, issued by the U.S. Chemical Safety and Hazard Investigation Board (CSB), cites: “The Texas City disaster was caused by organizational and safety deficiencies at all levels of the BP Corporations (CSB, 2007).” The CSB, using investigation techniques that were similar to the techniques used by the Columbia Accident Investigation Board during their probe in the explosion of the space shuttle, found that warning signs of possible disaster were present for several years before the 2005 BPTCR explosion. The unethical decisions that were made to ignore the safety of BP’s employees and contractors, in order to shave costs and increase profits, lead OSHA to handout the largest penalty in the regulator’s history.

BP agreed to settle with OSHA, in what was then the highest penalty given, at $21 million (OSHA, 2009). The 2005 Settlement Agreement included:

Agree to pay $21 million in penalties.

A comprehensive evaluation of BPTCR’s Process Safety Management program by an independent auditor.

Implementation of all feasible recommendations of the auditor.

Required other abatement actions such as conducting audits and determining the adequacy of pressure relief for individual pieces of equipment.

April 24, 2006, BP’s Senior Group Vice President of Safety & Operations, John Mogford, gave a speech, about the Texas City incident, to express the lessons learned from the accident and to help others from enduring the same fate (Mogford, 2006). During the speech John stated that, “This was a preventable incident” and “It should be seen as a process failure, a cultural failure and a management failure.” John also addressed BP’s commitment to make sure that what happened at the Texas Refinery never happens again.

John Mogford’s speech says a lot about how BP is now newly energized and focused to ensure their past unethical convictions end and a new ethical chapter begins. However, will this new ethical commitment become a lasting one? Or, has the unethical behavior within BP been so deeply engrained into the company’s fabric that no amount of recommitment will ever change the foundation of BP?

Part of BP’s 2005 settlement was to resolve more than 300 separate alleged violations of OSHA regulations (Mogford, 2006). In 2006, John Magford’s speech reassures BP’s stakeholders that they are committed to resolving all safety issues. So, why in 2009, when all of the 300 separate alleged violations were to be complete, did OHSA find that BP failed to correct 270 previous citations and found 439 new violations (OSHA, 2009)? It seems John’s speech was nothing more than puffery and BP was still up to their old unethical habits. OHSA cited BP with another record breaking penalty totaling $87 million for their failure to abate.

Summary

With BP’s long history of unethical behavior, what will it take to ensure that this profit driven Oil Company follows not just the laws but the spirit of the law in order to prevent even more deaths from occurring? BP’s flagrant disregard to safety is unacceptable and those responsible should be held accountable for their actions. Criminal charges should be pressed for those who knew of any life threatening safety violations that resulted in the otherwise preventable death of an employee. In my opinion BP should be held accountable for murder and nothing short thereof. Those employed by BP, or any organization, has the right to go to work without fear that their working environment is unsafe and their lives are not put at risk because of greedy executives who thrive on profit mongering.

References

Adelson, B. (2010, April 29). Troubling Details Emerge About BP's Oil Rig Explosion and Spill. Retrieved June 1, 2010, from Whistleblower.org: http://www.whistleblower.org/blog/31-2010/534-troubling-details-emerge-about-bps-oil-platform-explosion

CSB. (2007, March). Investigation Report - Refinery Explosion and Fire. Retrieved June 1, 2010, from CSB.gov: http://www.csb.gov/assets/document/csbfinalreportbp.pdf

Mogford, J. (2006, April 24). The Texas City Refinery Explosion: The Lessons Learned. Retrieved June 1, 2010, from bp.com: http://www.bp.com/genericarticle.do?categoryId=98&contentId=7017238

OSHA. (2009). Fact Sheet on BP 2009 Monitoring Inspection. Retrieved June 1, 2010, from OSHA.gov: http://www.osha.gov/dep/bp/Fact_Sheet-BP_2009_Monitoring_Inspection.html


By: Joseph Dustin

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The Fall of British Petroleum’s Ethics

British Petroleum (BP), a global energy group based in London, is no stranger to environmental hazards. Over the last 20 years, dating back from the Exxon Valdez oil spill to the present day Gulf Coast oil spill that followed the explosion of an off-shore drilling site late last month, BP has found themselves in a number of unethical decisions that have caused a drop in their reputation. Companies are formed to turn profits for their stakeholders. However, we must ensure that unethical decisions do not hold back profits by damaging the company’s reputation. I will attempt to explain how unethical decisions can be linked to a company’s reputation and inevitably affect profits.

Down Hill Slide

In 2005, an independent research and rating company named Management & Excellence S.A. (S&E) was founded in Madrid in 2000. S&E released the 2005 results of their ethical study that covered ethics within some of the top oil companies in the world. The S&E ethical study was titled, “Ethics in the Oil Industry 2005” and upon it was BP at number three on the list. The only two oil companies ahead of BP were Royal Dutch Shell at number one and Exxon Mobil at number two. (Manage & Excellence, 2005) BP has displayed that they take ethics very seriously, at least enough to be recognized in the study. This will be our apex to the slippery slope in which the reputations of BP will start its decent.

Also, in 2005, BP faced its worst disaster to date when one of BP’s refineries located in Texas City, Texas, exploded killing 15 people and injuring another 180 individuals and forced thousands of nearby residents to take up shelter within their homes. (Mauer & Tinsley, 2010) An Investigation lead by the U.S. Chemical Safety and Hazard Investigation Board found, “organizational and safety deficiencies at all levels of the BP corporation.” British Petroleum pleaded guilty to felony acts that violated the Clean Air Act and was fined $50 million while only receiving a three year probation sentence. The Occupational Health and Safety Administration (OSHA) issued the largest fine in OSHA history, $87 million, to BP after conducting their investigation. (Mauer & Tinsley, 2010) OSHA discovered over 270 violations that had been previously cited but not fixed and 439 new violations. Ethical problems can be seen with the 270 violations that were ignored and not fixed by BP.

In 2006, BP pleads guilty to a federal misdemeanor that cost BP $20 million in criminal penalties due to an estimated 201,000 gallons of oil that leaked out into the Alaskan Tundra. The Anchorage Daily News stated, “Prosecutors said BP manager failed to heed “many red flags and warning signs” that key pipelines within the nation’s largest oil field were going bad.” (Loy, 2007) BP continues to show ethical problems by ignoring red flags and warning signs that could have stopped the leaks from occurring.

In 2007, BP faced increased problems concerning pollution at a refinery in Whiting, Indiana. British Petroleum uses this refinery to refine heavy crude oil from Canada and is the nation’s fourth largest refinery. (Verschoor, 2007) The refinery is also one of the largest polluters in the Midwest, and now with BP looking to expand the refinery, would release 54% more ammonia and 35% more “sludge” into Lake Michigan. (Verschoor, 2007) Ammonia allows for the growth of algae blooms that can kill fish and trigger beach closings and the sludge contains concentrated heavy metals like lead, nickel, and vanadium. How does BP get away with mixing toxic waste into Lake Michigan when this type of process BP uses is banned in Lake Michigan? Regulators gifted BP with the first ever exemption for the process of mixing waste with clean lake water 200ft offshore Lake Michigan. BP continues to create ethical problems in all forms of environmental issues. How did BP obtain the exemption and why didn’t they respect the laws already in place for the Lake?

After three years of unethical decisions being conducted by BP, we are starting to see a clear ethical drop in BP’s practices. Another report by M&E released in 2007 titled, “World’s Most Sustainable and Ethical Oil Companies 2007,” again positioned the top oil companies in the world from highest to lowest in Ethics using a 120 point evaluation process. (Management & Excellence, 2007) The 2007 report shows that BP has fallen to number four on the list. Shell, Petrobras, and Total hold the top three spots now. These reports coincide with the unethical behavior being conducted by BP. Furthermore, in 2008, BP had no major unethical environmental outbursts and the M&E report for 2008 placed BP at number three on the list.

Summary

With the recent Gulf Coast oil spill, BP’s ethical dilemmas are continuing to grow. As authorities try to uncover why the explosion happened and the events that lead up to it, I would bet that a whole new crop of unethical decisions made by BP will be seen. Some of the unethical issues to arise already are BP’s failure to admit that an accidental surface or subsurface oil spill would occur from the well in a report to the federal Minerals Management Service and BP never addressed how to address a spill at 5,000 feet or below. (CBS/AP, 2010) Common sense would tell you that you should address at a minimum how to stop an oil spill at new depths before drilling. Only time will tell what next years M&E ethical report will grade BP, but if I had to guess, I would say it’s going down a few spots.

References

CBS/AP. (2010, April 30). BP Didn't Plan for Major Oil spill. Retrieved May 10, 2010, from CBSNews.com: http://www.cbsnews.com/stories/2010/04/30/national/main6449241.shtml

Loy, W. (2007, October 26). BP Fined $20 million for pipeline corrosion. Retrieved May 10, 2010, from VicVickers.com: http://www.vicvickers.com/files/ADN-20071026-BP-Fine.pdf

Manage & Excellence. (2005, February 24). Studies and Rankings. Retrieved May 10, 2010, from Manage & Excellence: http://www.management-rating.com/index.php?lng=en&cmd=210

Management & Excellence. (2007, February 21). World's Most Sustainable and Ethical Oil Companies 2007. Retrieved May 10, 2010, from Management & Excellence: http://www.management-rating.com/archivo/Brochure%20Oil%20Study%202007l.pdf

Mauer, R., & Tinsley, A. M. (2010, May 10). BP has long history of legal, ethical violations. Retrieved May 10, 2010, from STLToday.com: http://www.stltoday.com/stltoday/news/stories.nsf/nation/story/8B253843F6E57DD58625771E00821C1C?OpenDocument

Verschoor, C. C. (2007, September). Is BP an Acronym for "Big Polluter"? Retrieved May 10, 2010, from imanet.org: http://www.imanet.org/pdf/09_07_ethics.pdf

By: Joseph Dustin

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Ethics Within the SEC During the Madoff Years

On 10 December 2008, the largest “Ponzi-scheme” started to unfold when Bernard L. Madoff reportedly admitted to “one or more employees of BMIS” that he was conducting a Ponzi-scheme and his liabilities estimated around $50 billion (SEC vs. Bernard L. Madoff, 2008). The next day the Securities and Exchange Commission (SEC) filed a complaint against Madoff and Bernard L. Madoff Investment Securities LLC (BMIS) to (a) halt ongoing fraudulent offerings of securities and investment advisory fraud by Madoff and BMIS, (b)expedite relief needed to halt the fraud and prevent the Defendants from unfairly distributing the remaining assets in an unfair and inequitable manner to employees, friend and relatives, at the expense of other customers, and (c) seek emergency relief, including temporary restraining orders and preliminary injunctions, and an order to impose asset freezes; appointing a receiver over BMIS; allowing expedited discovery and preventing the destruction of documents, and requiring the defendants to provide verified accountings (SEC vs. Bernard L. Madoff, 2008).

Prior to his Ponzi-scheme, Madoff’s managed funds were ranked highly in NASDAQ stocks, order flow in the New York Stock Exchange, and in other specialized securities (Ocrant, 2001). Erin Arvedlund, a Barron’s reporter, published an article on May 7, 2001, this article attempts to explain how Madoff delivers above average returns, 10% to 15%, using a secretive split-strike strategy (Arvedlund, 2001). Within the Barron’s article, Erin Arvedlund states, “What’s more, these private accounts have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.”

Madoff Investment Securities reportedly had $6-7 billion in assets that were funneled through him by three feeder funds (Ocrant, 2001). These feeder funds brought in new customers and established a steady stream of cash flow to allow the Ponzi-scheme to carry on for years. Madoff’s knowledge of the markets, regulatory gray area in the securities industry, and the lack of internal ethics within the SEC helped Madoff continue his operation for sixteen years.

The Regulatory Gray Zone

As Madoff conducted his Ponzi-scheme, where were the watchdogs that are supposed to protect investors from these types of fraudulent activities, and why didn’t they catch him? The SEC has the authority to investigate entities such as BMIS as well as Bernard Madoff himself. According to the SEC’s website,

“The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud (SEC, 2010).”

However, Madoff was not a registered broker-dealer or a registered investment advisor. The Investment Advisers Act of 1940 and its amendment in 1996, under section 203 titled Registration of Investment Advisers, describes exceptions to those who do not have to register with the SEC. For example, subsection (3) states any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act (SEC, 2009).

The exceptions within the Investment Advisers Act and other similar exceptions help formulate a “gray area” that allows people like Madoff to fly under the radar. Staying under this “radar” would mean finding the loopholes in each regulatory agency’s rules and it seems Bernard Madoff was just the man for the job.

Madoff was a prominent member in the securities industry throughout his career. The National Association of Securities Dealers (NASD) knew Madoff as their vice chairman for a period of time, a member of NASD board of governors, and as chairman of its New York region. The NASDAQ Stock Market knew Madoff as a member of the board of governors and executive committee while serving as chairman of its trading committee (SEC, 2008).

Because of his affiliation with each agency that works with the securities industry Madoff was in the position to fully comprehend the ins-and-out of the system and if anyone could find a loophole, it was Madoff. Madoff would use his “Industry Stature” to intimidate examiners and investigators during the 16 years that the SEC complaints started coming in. For example, one examiner from the SEC’s Northeast Regional Office (NERO) characterized Madoff as “a wonderful storyteller” and “very captivating speaker” and noted that he had “an incredible background of knowledge in the industry (Kotz, 2009).” Another NERO examiner, from the same report, recalls that Madoff would become angry during examinations and then Madoff’s “veins were popping out of his neck” and he was repeatedly saying, “What are you looking for? . . . . Front running. Aren’t you looking for front running, “and “his voice level got increasingly loud.”

Madoff may have known the security industry better than the SEC’s teams that investigated him, but did this give the SEC a reason not to catch Madoff’s Ponzi-scheme? Even though Madoff hid his activities behind the gray areas of the security industry, evidence points to other reasons for the SEC’s failure to catch Madoff.

SEC’s failure to catch Madoff

After Bernard Madoff confessed to his multi-billion dollar Ponzi-scheme an investigation conducted by the Office of Inspector General (OIG); the OIG findings are detailed in a report titled, “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme.” Lead by Inspector General H. David Kotz, the investigation details that the SEC received eight separate complaints between June 1992 and December 2008. Three of the complaints were from the same source and the first two versions were dismissed entirely (Kotz, 2009). The report also makes known that the SEC was fully aware of the two articles regarding Madoff’s questionable returns. If the SEC had received complaints and knew about the two articles then why didn’t the SEC catch Madoff?

During the sixteen year time span that the SEC received complaints concerning Madoff and BMIS, the SEC conducted three examinations and two investigations into his advisory business based on the complaints that Madoff was possibly misrepresenting his trading and could be operating a Ponzi-scheme. The OIG report states that the most critical step in examining or investigating a potential Ponzi-scheme is to verify the subject’s trading through an independent third party,” and “Yet, at no time did the SEC ever verify Madoff’s trading through an independent third-party, and in fact, never actually conducted a Ponzi scheme examination or investigation of Madoff (Kotz, 2009).”

The first opportunity that the SEC had to catch Madoff’s Ponzi-scheme was in 1992, sixteen years before Madoff confessed. A complaint lead the investigation team to door steps of Avellino & Bienes, an unregistered investment firm providing its customers with 100% safe investments. Although, the focus of this examination was to discover if Avellino & Bienes was operating as an unregistered investment firm, the SEC’s lead examiner states that, “Madoff’s reputation as a broker-dealer may have influenced the inexperienced team not to inquire into Madoff’s operations (Kotz, 2009).” Madoff would rinse and repeat this strategy within all investigations and examinations that were conducted.

The SEC’s blunders into all investigations concerning Madoff and his associates could be considered gross neglect. The interworking of the SEC seems to be missing something that would help them perform their duties better. Maybe that specific piece of the puzzle is ethical values.

Ethics within the SEC

The SEC made many mistakes during the Madoff investigations. Were these mistakes related to internal ethical decisions on the part of the SEC? One way to find out if the SEC’s mistakes were due to internal ethical decisions is to look into the decision history during the Madoff investigations.

Over the years the SEC has established a number of ethics changes in its rulemaking. One ethical change was the SEC’s Final Rule for implementing section 406 and 407 of the Sarbanes-Oxley Act of 2002 (Haynes and Boone, LLP, 2003). Also, a Final Rule, titled Investment Adviser Codes of Ethics, adds new amendments to the Investment Advisers Act of 1940, and requires registered advisers to adopt codes of ethics (SEC, 2004). As we can see the SEC is aware of the need for companies to implement a code of ethics.

The SEC faced many ethical situations during the Madoff investigations; the ethical situations that were prevalent within the SEC, during the time of the investigations, seemed to affect the core decisions that were being made within the SEC. As stated earlier the SEC’s main goal is maintaining fair dealing, and protecting against fraud, with this in mind unethical decisions would entail any decision that fails to align with that mission statement. The OIG report contains a number of decisions, made by the SEC, that failed to align with their mission statement, to name a few: (a) failure on behalf of the SEC to perform due diligence when conducting investigations; (b) the SEC failed to prevent conflict of interests; (c) the lack of internal controls and standardization for conducting investigations; (d) absence of “Tone-at-the-Top;” and (e) the SEC’s lack of formal training for investigators (Kotz, 2009).

The future of the SEC will rest in the ability to perform better investigation and examinations. David Kotz outlines several recommendations, for the SEC, that will improve investigations in the future. Among the recommendations are better training to investigators, better internal controls, and mandating better control over how to handle tips, and arranging more qualified investigation teams (Kotz, Testimony Before the U.S. Senate Committee on Banking,Housing and Urban Affairs, 2009).

Summary

Bernard Madoff may have been a great manipulator and master of the security industry, the fact still remains, the SEC should have caught on to the Ponzi-scheme years before he confessed. The SEC had more than enough complaints, from reputable sources that pointed out many red flags. A total of three examinations and two investigations failed to catch Madoff’s Ponzi-scheme. The SEC displayed unethical decisions throughout all inquiries conducted within Madoff’s businesses. Now that the SEC has the hindsight into what when wrong, it’s up to the SEC to fix their internal issue.

In the end, the lives of the people that invested with Madoff and his feeder funds were forever changed. Pointing the finger at this point in time may give some relief to those who seek justice but does nothing to change the outcome to what has already taken place. We, as society, must push to become a more proactive nation that seeks due diligence and higher ethical values for everyone. Forcing companies to setup ethics policies and perform due diligence will not stop people from unethical behavior or making poor decisions. I believe we must find away to instill not just the letter of the law into society but the spirit in which the law was created. My moving beyond compliance, I believe, society will suffer far less instances of fraud by eliminating gray areas that laws fail to address.

References

Arvedlund, E. (2001, May 7). Don't Ask, Don't Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum'. Barron .

Haynes and Boone, LLP. (2003, January 24). SEC Adopts Code of Ethics Disclosure Rules. Retrieved April 18, 2010, from HG.org: http://www.hg.org/articles/article_182.html

Kotz, H. D. (2009). Investigation of Failure of the SEC to Uncover Bernard Madoff's Ponzi Scheme. Office of Inspector General (SEC).

Kotz, H. D. (2009, September 10). Testimony Before the U.S. Senate Committee on Banking,Housing and Urban Affairs. Retrieved April 20, 2010, from SEC.gov: http://www.sec.gov/news/testimony/2009/ts091009hdk.htm

Ocrant, M. (2001, May). Madoff tops charts; skeptics ask how. MAR/Hedge No. 89 , pp. 1-5.

SEC. (2004, July 4). Investment Adviser Codes of Ethics. Retrieved April 18, 2010, from SEC.gov: http://www.sec.gov/rules/final/ia-2256.htm

SEC. (2009, October 13). INVESTMENT ADVISERS ACT OF 1940 [AS AMENDED THROUGH P.L. 111-72].

SEC. (2008, December 11). SEC Charges Bernard L. Madoff for Multi-Billion Dollar Ponzi Scheme. Retrieved April 19, 2010, from SEC.gov: http://www.sec.gov/news/press/2008/2008-293.htm

SEC vs. Bernard L. Madoff, 08 CIV 10791 (U. S District Court Southern District of New York December 11, 2008).

SEC. (2010, January 20). What We Do. Retrieved April 19, 2010, from SEC.gov: http://www.sec.gov/about/whatwedo.shtml

By: Joseph Dustin

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