Ethics and BP: Corporate Governance - Part 1

As an investor, it is important to understand the type of Corporate Governance framework established within the corporation before handing over your hard earned saving to the family broker. Corporate Governance, in its simplest form, can be described as the relationship between shareholders and management. When Corporate Governance goes bad, this relationship spoils and all stakeholders can be hurt in the process. For example, BP America (BP) has taken a massive reputational hit due to the April 20th explosion of the deep sea drilling platform, Deepwater Horizon, which killed 11 employees while spilling untold amounts of oil into the Gulf of Mexico (Casselman, 2010). Investigations into the explosions may not be finalized at the moment, however, we can take a look at this event and similar past incidents to reveal a pattern that can lead a prudent person to wonder if BP’s Corporate Governance is effective enough to mitigate risks and prevent other disasters from occurring in the future.

Introducing a new model for board effectiveness, Leblanc and Gillies (2003) established a model that attempts to measure the effectiveness of the Board of Directors. Their research points out that the majority of previous works use the “board structure” approach to corporate governance reform. What this correlates to is that board effectiveness is measured based off the corporation’s board structure. Leblanc and Gillies’ model indicates that the most important element is “board process,” which is the ability of Boards to come together and make decisions, and not “board structure,” which many are currently using for reform. The underlying foundation of the model has two types of effectiveness built into it: Board Effectiveness (BE) and Director Effectiveness (DE). I will attempt to use the model proposed by Leblanc and Gillies to further analyze BP America and their Corporate Governance Framework.

Board Effectiveness

To achieve board effectiveness, within the framework of this model, three elements are required: (i) board structure (BS), (ii) board membership (BM), and (iii) board process (BPr) (this was shortened to BP in the actual model; however BP is the corporation in this writing). Each element should be measured then added together to form a final tally showing the overall board effectiveness.

Board Structure

There are three separate items to consider when analyzing “board structure:” (i) leadership, (ii) composition, and (iii) size. With board structure being the basis for many debates concerning board effectiveness, it is important to understand what makes a board effective.

Leadership

Leadership is described as having either a non executive chair or the same person occupies the posts of Chairman of the Board (COB) and Chief Executive Officer (CEO), or what is known as CEO and COB Duality. Concerns over the effectiveness of CEO duality and its ability to create change within the firm are seen within two separate theories: agency theory and stewardship theory (Dickins, 2010).

Dickins (2010) describes agency theory as “emphasiz[ing] the importance of monitoring manageragents who seek to maximize their personal utility by maximizing their pay, or reducing their workload (shrinking).” Within the confines of agency theory the separation of CEO from the COB allow for better monitoring which decreases management’s ability to act in their own interests over that of shareholders.

Stewardship theory “emphasizes accountability and the importance of minimizing information-sharing costs.” This theory merges the two roles to make it easier to assign responsibility and minimizes the cost of sharing information.

Both, Leblanc and Gillies (2003) and Dicken (2010), suggest that there is inconsistent evidence to indicate which of the two theories are most effective. So, which theory does BP fall into? At a glance one could easily say that BP falls into the first theory, agency theory. A conclusion of this sort would be derived from the appearance of having both a CEO, Tony Hayward and a COB, Carl-Henric Svenberg. This separation of duty would allow for an increase of oversight of management by the COB.

However, upon further inspection of BP’s Corporate Governance framework we see evidence that the COB relinquishes his duty as the “overseer of management” to the CEO. BP’s Board Governance Principals state, “The Board believes that the governance of BP is best achieved by the delegation of its authority for the executive management of BP to the Group Chief Executive (GCE) subject to defined limits and monitoring by the Board (BP p.l.c.).” Using what looks to be a hybrid of theories it appears that BP has the best of both worlds; the appearance of agency theory by having both a CEO and COB but with governance being created by the CEO which is a concept of stewardship theory.

Composition and Size

Composition can be seen as the number of outside directors vs. the number of insider directors that make up the board members. According to Leblanc and Gillies (2003) the greatest concern associated with board structure has been the “independence” of directors. They further conclude that the evidence linking board structure and independence shows that 20 years of research find little evidence to its effectiveness. This does not mean that board independence is ineffective; it just means we need to develop more efficient tools to track the effectiveness of board structures. BP’s board composition can be seen in section 3.4 of BP’s Board Governance Principles (BP p.l.c.), Composition, Size, Independence and Tenure. BP maintains, “Over half of the directors, excluding the Chairman, will comprise Non-Executive directors who are determined by the Board to be independent in character and judgment and free from any business or other relationship which could materially interfere with the exercise of their judgment.” Non executive directors will occupy over half of the board seats which will not normally exceed sixteen. With the board holding sixteen seats, “Size,” should not create an issue.

Board Membership

Board membership analyzes the processes that determine how a corporation recruits its members for their board. According to Leblanc and Gillies (2003), “[b]oard membership includes the full panoply and balancing of all director competencies in matching the strategic needs of the company.” The board members need to be balanced in order to be effective as a group. BP’s board members are expected to have:

(a) Experience in dealing with strategic issues and long-term perspectives;

(b) Leadership experience, a supervisor knowledge of business principles and capacity for independent thought;

(c) An ability to participate constructively in deliberations; and

(d) A willingness to exercise authority in a collective manner.

The Nomination committee will oversee the mix of skills required for board members and make the appropriate recommendations (BP p.l.c.).

Board Process

The day-to-day operations of a corporation are carried out by management. As management styles differ from corporation to corporation and on an individual basis, a framework needs to exist to ensure management acts with the corporation’s best interests in mind. The unethical acts of management can be detrimental to the corporation and their stakeholders, which bring up the issue, as to, what are the corporation’s obligations to its stakeholders? Can we truly determine if a corporation is acting in an ethical manner?

A study, conducted by Management & Excellence (2008), lists BP as number three of the world’s most sustainable and ethical oil companies of 2008. The criteria for rating each oil company looks to be based substantially off board structure and the policies & procedures governing the corporation. However, the ratings do not take into account the ethical actions taken by the management team. How the Board of Directors oversees these ethical actions and creates corporate strategies for management to carryout is the basis of board process.

Board of Directors and Board Process

The ability of the Board of Directors to oversee management is a key goal in corporate governance. Shareholders rely on this oversight to ensure management acts appropriately. According to Vallabhaneni (2008), the Board of Directors is responsible for setting ethical standards as well as overseeing their compliance. Each board may look at corporate governance differently and have separate business views on how to govern.

One newly emerging business view that is on the rise is taking place globally. This view incorporates a set of core values that include: human rights; environmental protection; anti-corruption measures; board oversight; relationships with management, and accountability to share-owners (UN Global Compact, 2009). Central to this view, in accomplishing these objectives, is the Board of Directors that governs corporations. Two leading initiatives are trying to change the way we think about boards and their responsibilities. These two initiatives are the Organisation for Economic Co-Operation and Development’s (OECD) Principles of Corporate Governance and the United Nations Global Compact (global framework). The underlying framework, of these two emerging think-tanks, build upon research that shows responsible corporate governance creates a business ethos and environment capable of building integrity and trust within society and to share-owners. Focusing on board responsibilities, the global framework includes three fundamental strategies for boards and their directors: (i) Protecting Stakeholder rights and interests; (ii) Managing Risk; and (iii) Creating long-term business value.

As directors, fiduciary duties are imposed “on them to act in good faith, with reasonable care, and in the best interest of the corporation and its shareholders (Senate, 2002).” An investigative committee for the U.S. Senate (2002) named three broad fiduciary duties that corporate directors operate under: obedience, loyalty, and due care. Operating under this umbrella of trust, the board must balance their delegation of power with the right about of oversight.

By: Joseph Dustin

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Ethics and BP: Corporate Governance - Part 2

Delegation of Duty

For boards to effectively carryout these strategies they must delegate to the CEO, who in turn delegates to other senior management the authority to manage the day-to-day affairs of the corporation. Although the board delegates authority to oversee the day-to-day operations, the board is still responsible for monitoring of management on behalf of the shareholders (Vallabhaneni, 2008).

According to Vallabhaneni (2008), senior management is charged with the following tasks: (i) Operating the Corporation; (ii) Strategic Planning; (iii) Annual Operating Plans and Budgets; (iv) Selecting Qualified Management and Establishing an Effective Organizational Structure; (v) Identifying and Managing Risk; and (vi) Accurate and Transparent Financial Reporting and Disclosures. BP has policies in place that meet these tasks; making a better corporate governance program. BP’s policy matching Vallabhaneni’s tasks were taken from BP’s Board Governance Principles and Annual Report and Accounts 2009 as shown below (BP p.l.c.) (Svanberg, 2009).

(a) Operating the Corporation - The Board delegates its authority for the executive management of BP to the Group Chief Executive subject to the defined limits and monitoring by the Board and all GCE actions must be carried out and practiced in a professional and ethical manner;

(b) Strategic Planning - The GCE is authorized to establish any policy, make any decision, enter into any obligation, take any action and develop any activity that will achieve the BP Goal and which is within a reasonable interpretation of the Executive Limitations;

(c) Annual Operating Plans and Budgets - The GCE will propose for Board consideration, the GCE’s Strategy for achieving the BP Goal. Annually the GCE will propose the Plan together with specific results to be achieved during the financial year in pursuit of the BP Goal;

(d) Selecting Qualified Management and Establishing an Effective Organizational Structure - Not directly addressed within BP’s Board Governance Principles;

(e) Identifying and Managing Risk - The GCE will not cause or permit BP to operate without a comprehensive system of controls that manages the risks to protect BP’s assets;

(f) Accurate and Transparent Financial Reporting and Disclosures - The GCE will not cause or permit BP to operate in a manner which would or would be likely, to result in BP becoming financially distressed.

Occupational Fraud

Finding effectiveness in the boardroom has emerged as a popular topic after the financial collapse of, once highly regarded, corporations like those of Enron, Tyco and Adelphia. Finding effectiveness may sound like an easy task to accomplish, however, in today’s complex corporations there are far too many variables to identify, monitor, and measure when assessing effectiveness. Carolyn Iglesias (2008) states, “The absence of a universal model for effective board governance creates a significant challenge, and companies often find it difficult to know where to start.” Michael Ross (2008) makes note that effective directors are those who take their fraud-detection responsibility seriously and focus on fraud’s telltale “red flags.” DiNapoli describes “red flags” as, “a set of circumstances that are unusual in nature or vary from the normal activity.” Directors should not solely focus on the identification of red flags, they should focus on identifing “effective red flags.” Thus, improving the effectiveness of red flags should lead to a more effective boardroom.

The Association of Certified Fraud Examiners (ACFE) defines Occupational Fraud as, “The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” Preventing Occupational Fraud can save organizations a substantial amount of revenue; an estimated 5% of an organizations’ annual revenue is lost to fraud in a given year. The median loss across all fraud schemes were reported to be $160,000, one-third reported a loss of more than $500,000 and one-quarter reported losses of $1,000,000 or more (ACFE, 2010). Organizations engaging in fraudulent activities often suffer from long-term consequences. An analysis of U.S. Public Companies, conducted by the Committee of Sponsoring Organization of the Treadway Commission (COSO) indicates corporate fraud often leads to bankruptcy, delisting from a stock exchange, and an average initial drop of 16.7 percent in stock prices after an alleged fraud makes it to the press. Of course this is not a complete list of the consequences of fraudulent activities; only a small sample is necessary to recognize the devastation that fraud can have on an organization (COSO, 2010).

Cressey’s Fraud Triangle

Corporations looking to mitigate the damages caused by fraudulent activities must first understand the psychology of fraudsters. The importance in identifying the motives of criminals committing these fraudulent acts is in the ability to devise initiatives to prevent, deter, or stop occupational fraud from occurring. While working on his PH.D in criminology at Indiana University, Donald Cressey’s hypothesis became, what is now known as, the Fraud Triangle. Dr. Cressey’s Fraud Triangle highlights three elements that must be present in order for fraud to occur: Opportunity, Incentive (Pressure), and Rationalization (Wells, 2008).

The first element of the fraud triangle is opportunity, which occurs when an individual has the ability to commit a fraudulent activity. According to Joseph T. Wells (2008), opportunity can be broken down into two separate parts: general information and technical skill. General information is, knowing that a fraud can be carried out and technical skill is the ability to execute the fraud. The second element, Incentive (Pressure), can occur when an individual: (i) feels pressure to keep a certain social status, (ii) feels pressure to keep up with peers at work, or (iii) incur a financial burden that must be alleviated. The third element, Rationalization, is the justification of the crime that the perpetrator wishes to attempt. The fraudster might feel like their employer owes them something, justifying their position as not being a criminal. If we can eliminate any one of these three elements, theoretically we will stop the fraud from occurring.

Effectiveness of Red Flags

According to the ACFE (2010), the top four effective detection methods for identifying fraud schemes are: Tip, Internal Audit, Management Review, and Account Reconciliation. Notice the absence of External Audits from the ACFE list; external audits are important, but they should not be relied upon exclusively for fraud detection (ACFE, 2010). If we are not to rely on external sources for fraud detection, it becomes important that management and employee receive red flag training to better understand the red flags in their area of expertise.

Most red flags dealing with fraudulent activity are categorized as employee or management red flags. Employees commit fraud on a more frequent basis (41.2%), however fraud conducted by management was three times as costly ($218,000) then those perpetrated by employees (DiNapoli, 2010).

Red flags should be built around all three elements of the fraud triangle. Risk assessments should be conducted to establish areas of high risk for fraud. Once these “opportunities” are identified you can start building roles that identify those with the technical ability or in trusted positions to perpetrate the fraud scheme. These roles can then be monitored for behavioral red flags indicating an elevated rate for fraudulent activities to occur. The effectiveness of red flags depends upon the effectiveness of those who identify, monitor, and measure red flags.

By: Joseph Dustin

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read more “Ethics and BP: Corporate Governance - Part 2”

Ethics and BP: Corporate Governance - Part 3

Summary

BP looks to have all three elements of an effective board structure in place. They have incorporated or addressed leadership, composition, and size. If board structure acts as the lever that controls the firm’s effectiveness, then it looks like the lever is turned on. So, why does BP effectiveness not flow when the board structure is fully operational? I believe this suggest that the model described by Leblanc and Gillies might take us closer into measuring the effectiveness of Corporate Governance, which identifies board process as the key element of good governance; not board structure.

As you can see, on paper, it looks like BP addressed the management team’s responsibilities in their corporate governance program. It is this same program that is being rated by Management & Excellence and ranked accordingly as shown on the list. With BP raked number three on the list; one might want to know, what is it about BP’s ethics that they achieve the third highest ranking in the world’s most ethical oil companies? I believe BP’s ethics were based solely on board structure and policies. If the rating were based on management actions then we would have a new raking, as ethics should be based on the “verbs” that management take in the day-to-day operations of the company; not the policies.

As far as actions go, Olsen (2005) points to BP having more fatalities than any other oil company. BP continues to accumulate an even higher death rate, which includes the 11 deaths in the resent April 20, 2010 explosion of the Deepwater Horizon (Casselman, 2010). Considering just the death toll of BP and not disaster like the Texas Refinery explostion, pipeline leaks, illegal duming, and the Gulf Coast oil leak, we start to see something out of place. How many ethical points did BP lose per death? Or, do deaths not count in the ethical rating system. I think the rating system has it wrong as ethics can not be measured by looking at the policy and procedures alone. We must incorporate the “Verbs” of the corporation and how they act upon their day-to-day activities to guage ethical behavior.

Effective boardrooms need to be able to detect fraud and misdeeds within their organization. To accomplish this, directors need to ensure they have internal controls that monitor, detect, and measure the effectiveness of red flags. Employees and management must be properly trained to identify red flags within the scope of their job functions. Properly trained employees and management should be able to spot red flags sooner; leading to a reduction in cost per incident for fraudulent activities within the organization.

Creating an effective board, by utilizing Leblanc and Gillies’ (2003) model, can strengthen the overall sustainability of an organization. Effective boards have to understand the ethical risks, red flags, and internal controls within their organization. As failure to do so, often leads to a road, no one wishes to go down.

References

ACFE. (2010). Report to the Nations on Occupational Fraud and Abuse. Austin, TX: ACFE.

BP p.l.c. (n.d.). BP p.l.c. Board Governance Principles. Retrieved September 20, 2010, from bp.com: http://www.bp.com/liveassets/bp_internet/globalbp/STAGING/global_assets/downloads/B/bp_board_governance_principles.pdf
Casselman, B. (2010, September 11). Rig Workers Had Chance to Prevent Explosion. Retrieved September 23, 2010, from Wall Street Journal: http://online.wsj.com/article/SB10001424052748704505804575484053238831866.html?mod=WSJ_hpp_LEFTWhatsNewsCollection

COSO. (2010). An Analysis of U.S. Public Companies. Retrieved October 5, 2010, from COSO.org: http://www.coso.org/documents/COSOFRAUDSTUDY2010.pdf

Dickins, D. (2010, Jul/Aug). CEO AND COB DUALITY: DOES IT MATTER? Internal Auditing. Boston: Jul/Aug 2010. Vol. 25, Iss. 4 , pp. pg. 35, 4 pgs.

DiNapoli, T. P. (2010). Red Flags for Fraud. New York: State of New York Office of the State Comptroller.

Iglesias, C. (2008, May). Finding Effectiveness in the Boardroom. Retrieved October 7, 2010, from Deloitte.com: http://www.deloitte.com/view/en_US/us/Services/audit-enterprise-risk-services/governance-regulatory-risk-strategies/Governance-Services/3459835011011210VgnVCM100000ba42f00aRCRD.htm

Leblanc, R., & Gillies, J. (2003). The Coming Revolution in Corporate Governance. Ivey Business Journal .

Management & Excellence. (2008). World's Most Sustainable and Ethical Oil Companies 2008. Management & Excellence.

OLSEN, L. (2005, May 15). BP leads nation in refinery fatalities. Retrieved Oct 1, 2010, from chron.com: http://www.chron.com/disp/story.mpl/special/05/blast/3182510.html

Ross, M. (2008, April 1). Fraud's Red Flags. Retrieved October 5, 2010, from Directorship.com: http://www.directorship.com/frauds-red-flags/

Senate, P. S. (2002). Report 107-70 The Role of The Board of Directors in Enron's Collapse. FindLaw.com.

Svanberg, C.-H. (2009). BP Annual Report and Accounts 2009. BP.

UN Global Compact. (2009). Corporate Governance - The Foundation for Corporate Citizenship and Sustainable Businesses. Retrieved Oct 1, 2010, from unglobalcompact.org: http://www.unglobalcompact.org/docs/issues_doc/Corporate_Governance/Corporate_Governance_IFC_UNGC.pdf

Vallabhaneni, S. R. (2008). Corporate Management, Governance, and Ethics Best Practices. Hoboken, New Jersey: Wiley & Sons, Inc.

Wells, J. T. (2008). Principles of Fraud Examination 2nd edition. Hoboken, New Jersey: John Wiley & Sons, Inc.


By: Joseph Dustin

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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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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

read more “Some Things Never Change: BP's Unethical Business Practices”

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

read more “The Fall of British Petroleum’s Ethics”

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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The U.S. Financial Meltdowns: Then and Now

Bank Failures created in the 1930’s

Banks during the 1930s were vastly embarking into an unforeseen calamity; causation leading to the bank failures is still open to interpretation. At the turn of the 20th century, banks began to “boom.” The next two decades saw an increase in the numbers of banks that peaked in 1921 with roughly 31,000 banks in operation (Walter, 2005). So, what caused the catastrophic ripples, throughout the banking industry, that ended with the onset of the Great Depression?

Did the Bank of the United States (BUS) lead to the economic downswing during the early 1930s; thus becoming the catastrophic ripple? BUS, prior to its failure in December, 1930, was the twenty-eight largest commercial bank in the country (Trescott, 1992). To better understand the causation of bank failures during the 1930s, I will explore previous literature that attempt to scrutinize the Bank of the United States.

Milton Friedman and Anna J. Schwartz’s research, A Monetary History of the United States, has been said to be “the leading and most persuasive explanation of the worst economic disaster in American history,” by Ben S. Bernanke (Bernanke, 2002). Friedman and Schwartz’s research advocates that bank failures, during the “Great Contraction of 1929-33,” arise from monetary issues and view bank failures as a result of unwarranted “panic” and that failing banks were in large measure illiquid rather than insolvent (Calomiris, 2007). Others, including Paul B. Trescott, “argue that the bank’s closing was a response to actual and threatened insolvency, not illiquidity (Trescott, 1992).”

It is important to understand if banks at the time were failing due to becoming illiquid or insolvent. If banks, during the Great Contraction, were illiquid at the time then one could be lead to believe that contagion and/or bank runs might be at fault. On the contrary, if banks at the time were insolvent then we might need to look into other reasons as to why banks were failing.

One could easily come to the conclusion that banks, during the Great Contraction, were indeed illiquid. This conclusion could be explained through the creation of the Federal Deposit Insurance Corporation (FDIC). The creation of the FDIC in 1934 and the simultaneous halt of bank failures are both valid points that insinuate strong evidence that contagion may have played a factor. The FDIC insured deposits to prevent unfounded bank failures caused by contagion (Walter, 2005). The creation of the FDIC may have calmed the ripples moving throughout the banking industry, but could there be any other reason besides contagion that stopped the ripples?

There are a few explanations that might lead us to believe that the FDIC’s halt of bank failures was not caused by contagion. First, deposit insurance augmented the profits of risky banks, protecting them from failure. Second, the creation of deposit insurance undercut a market process that caused supervisors to close troubled banks quickly (Walter, 2005). So, if contagion was not a factor then maybe banks were not illiquid but rather insolvent.

Paul B. Trescott, professor of economics at Southern Illinois University, states that BUS was fairly liquid in the few months prior to its close in December, 1930. Trescott, also elaborates on the Bank of United State’s management strategy. These three elements are expansion through mergers and bank purchases, involvement with a series of securities affiliates and a syndicate for stock trading, and extensively investing in real estate development projects (Trescott, 1992). BUS was heavily into real estate lending, as were other banks in the New York area, but the loans lacked the usual safeguards relating to borrowers’ equity and collateral. Combine the risky lending with the heavy investing in BUS stocks and you have a recipe for disaster. The FDIC insurance allowed banks, which might have operated like the Bank of United States, to gain significant profits in subsidy by allowing them to take more risks. In this case the FDIC ended bank failures by providing insolvent banks a way to stay afloat. In either case, banks being illiquid or insolvent, the creation of the FDIC terminated bank failures during the Great Contraction.

Bank Failures during the Financial Crisis of 2007

During the 1980s the United States was going through a Savings & Loans (S&L) Crisis. The S&L crisis, brought on by years of deregulation and moral hazard (Degen, 2009), was bringing down the public’s confidence in the thrifts markets. Runs began to hit the S&L industry as values started to drop. Much like the FDIC, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), in an effort to restore confidence, this time in the thrift industry.

The purpose of FIRREA, as set forth in Section 101 of the bill, was to promote a safe and stable system of affordable housing finance; improve supervision; establish a general oversight by the Treasury Department over the director of the Office of Thrift Supervision; establish an independent insurance agency to provide deposit insurance for savers; place the Federal Deposit Insurance System on sound financial footing; create the Resolution Trust Corporation; provide the necessary private and public financing to resolve failed institutions in an expeditious manner; and improve supervision, enhance enforcement powers, and increase criminal and civil penalties for crimes of fraud against financial institutions and their depositors (Law Brain, 2010).

FIRREA gives the FDIC the duty of insuring the deposits of savings associations as well as banks. In addition, FIRREA created a separate fund under the management of the FDIC called the FSLIC Resolution Fund. The FSLIC Resolution Fund generally assumed all of the "assets and liabilities" of FSLIC as of the day before its abolition (Moss, Randolph D., 1998).

Did the creation of FIRREA settle the S&L industry by providing these institutes with relief from contagion or did it allow for more risky behavior? The next two decades are again cast with troubles. First, with the “dot com” bust in the 1990s, then the housing bubble bursting in 2006, and followed by the “shadow banking” industry in 2008. This rapid growth followed by rapid burst is starting to become the norm within our economy. A norm, if left unchecked, could devastate the United States.

Summery

The FDIC and FIRREA were two pieces of legislation that were created out crisis. We may not all agree as to the exact causes of the crisis but we can agree that something needed to be done. Determining if the banking industry was illiquid or insolvent during these crises may be hard to discover and I believe that both played their part. As legislators rush to fix one part of our broken financial system the industry will leap to invest in another profiteering idea until it bursts. This herd mentality, which the financial industry’s management must refrain from, is the only way to slow down the crises. As long as the banking industry is allowed to take risks, speculate values, and use loopholes, we should all prepare ourselves for another bailout.

References

Bernanke, B. S. (2002, November 8). On Milton Friedman's Ninetieth Birthday. Retrieved April 5, 2010, from Federal Reserve: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm

Calomiris, C. W. (2007). Bank Failures in Theory and History: The Great Depression and Other "Contagious" Events.

Cecchetti, S. G. (2008). Monetary Policy and the Financial Crisis of 2007-2008.

Degen, R. J. (2009). Moral hazard and the financial crisis of 2007-9: An Explanation for why the subprime mortgage defaults and the housing market collapse produced a financial crisis that was more severe then any previous crashes (with exception of the Great Depression of 1929). Glob Advantage.

Law Brain. (2010, March 16). Savings and Loan Association. Retrieved April 6, 2010, from Law Brain: http://lawbrain.com/wiki/Savings_And_Loan_Association

Moss, Randolph D. (1998, July 22). APPROPRIATE SOURCE FOR PAYMENT OF JUDGMENTS AND SETTLEMENTS IN UNITED STATES v. WINSTAR CORP. AND RELATED CASES. Retrieved April 6, 2010, from Justice.gov: http://www.justice.gov/olc/winstarfinal.htm

Trescott, P. B. (1992). The Failure of the Bank of United States, 1930. Journal of Money, Credit, and Banking, Vol. 24, No. 3 (August 1992) , 384-399.

Walter, J. R. (2005). Depression-Era Bank Failures: The Great Contagion or the Great Shakeout? Federal Reserve Bank of Richmond Economic Quarterly Volume 91/1 Winter 2005 , pp. 39-54.

By: Joseph Dustin

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