The Truth About Business

Ethics and BP: Corporate Governance - Part 1

2010-10-20T16:25:00.001-05:00

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

2010-10-20T16:07:00.001-05:00

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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Ethics and BP: Corporate Governance - Part 3

2010-10-20T16:03:00.001-05:00

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

2010-10-01T12:34:00.003-05:00

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

Violations of Reg O & the Federal Sentencing Guidelines

2010-08-13T13:30:00.003-05:00

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

Supervisory Powers over Financial Institutions

2010-08-13T13:14:00.005-05:00

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

The Benefits of the FFIEC and CSBS

2010-08-13T13:08:00.001-05:00

The United State’s banking system is a highly complex banking system. To help regulate these financial institutions, six primary regulatory agencies were created to address issues within the system. The six regulatory agencies are the Board of Governors of the Federal Reserve System (The Fed); the Federal Deposit Insurance Corporation (FDIC); the Office of Thrift Supervision (OTS); the Comptroller of the Currency (OCC); the National Credit Union Administration (NCUA), and State Regulators. Within the current regulatory environment over banking activities, regulatory functions performed by the state and federal regulators may be divided into three broad categories: Chartering, Supervision, and Examination (Malloy, 2003). Each regulatory agency plays a specific role in the regulatory environments listed above. However, with each regulatory agency creating policy within their own silos, financial institutions will pay the ultimate price for the non-standardization between the regulatory agencies. To help with this problem of a non-standardized system, the Federal Financial Institutions Examination Council (FFIEC) was established.

The FFIEC was established on March 10, 1979 as part of the Financial Institutions Regulatory and Interest Rate Control Act of 1978 (FIRA). The Appraisal Subcommittee (ASC) was established in 1989 as part of the Financial Institutions Reform, recovery and Enforcement Act of 1989 (FIRREA). The ASC’s powers grew in 1980 when the Housing and Community Development Act was passed. This act gave the ACS the responsibility to facilitate public access to data that depository institutions must disclose under the Home Mortgage Disclosure Act of 1975 (HMDA) (FFIEC, 2010). The Council is empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions for the federal examination of financial institutions in each of the federal regulatory agencies and to make recommendations to promote uniformity in the supervision of financial institutions (FFIEC, 2010).

With the FFIEC helping the federal regulatory agencies with their day to day tasks and helping to recommend and promote uniformity, who is looking at for the local interest of the state banks? The Conference of State Banks Supervisors (CSBS) has been positioned as the only national organization dedicated to protecting and advancing our nation’s dual banking system (CSBS). In 2006, the State Liaison Committee (SLC) was added to the FFIEC as a voting member, which the CSBS is a part of. The CSBS has a number of roles that it performs for the state banks. Some of those roles are (CSBS, 2010):

Optimize the authority of individual states to determine the activities of their financial institutions.
Enhance the professionalism of state banking departments and their personnel.
Represent the interests of the state banking system to federal and state legislative and regulatory agencies.
Ensure that all banks continue to have the choice and flexibility of the state charter in the new era of financial modernization.

The FFIEC is like a one stop shop for financial information and reporting for the banking industry. One of the services that the FFIEC offers is the Rating Systems. Ratings known as the Uniform Financial Institutions Rating system, which is referred to as CAMELS rating, evaluates and rates all financial institutions under the FFIEC. The CAMELS rating highlights six different areas of bank performance, Capital adequacy, Asset quality, Management administrations, Earning, Liquidity, and Sensitivity to market risk (OCC, 2008). This rating system allows for a better approach to accessing the stability of the banking system as a whole. With the ability to access banks the FFIEC provides a crucial service the each regulatory agency.

Summary

Both the FFIEC and the CSBS play a crucial part in our banking system. As we move on in this ever unfolding financial crisis that we find ourselves in, will these two organizations continue to be effective in today’s world? Is the creation of these two agencies a sign that government has gotten two big and reform is hopeless unless it simplifies the processes that take place? With new reform coming, only time will tell if politicians did enough to make sure the future of banking will be here for the next generation.

References

CSBS. (n.d.). About the CSBS. Retrieved July 1, 2010, from CSBS.org: http://www.csbs.org/Content/NavigationMenu/AboutUs/WhatisCSBS/WhatIsCSBS.htm

CSBS. (2010). CSBS.org. Retrieved July 1, 2010, from CSBS Works To: http://www.csbs.org/Content/NavigationMenu/AboutUs/WhatCSBSDoes/WhatCSBSDoes.htm

FFIEC. (2010, March 9). About the FFIEC. Retrieved July 1, 2010, from FFIEC.gov: http://www.ffiec.gov/about.htm

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

OCC. (2008, April). A guide to the National Banking System. Retrieved July 1, 2010, from occ.treas.gov: http://www.occ.treas.gov/nb/nbguide.pdf

By: Joseph Dustin

DIDMCA - Deregulation and its Significance

2010-08-13T13:00:00.003-05:00

During the late 1970s people who saved their money at mortgage lending institutions began withdrawing their deposits from these institutions. The disadvantages of saving in the mortgage lending institutions were hurting the investor’s returns. In order to achieve more profitable returns, these traditional savers started investing in high-yield money market mutual funds and other various markets (Brewer III, 1980). With money leaving the mortgage lending institutions, the housing markets were being squeezed. This squeeze on banks, felt in some states, caused banks to cut off credit to households, farmers, and small businesses. Also, during this time only depository institutions were required to maintain non-interest bearing reserves with the Federal Reserve Bank (Allen & Wilhelm, 1988). This caused a record number of banks giving notice of leaving the Federal Reserve in order to be more competitive in the markets. Toward the end of the 1970s inflation was at a high level along with the interest rates. The culmination of these events along with other events called for new legislation to be written.

The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) was signed into law by President Jimmy Carter on March 31, 1980. DIDMCA was considered, by many, as the largest change in the financial industry since the Federal Reserve Act in 1913. Two of the major sections of DIDMCA are Titles I and II. Title I, known as the Monetary Control Act of 1980, sets new standards in reporting requirements, reserve requirements, pricing for services, and sets effective dates. Title II, known as the Depository Institutions Deregulation Act of 1980, sets to create establishment and authority of committee, give directive to the committee, establish targets, reports, and termination of deposit interest rate ceilings (Federal Reserve Bank of Boston, 1980). DIDMCA also allowed the Savings and Loans Institutions to invest up to 20 percent of their assets in consumer loans, commercial paper, and corporate debt securities (Allen & Wilhelm, 1988) (Visser & Wu, 1989) (Moysich, 1997).

Empirical research conducted by Allen and Wilhelm (1988) assesses the impact of DIDMCA within three different types of depository institutions. Allen and Wilhelm used intervention analysis on each portfolio, FRS banks, non-FRS banks, and Savings & Loans (S&Ls). The study concluded that the FRS banks exhibited a gain of 3.9 percent and the non-FRS and S&L’s portfolios lost 4.3 percent and 4.4 percent, respectively. This research indicates that the passage of the DIDMCA, in one respect, was a way to redistribute wealth back into the FRS banks at the expense of S&Ls and non-FRS banks. However Allen and Wilhelm’s research only focused on weekly returns for 179 weeks before and only 30 weeks after the enactment of DIDMCA on March 31, 1980. A better example may come from a long term study of the industry.

Other research, such as Visser and Wu’s (1989) study on the effects of deregulation on bank stock price-earnings ratios (P/Es), set to determine the price-earnings ratios within the banking industry after a major legislative event, like DIDMCA. The study was run over a 10-year period, from 1976 to 1985. The study highlights the variables known to influence P/Es and of the nine titles of DIDMCA only Title IV appeared to have unambiguously negative effects on the P/Es of large banks. Title IV increased the powers of thrifts, which potentially can lower expected earnings for banks as thrifts penetrate their markets. Visser and Wu concluded that the DIDMCA significantly raised the P/Es of large banks, caused them to fluctuate more, and fundamentally changed the way in which they are determined. With P/Es raising investors are left paying more for each unit of stock.

DIDMCA increased the amount of deposit insurance covered by the FDIC from $40,000 to $100,000. This increase in insurance allow for an increase of risk and “moral-hazard.” This increase of the FDIC insurance and deposits interest rates were established to alleviate disintermediation, or the flow of deposits out of financial institutions into money market mutual funds and other investments (Moysich, 1997). The deregulation and increase of “moral hazard” lead to a growth in the S&L industry. From 1980-86 the S&L industry saw a rise of nearly 500 new charters, and the S&L stock contributed to 21 percent of the industry. The percentage of S&L assets in mortgage loans, from 1981-1986, dropped from 78 percent to 56 percent. S&L assets were insolvent and a bailout was not too far away.

Summary

With the onset of increasing competitions between the different financial institutions, investors pulling deposits out of deposit institutions for more lucrative returns, banks pulling out of the Federal Reserve, and decades without financial reform, the need for a financial overhaul was inevitable. Starting from the beginning of the 1980’s, deregulation and moral hazard lead to S&L crisis. As congress fights on to create a new set of financial reform, I hope they have all learned that deregulation is not reform. I believe banks need to be able to fail; this will separate the strong from the weak. If people wish to gamble their money in risky stocks then they should be able to lose, after all it’s a gamble not certainty.

References

Allen, P. R., & Wilhelm, W. J. (1988). The Impact of the 1980 Depository Deregulation and Monetary Control Act on Market Value and Risk: Evidence from the Capital Markets. Jorunal of Money, Credit, and Banking , 364 - 380.

Brewer III, E. (1980, September 11). The Depository Institutions Deregulation and Monetary Control Act of 1980. Retrieved June 22, 2010, from ChicageFed.org: http://www.chicagofed.org/digital_assets/publications/economic_perspectives/1980/ep_sep_oct1980_part1_brewer.pdf

Federal Reserve Bank of Boston. (1980). Depository Institutions Deregulation And Monetary Control Act of 1980. Retrieved June 22, 2010, from Bos.FRB.org: http://www.bos.frb.org/about/pubs/deposito.pdf

Moysich, A. (1997). The Savings and Loan Crisis and Its Relationship to Banking. Retrieved June 22, 2010, from FDIC.gov: http://fdic.gov/bank/historical/history/167_188.pdf

Visser, J. R., & Wu, H.-K. (1989). The Effects of Deregulation on Bank Stock Price-Earnings Ratios. Financial Analysts Journal , 62 -67.

By: Joseph Dustin

Some Things Never Change: BP's Unethical Business Practices

2010-06-10T17:22:00.003-05:00

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

The Fall of British Petroleum’s Ethics

2010-05-31T09:31:00.001-05:00

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

Ethics Within the SEC During the Madoff Years

2010-05-30T17:36:00.002-05:00

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

The U.S. Financial Meltdowns: Then and Now

2010-05-30T17:01:00.003-05:00

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

A Baseline for Ethical Reporting Models

2010-05-26T14:59:00.007-05:00

Organizations looking to implement a way to report unethical conduct can choose from a wide range of Ethical Reporting Models. Reasons for the variety of models can be argued that organizations, in general, do not share the same functional business models. Some of the organizational issues that can affect the Ethical Reporting Model an organization will choose are (a) the differences in operating funds, (b) the number of employees/stakeholders, (c) different laws the organization is governed by, and (d) the initiative to want change. Ultimately, organizations are left to choose a model that works well for them. So, what does an organization look for when choosing a model? To answer this question, I will analyze several different ethical reporting models to find commonalities that establish the necessary baseline of any model an organization may choose.

Ethical Reporting Models Analyzed

The first ERM analyzed is being used by the Global Fund to Fight AIDS, Tuberculosis and Malaria. The Global Fund appointed Willem A. Landman as the Independent Ethics Advisor to help give advice to the Ethics Committee on a wide range of ethical issues. The Global Fund’s Ethics Committee requested Landman to lend his expertise on implementing a whistling-blowing program to help complement the ethics and conflict of interest policies (The Global Fund, 2005).The Global Fund’s ERM is based off the guidebook, First to know: Robust internal reporting programs, published in 2004 by Trace International Inc, in collaboration with ISIS Asset Management and the Prince of Wales International business Leaders Forum. In 2005, Landman, as CEO of Ethics Institute of South Africa, obtained copyrights to produce its own edition of the guidebook, with due recognition (Landman, 2005). The Global Fund’s ERM is described as a, “legal and ethical misconduct prevention and detection strategy,” by Landman and addresses the five components of the U.S. Federal Sentencing guidelines for Organizations’ best practices, the UK’s Public Interest Disclosure Act, the U.S. Sarbanes-Oxley Act, and South Africa’s Protected Disclosures Act (Landman, 2005). This robust Ethical Reporting Model contains eleven key best practices.

The next ERM is published by Grant Thornton LLP, one of the six global audit, tax and advisory organizations, as part of their Corporate Governor Series. Grant Thornton developed a process called the Model Accounting Complaint-Handling Process (MACH Process). The MACH Process was created to be meaningful and flexible for any organization to use (Grant Thornton LLP, 2009). The MACH Process expresses the need to understand all stakeholders and their needs within the organization. The MACH Process is a customizable six step process that breaks down the processes for creating complaint handling procedures. This model also expresses a need for the MACH Process to be monitored using metrics to measure performance.

The third ERM analyzed was published by Foley & Lardner, LLP (F&L), a national law firm that provides a full range of corporate legal services. The guidebook published by F&L is titled, Implementing an Effective Corporate Compliance and Whistle-Blower Program. The F&L program starts with the organization’s Code of Ethics as the base of for the ERM. Then the program highlights four key elements for effective implementation. These key elements are education, fostering communications, evaluating compliance, and enforcement. The F&L program also ensures confidentiality and details the role of the company boards (Brown, Wilson, & Svendson, 2004).

The last ERM analyzed was introduced by Dr. Muel Kaptein, a senior Consultant at KPMG Ethics & Integrity Consulting, in the Journal of Business Ethics titled, Guidelines for the Development of an Ethics Safety Net. There are three Ethical Reporting Models described by Dr. Kaptein, of them, the Ethical Helpdesk Model was analyzed. The Kaptein Model revolves around the use of a centralized Ethical Helpdesk that is responsible for receiving all types of violations, adding violations into the organization’s reporting system, referring violations to the appropriate officers, and then following-up on violations to ensure all procedures are carried out properly. The Kaptein Model also uses steps for determining an Ethical Code of Conduct using a set of key principles and critical factors (Kaptein, 2002).

Commonalities of the Ethical Reporting Models

Upon reviewing each Ethical Reporting Model, a recurring theme started to appear. This recurring theme has eight distinct commonalities that can be broken down into two separate functionality groups (see Table I for details). The first functionality group consists of “Tone at the Top,” Code of Conduct, Reporter Protection, and Routing & Screening. This group determines the scope of the ERM by allowing an organization the ability to be as aggressive and flexible as they need. To understand this first functionality group better I will provide some examples.

Table I
Group	Commonalities	Global Fund	MACH	F&L	Helpdesk
	Tone at the Top	X	X	X	X
	Code of Conduct	X	X	X	X
	Reporter Protection	X	X	X	X
	Routing & Screening	X	X	X	X
	Investigation	X	X	X	X
	Resolve	X	X	X	X
	Monitor & Report	X	X	X	X
	Training	X	X	X	X

The involvement of top level management is the first commonality explored in the first group and all four ERMs expressed the need for high level commitment. Willem A. Landman’s Global Fund Model states, “Programs will fail if management does not provide support, both through frequent and high level public statements and through the commitment of staff and resources(Landman, 2005).” The F&L model extends this notion by indicating that the “tone at the top” exhibited by corporate management drives the program and for organizations to be effective they must have an ethics/conduct code (Brown, Wilson, & Svendson, 2004). The organization’s code of conduct allows for flexibility by tailoring the code of conduct to include applicable laws or by going beyond compliance and instilling a higher level of responsibility. Although, reporter protection is another key commonality, not all Ethical Reporting Models agreed in how to provide this protection. The Ethics Helpdesk Model is flexible and allows for the organization to use either anonymous reporting or identification (Kaptein, 2002). The MACH Process, on the other hand, states the need for confidentiality and anonymous submissions that are required by the Sarbanes – Oxley Act (Grant Thornton LLP, 2009). The last commonality within this functionality group is routing and screening. This step can consist of written internal controls and procedures designed to handle violations of the code of conduct. The core of each ERM features processes that identify different ways organizations can address handling violations of the code of conduct. The first functionality group can be considered the roadmap for the second functionality group.

The second functionality group consists of Investigating, Resolving, Monitoring & Reporting, and Training. This group allows the organization to reduce and improve their unethical behavior. The first commonality of the second group is the investigation process. Although, not all ERMs specifically stated the investigation process in detail, those that didn’t, implied that investigation is necessary by applying remedial action to violations of the code of conduct. The MACH Process states, “The investigation should consist of all necessary procedures and actions to provide for the discovery, location and procurement of sufficient facts to reach accurate conclusions (Grant Thornton LLP, 2009).” The next commonality is resolve. If organizations don’t take remedial action of reported violations, it will threaten to stop the flow of information (Landman, 2005). Information gathered throughout the ERM process will need to be logged, thus allowing the ability to monitor and report against it. The Foley Model expresses that monitoring and reporting has taken on greater urgency under SOX 404 and this urgency requires management to attest to the effectiveness of the internal controls (Brown, Wilson, & Svendson, 2004). The last commonality in this functionality group is training. Training can be seen as training employees how to report and what to look for, training management how to handle violations, and training on how to improve the overall ERM system.

Summary

Organization looking to implement a way to report unethical conduct or implementing a whistle-blowing program to deter fraud can choose from a wide range of Ethical Reporting Models. I would encourage any organization in this situation to choose a model that, at a minimum, incorporates the two functionality groups. The two functionality groups work with each other to form a flexible ERM that can be used as a baseline when choosing an Ethics Reporting Model.

References

Brown, S. A., Wilson, D. O., & Svendson, D. M. (2004, May 19). Implementing an Effective Corporate Compliance and Whistle-Blower Program. Retrieved May 17, 2010, from Foley.com:http://www.foley.com/files/tbl_s31Publications/FileUpload137/2240/Whistleblower.pdf

Grant Thornton LLP. (2009). Establishing an effective whistleblower complaint-handling process. Retrieved May 17, 2010, from GT.com:http://www.gt.com/staticfiles//GTCom/files/services/Forensic%20accounting%20and%20investigative%20services/Establishing%20an%20effective%20whistleblower%20complaint-handing%20process.pdf

Kaptein, M. (2002). Guidelines for the Development of an Ethics Safety Net . Journal of Business Ethics , 217-234.

Landman, W. A. (2005, October 23). Whistle-blowing program best practice - some policy considerations for the Global Fund. Retrieved May 17, 2010, from TheGlobalFund.org:http://www.theglobalfund.org/documents/board/12/GFB-12-13-EC_Report_Whistleblowing.pdf

The Global Fund. (2005, September 28-30). Eleventh ANNUAL REPORT OF THE ETHICS COMMITTEE. Retrieved May 17, 2010, from TheGlobalFund.org:http://www.theglobalfund.org/documents/board/11/gfb1111.pdf

By: Joseph Dustin

The Administrative Procedures Act

2010-05-17T16:45:00.002-05:00

The Administrative Procedures Act (APA) was initially conceptualized as an oversight tool designed to help increase accountability and to bring order to a rapidly expanding government in the period after the Great Depression. (Nylander, 2006) To address the issues, which developed during the Great Depression, President Roosevelt expanded the federal government regulatory with his creation of the New Deal. This wave of expansion, in the federal government, pitted proponents of government expansion against those who feared that vesting administrative agencies with regulatory and adjudicatory functions amounted to the establishment of a fourth branch of government without formal accountability to the public.

On June 11, 1946, the APA was approved to ensure the administrative agency’s rule making process was standardized across all administrative agencies. Then, on June 4, 1966, President Lyndon Johnson amended the APA by signing into law the Freedom of Information Act (FOIA). The FOIA helped to expand public access by allowing citizens access to government records; it also places the burden on the government to document why information may not be released. (Nylander, 2006) The Federal Privacy Act of 1974 limits release of certain information about individuals. The Government in the Sunshine Act, passed in 1976, is based on the policy that “the public is entitled to the fullest practicable information regarding the decision making processes of the Federal Government.” (Berg, Klitzman, & Edles, 2005) The Government in the Sunshine Act amended the APA by creating section 552(b) titled “Open Meetings.” Today, administrative agencies actually create more rules than Congress and the courts combines. (Kubasek & Silverman, 2000)

Steps in Formal Rulemaking

Administrative agencies develop rules, which specific industries, must comply with. Part of the APA was created to ensure consistency across all agencies during the rulemaking process. The Administrative Procedures Act’s section 553 sets out the informal rulemaking for administrative agencies. Within section 553, subsection 553(c) states:

When rules are required by statute to be made on the record after opportunity for an agency hearing, sections 556 and 557 of this title apply instead of this subsection.

That sentence establishes the distinction between informal, notice-and-comment rulemaking under section 553 and formal, “on-the-record” rulemaking under sections 556 and 557. (Lubbers, 2006) Of the two types of rulemaking, informal rule making is most often used and formal rulemaking has always been the exception rather than the norm. Formal rulemaking is used for ratemaking, food additives, and other limited categories. (Eisner, 2003) Jeffrey S. Libbers states, in his book Federal Agency Rulemaking, which “some people believe that informal rule making is unfair because parties who are interested in the proposed rule have no idea what types of evidence the agency has received from other sources with respect to that rule. Thus, if the agency is relying on what one party might perceive as flawed or biased data, that party has no way to challenge those data. A second type of rule making, formal rule making, avoids that problem.” (Lubbers, 2006)

The first step in formal rulemaking is publication of a notice of a proposed rule making by the agency in the Federal Register. Once the rule has been published a date will be given as to when the hearing will take place. The public hearing will grant witnesses the ability to give their testimony on the pros and cons of the proposed rules and are subjective to cross examination. Next, an office transcript of the hearing is kept and the agency must make and publish all formal findings; if regulation is adopted, the final rule is published in the Federal Register. (Kubasek & Silverman, 2000)

Summary

Administration agencies have their place in our society today. Congress is not prepared to make an in-depth analysis that is required to create some of the highly sophisticated issues arising within many industries. Administration agencies are not elected officials like members of congress, thus in theory, the agencies would have more education in the area of which they serve. I believe that the Administration agencies play a vital role in lawmaking and should continue to operate to better serve our government as a whole. I believe that the Administration agencies are not perfect and could use a little reform. Informal rulemaking has taken over, as the norm; I believe this is not just a way for the agency to save time and money as it is a way for the agencies to be less transparent. I see Informal rulemaking as being a more secretive method as it does not allow for other to cross-examine what is being considered by each agency as it would be in formal rulemaking. However, with that said, I believe the APA and the Administrative agencies still have a place in government today.

References

Berg, R. K., Klitzman, S. H., & Edles, G. J. (2005). An Interpretive Guide to the Government in the Sunshine Act second edition. Chicago: ABA Publishing.

Eisner. (2003, January). E-Rulemaking. Retrieved April 14, 2010, from Harvard.edu: http://www.hks.harvard.edu/m-rcbg/Conferences/rpp_rulemaking/Eisner_Presentation.pdf

Kubasek, N. K., & Silverman, G. S. (2000). Environmental Law. Prentice Hall.

Lubbers, J. S. (2006). A Guide to Federal Agency Rulemaking. Chicago: ABA Publishing.

Nylander, J. (2006). The Administrative Procedure Act. Michigan Bar Journal , 38-41.

By: Joseph Dustin

The Cyber Security Act of 2009 Revisited

2010-04-01T21:27:00.006-05:00

As the Cyber Security Act of 2009 moves closer to becoming law, I would like to take a closer look into what we can expect in our not so distant future.

Rep. Lanevin addresses Congress in regards to The Cybersecurity Enhancement Act of 2009.

It looks like the main topics of focus may be on the President’s ability to shutdown the internet.

Greg Nojeim of the Center for Democracy and Technology discusses this issue. He give DoS attacks on critical Infrastructure as cause for the bill.

President Obama addresses the nation on Cybersecurity. The President announces his plans for securing America's digital future. May 29, 2009. (Public Domain) This address takes place before the Cybersecurity Act of 2009 was introduced. It will be interesting to see how President Obama will handle this piece of legislation.

By: Joseph Dustin

Difference Between Laws and Regulations

2010-04-01T15:18:00.005-05:00

Distinguishing the differences between Laws and Regulations can be somewhat confusing at times. With new laws being passed in Congress and new regulations targeting various industries within the United States are making it harder to keep track of each law and regulation individuals and business must comply with. To make matters even more confusing, law and regulations can come from Federal, State, or Local governments.

Laws and regulations interact with each other and can help expedite the legislative process. Legislators are best suited to write laws that allow administrative agencies to regulate and enforce each new law; administrative agencies have the ability to assimilate research that will be needed to set fourth affective guidelines on how to comply with the law. This will allows for a more in-depth law making process.

According to the University of Delaware Library’s Reference Website, There are three types of law which prevail at the federal, state, and local levels of government in the United States. They are:

1. Statutory Law - Statutory law consists of the acts of legislatures.

Statutes are the laws passed by the Congress or state legislature. A statute, also called an act, legislation, or, confusingly, a law, is often a broad statement of principle that is interpreted and applied by case law or implemented through administrative regulations. (Hilton C. Buley Library)

2. Case (Judicial Law) – Case law is the law of reported judicial opinions. “Stare Decisis” (or precedent) is the basic concept of case law (common law) in which courts look to statutes and regulations and prior court decisions to formulate opinions.

3. Regulations (or Administrative Law) – Regulatory agencies create regulations according to rules and processes defined by another law know as the Administration Procedure Act (APA). (2010, Longley)

Regulations are written by executive agencies
Establish rules and procedures to administer the statutory law passed by Congress and signed by the President
Published in the Federal Register
Published in the Code of Federal Regulations after being catagorized

Regulations can be thought of as industry specific laws that apply to certain groups. The key here is knowing which Regulatory Agencies apply to your corporation and learn to become confortable with each of them. Compliance officers are a great way to keep your corporation or business in compliance as they are generally well versed in dealing with compliance issues. If questions occur, it can be benificial to seek advise from a Lawyer versed in compliance law.

By: Joseph Dustin

Non-Cash Asset Fraud Schemes

2010-03-19T16:24:00.004-05:00

Occupational fraud and abuse comes in many forms. One form of occupational fraud is called asset misappropriations. Asset misappropriation, as defined by The Complete Idiot’s Guide to Frauds, Scams, and Cons, is, “when your employees take your stream of revenue and divert some of it into their own pockets.” (Swierczynski, 2003)

Asset misappropriations can be broken down into two different silos, cash and non-cash assets. According to the 2006 National Fraud survey, conducted by the Association of Certified Fraud Examiners (ACFE), states that cash assets have a higher frequency of misappropriations with 87.7% of all asset misappropriations. Although cash misappropriations are more frequent then non-cash assets, non-cash asset schemes are more costly to the company.

The ACFE also states that the cash asset median loss is $150,000 dollars compare that to non-cash assets at $200,000 dollars. (ACFE, 2006) Non-cash misappropriations schemes can be broken down into five categories. The five categories are misuse, unconcealed larceny, asset requisitions and transfers, purchasing and receiving schemes, and fraudulent shipments. Of the five categories of non-cash misappropriations schemes, I will be taking a closer look into unconcealed larceny schemes and how they can be prevented.

Unconcealed larceny is one of the most basic types of thefts as employees simply walk out with the company’s assets without trying to cover up the accounting books or records. As you can assume, larceny of the company’s inventory can be very costly for employers. If an ongoing larceny scheme goes unnoticed over a period of time, the damage can easily be estimated in the millions. One such story of unconcealed larceny that went unnoticed for five years cost one New York based jewelry store an estimated $3 - $12 million dollars of lost inventory. (Huff, 2009)

Teresa Tambunting worked for the jewelry store for over twenty-eight years and was thought to be a trusted employee. However, somewhere along the way Teresa got sticky fingers. During the last five years that Teresa was employed with the jewelry company she began to stuff some of the jewelry into her purse as she walked out. Over a five year span, Teresa amassed a mountain of gold by patiently carrying out her scheme one gold nugget at a time.

From the fraudster’s point of view, the main problem with unconcealed larceny is the absence of cooking the books or manipulating the records to account for the missing inventory. Eventually, the store realized that between $3 and $12 million dollars worth of inventory was missing and conducted an investigation. Teresa returned one suitcase full of jewelry while authorities found another 447 pounds of gold in her house. As you can see, unconcealed larceny can be very costly to unsuspected employers.

Companies put in a lot of hard work to produce and stock inventory for their company and customers. It should also be important to not let someone walk-off with that hard worked inventory. Joseph T. Wells, CFE is a well known author on fraud and Mr. Wells has a few ideas on how you can prevent and detect larceny of non-cash assets. (Wells, 2008)

First, separation of duties between requisitioning, purchasing, and receiving should be maintained. Further separation of duty would include accounts payable with accounts receivable and purchasing. These separations of duty are set in place to make it harder for one employee to commit fraud without having to include an accomplice.

Physical security is another way to stop larceny of your company’s inventory. Keeping the company inventory behind locked doors will keep most employees from being able gain access to the inventory while maintaining a log on all personnel that do have access will provide you with a list of employees encase inventory does go missing. If the employee believes that there is a high chance for them to be caught, the employee will most likely not commit the fraud according to Richard C. Hollinger and the Hollinger-Clark study. (Wells, 2008)

To exploit this technique of perception, the installation of surveillance cameras can aide in the deterrence of larceny of inventory. The security cameras should not be hidden but placed in a dominant spot for all to see. To prevent the loss of inventory over an extended period of time, you should conduct physical inventory counts on a frequent basis to determine if your inventory control system is the same as your physical count of the inventory.

Your company’s life line lies within the health of your inventory. When your employees start to steal from your inventory, the company will slowly become sick as profits are being lost. To keep the company healthy proper internal controls that allow you to deter and detect non-cash asset schemes from occurring will help keep the company doctor away.

By: Joseph Dustin

Reference

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

Cybersecurity Act of 2009

2010-03-17T20:53:00.008-05:00

A new Cybersecurity bill is “shaking up” the information security world.

If it becomes law, HR 4061 will help "strengthen domestic cybersecurity talent and find new ways to leverage the expertise that exists in the private sector," says Rep. James Langevin, D-Rhode Island. (USAToday, 2009)

The House passed H.R. 4061, the Cybersecurity Enhancement Act, with an overwhelming number of votes 422 Yes to 5 No and 7 not voting at all. (NYTimes, 2009)

H.R. 4061, now being tossed around in the Senate, is known as SB773 - Cybersecurity Act of 2009. Both Security and Compliance professionals will endure many changes if this bill makes it to the President’s desk.

The Cybersecurity Act of 2009 is broken down into 23 sections and cover a wide range of topics.

Sec. 2 - Findings

In section 2, Congress lists 14 separate reasons as to why this bill is vital to our national security. Among the listed are:

(1) America’s failure to protect cyberspace is one of the most urgent national security problems facing the country.

(4) The Director of National Intelligence testified before the Congress on February 19, 2009, that ‘a growing array of state and non-state adversaries are increasingly targeting-for exploitation and potentially disruption or destruction-our information infrastructure, including the Internet, telecommunications networks, computer systems, and embedded processors and controllers in critical industries’ and these trends are likely to continue.

(8) Alan Paller, the Director of Research at the SANS Institute, testified before the Congress that ‘the fight against cybercrime resembles an arms race where each time the defenders build a new wall, the attackers create new tools to scale the wall. What is particularly important in this analogy is that, unlike conventional warfare where deployment takes time and money and is quite visible, in the cyber world, when the attackers find a new weapon, they can attack millions of computers, and successfully infect hundreds of thousands, in a few hours or days, and remain completely hidden.’.

The Cybersecurity Act of 2009 has the potential of turning Cybersecurity into the new Arms Race. An arms race that will take place between Cybersecurity minded professionals and those who wish to exploit the latest vulnerabilities in our nation's security systems.

By: Joseph Dustin

Corporate Integrity – A Toolkit for Managing Beyond Compliance

2010-03-12T19:24:00.007-06:00

Donna Kennedy-Glans & Bob Schulz have put together a comprehensive toolkit for managing Corporate Integrity beyond compliance.

Many companies already know about the value of implementing an “ethics and integrity program” and they have created elaborate ethical policies to protect themselves from compliance related issues. However, they often fall short when aligning their “corporate walk with their corporate talk.”

Corporate Integrity – A Toolkit for Managing Beyond Compliance is a great book to help organizations align their “corporate walk with their corporate talk.” The authors state,

“Compliance is a minimum standard of corporate performance and is often insufficient response to a corporation’s integrity values” and

“Overall, this is a practical how-to book that tailors, aligns, and consolidates business tools that enable companies to effectively and efficiently operationalize business integrity values.”

Corporate Integrity is divided into three parts:

Part 1: New Frontiers in Managing Corporate Integrity

Part 2: Process for Managing corporate Integrity and Scenario Applications

Part 3: The Road Ahead For Corporate Integrity

Each part has detailed Business Tools that will allow you to measure, monitor, and manage integrity. Some of the tools outlined in this book are:

The Integrity Ladder

Stakeholder Grid and Impact Assessment Tool

The Integrity Grid

Permeation of Change Model

Adapted Best Practices Tool

Benchmarking Practices

Community Investment Strategy Tool

I would highly recommend this book, Corporate Integrity, to any Ethics Professional interested in improving their Compliance and Ethics Program.

By: Joseph Dustin

The Sound of Corruption

2010-03-08T18:25:00.004-06:00

John Yeh is a businessman. Like most businessmen, John has the drive and determination that inspire people to succeed. John went to college at the University of Maryland where he earned his bachelor’s degree in mathematics and then pursued his master’s in computer science.

After graduation John started his own company. The company was known as Integrated Microcomputer Systems and after a few successful government contracts, John’s company quickly grew with a revenue of $21 million in 1987.

What makes John Yeh any different from others that have succeeded?

John has a disability that made him have to work a little bit harder than most. Born without the ability to hear, John needed to find an alternate way to communicate. Growing up in China, Taiwan, and Brazil he learned to read lips and knew Chinese sign language.

At the age of 15, John arrived in the United States were he had to translate Chinese to English and then English to sign language. In school he was put in a class with eight and nine year olds, leaving John feeling embarrassed; yet determined.

After graduation he struggled to land a job. When John was ready to start his own company he found it difficult to obtain a loan. Every bank that he went to, turned John away. Then, as luck would have it, John discovered a loan that was available to the handicapped through the U.S. Small Business Administration in the amount of $100,000 dollars. (Knocke, 1989) As you can see, John’s life was not that of anything I would call normal.

John went on to become the 2008 Deaf Person of the Year by Deaf Life magazine and Gallaudet University once honored him as Entrepreneur of the Year. (Washington Post) All of which makes John Yeh’s arrest seem to come as a shock.

What would drive John, who seems to have everything finally going right for him, to commit an occupational fraud? Although that question may never be answered, the Department of Justice unsealed twenty-six indictments on November 19, 2009. (Department of Justice Press Release, 2009) The twenty-six, including John Yeh, was charged with engaging in a scheme to steal millions of dollars from the Federal Communications Commission’s (FCC) Video Relay Service program.

John’s company, Viable Communications, makes Communication devices that allow deaf people to communicate over the telephone through a video type interface. The video shows a translator that translates the voice or data type message and then uses sign language to communicate back. John Yeh was then able to bill the FCC for a portion of the time being used. The program started off in 1993 with about $30 million and quickly grew to over $400 million in 2007. (Potter, 2010)

John is accused of coaching employees and other on how to make false calls that would not be suspicious. Some of the other twenty-five indictments include those involved with the scheme from various other call centers. Six other call centers are independently owned and did contract work for Viable Communications. Altogether, officials still have not said precisely how much they think was stolen, but the estimate was approximately in the “tens of millions.” (Glod & Johnson, 2010)

The question still remains; did John Yeh use his fiduciary powers to make people commit occupational fraud when they normally would not have?

Occupational fraud is a term that is used to describe a wide variety of corporate fraud cases and can be broken down into more distinct segments to help identify the different types of frauds being committed. Each type of fraud can be easily identified in some schemes, while other schemes are more difficult to identify. One reason for the difficulty in identifying a fraud type is during some cases where fraudsters are committing several fraudulent acts to commit their crimes, thus making it harder to categorize each scheme. For example, one investigation may start with a billing fraud scheme and turn into a conflict of interest/corruption scheme with multiple parties involved.

Corruption, according to Joseph T. Wells, can be defined as an act in which a person uses his or her position to gain some personal advantage at the expense of the organization he or she represents. (Wells, 2008) In this light, John Yeh had the equipment that was needed to deploy the services. John also worked with other independent contractor that needed what John had to offer to turn a profit. This would leave me to believe that he defiantly had the ability to misuse his fiduciary powers to conspire with other and corrupt their business relationships.

In the case of John Yeh, the details may not be clear as to the extent of the corruption. Details such as who was the initiator are still not clear. Knowing who the initiator would better determine the type of corruption, such as economic extortion or bribery.

In either case, to help deter corruption, you should keep an eye out for gifts and create an ethical policy that states employee are not allowed to receive gifts over a certain amount. Maintain a set of reports that actively looks for financial changes and policy deviations as red flags may indicate corruption.

When corruption is at its worst the amount of damage caused is hard to place a price tag on. Although millions of dollars are alleged to be stolen using this scheme, the money itself may not be the only thing lost. If John Yeh is convicted of his crimes, how will it affect all the deaf people that used the service legitimately? Will the service be discontinued or will the price go up if the government chooses to stop giving money for the program?

By: Joseph Dustin

Cressey's - Fraud Triange

2010-03-08T17:50:00.006-06:00

At Indiana University during the 1940’s, Donald Cressey worked on his PH.D in criminology; his hypothesis became what is now known as the “Fraud Triangle.” (Wells, 2008) The fraud triangle seeks to explain the elements that must be present before fraud can occur.

Nicole Merke, CPA, CFE, columnist for Examiner.com, states, “Cressey is honored by many anti-fraud organizations, including the Association of Certified Fraud Examiners.” (Merkle, 2009) Cressey’s fraud triangle consisted of three elements that reoccurred in all the cases that he studied. Opportunity, Incentive (Pressure), and Rationalization are the three elements that make up the fraud triangle. Using the fraud triangle to gauge why employees take part in abusive conduct will give us three distinctive categories that can be analyzed to better understand the fraudsters.

Opportunity is simply having the ability to commit abusive conduct. There are two parts to opportunity, General information and technical skill. (Wells, 2008) General information is when you that the fraud can be committed and technical skill is the ability to carry out the fraud.

Incentive or Pressure refers to a financial burden that the fraudster feels that they must find a way out of. A fraudster may feel pressure to keep a certain social status in order to keep up with those they work with.

Rationalization is when the fraudster justifies the crime to which he attempts. Cressey believes that rationalization is part of the motivation for the crime and that the fraudster does not see himself as a criminal. (Wells pg. 18) The fraudster may feel that their employer owes them something and thus are not thieves.

By: Joseph Dustin

References

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

Passwords Don't Secure Sh@t!

2010-03-03T20:14:00.007-06:00

I often hear the term strong and secure when talking about passwords and this can have adverse affects on overall security. System Access Controls are often considered the first line of defense against cyber-attacks and hackers. The problem we face with using passwords for authentications are that passwords are often written down and shared with other. I have seen passwords left in desks, taped to monitors, and placed under the keyboard. When passwords are written down, security becomes fragile.

Even the strongest of passwords are considered weak. To strengthen the access controls over an IT system will require what is known as two-factor authentication or three-factor authentication. Authentication is based upon three known factors:

Something You Know – Like passwords, Pin numbers, or passphrases, which are considered the weakest of all the Authentication types. Passwords can be guess, brute forced, shared, stolen, or compromised.

Something You Have – Like smart cards, USB tokens, and key fobs, which can be lost, stolen, broken, shared, borrowed, or duplicated.

Something You Are – biometrics are types of authentication used; they include devices like fingerprints scans, voice scans, and retina/iris scans.

What is then meant by two-factor Authentication is the combination of using two types of authentication. An example would be passwords combined with key fobs or something similar to the Kronos Time System I currently use at work. Kronos requires employees to use a badge and the employee's finger print to clock in. Three-Factor would require all three and is considered the strongest.

So the next time you hear someone say they have a secure password, please let them know that passwords used for authentication is not considered secure. Secure is accomplished through two or three-factor authentication.

By: Joseph Dustin

National Procrastination Week

2010-03-03T13:58:00.004-06:00

National Procrastination Week, (March 1st – 7th), has arrived and I’m already creating a list in my head of things I’m going to put off this week. After first hearing about this holiday, my first impression was that I should take the week off. Then, I got to thinking maybe there is more to this holiday then procrastinating; maybe it’s about educating and training employees how to be more proactive and punctual.

After a little online research about the topic, I was crushed, my week off was tossed in the trash quicker than my last pay raise. It looks like it might be time to motivate the troops and see what we can do to stop procrastination.

First, we need to identify exactly what makes a procrastinator. An online article at PsychologyToday.com, Procrastination: Ten Things To Know by Hara Estroff Marano, states 10 things about procrastination.

1. Twenty percent of people identify themselves as chronic procrastinators.

2. It's not trivial, although as a culture we don't take it seriously as a problem. It represents a profound problem of self-regulation.

3. Procrastination is not a problem of time management or of planning.

4. Procrastinators are made not born.

5. Procrastination predicts higher levels of consumption of alcohol among those people who drink.

6. Procrastinators tell lies to themselves. Such as, "I'll feel more like doing this tomorrow." Or "I work best under pressure." But in fact they do not get the urge the next day or work best under pressure.

7. Procrastinators actively look for distractions, particularly ones that don't take a lot of commitment on their part. Checking e-mail is almost perfect for this purpose. They distract themselves as a way of regulating their emotions such as fear of failure.

8. There's more than one flavor of procrastination. People procrastinate for different reasons. Dr. Ferrari identifies three basic types of procrastinators:

arousal types, or thrill-seekers, who wait to the last minute for the euphoric rush.

avoiders, who may be avoiding fear of failure or even fear of success, but in either case are very concerned with what others think of them; they would rather have others think they lack effort than ability.

decisional procrastinators, who cannot make a decision. Not making a decision absolves procrastinators of responsibility for the outcome of events.

9. There are big costs to procrastination. Health is one. Just over the course of a single academic term, procrastinating college students had such evidence of compromised immune systems as more colds and flu, more gastrointestinal problems. And they had insomnia. In addition, procrastination has a high cost to others as well as oneself; it shifts the burden of responsibilities onto others, who become resentful. Procrastination destroys teamwork in the workplace and private relationships.

10. Procrastinators can change their behavior—but doing so consumes a lot of psychic energy. And it doesn't necessarily mean one feels transformed internally. It can be done with highly structured cognitive behavioral therapy.

What are the costs associated with procrastination?

CC Holland blogged about the Staggering Cost of Procrastination; he states a recent study by research firm Basex puts the “cost of unnecessary interruptions” in terms of lost productivity and innovation at a shocking $650 billion.

If these unnecessary interruptions are costing companies so much what are they doing to combat this pandemic? Maybe it’s time we quit procrastinating and create policy to help fight the problem.

By: Joseph Dustin

An Overview of Loss Prevention and I.T. Security

2010-03-03T10:56:00.007-06:00

Loss prevention encompasses a wide range of threats and Loss Prevention Professionals have to be ready to handle each type of threat that could affect their corporation.

There are four main types of threats;

Natural

Environmental

Technical

Human

Natural Threats – Tornados, Earthquakes, Hurricane/Typhoons, Floods, Landslides, Lightning Storms, Heavy Rains, Blizzards, Fires, ect.

Environmental Threats – Gas Leak, Fires, Toxic Waste, Pandemics, Fuel Outage, Drainage Chokes, Neighborhood Hazards, ect.

Technical Threats – Power Outage, IT systems Failure, Fires, System Breakdowns, Manufacturing Defects, Malicious Codes, ect.

Human Threats – Terrorism, War, Spying, Sabotage, Theft, Arson, Hacking, Immoral Employee Ethics, Legal Disputes, Unaware Users, ect.

A study conducted by Robert W. Taylor et al., in the book Digital Crime and Digital Terrorism, states that 73% of the risk to computer security is from internal sources; while 23% is attributable to external sources. Internal threats include violence in the workplace, theft of proprietary information, sabotage, infiltration by gangs or organized crime, and terrorism. (Purpura pg. 134, Security and Loss Prevention) One of the most obvious of threats would be theft. Theft can be broken down into sub-categories to include shoplifting, occupational fraud and abuse, employee theft, and as described by Purpura theft of proprietary information.

The I.T. threat from within is of great concern to those who wish to protect a company’s proprietary information. There are many reasons that companies would want to protect their data. Reasons may stem from loss of trade secrets, compliance, national defense, the fear of lawsuits, defalcation, or business continuity. Whatever the reason, companies have good reason to be concerned about I.T. security.

The Fourth Annual US Cost of Data Breach Study, an independent study conducted by Ponemon Institute, states that the average cost of data loss has risen to $202, up from last year’s $197 per customer record.

Internal threats and data loss can be intentional or accidental and are caused by current employees, non-current employees, or Third Party Employees. There are many I.T. threats that corporations face with everyday. I.T. threats include many of the main threats listed above with an emphasis on Information Technology Business Continuity and Security.

To get a better understanding for what an I.T. Security Professional needs to know we can look at the International Information Systems Security Certifications Consortium (ISC)2 for guidance. (ISC)2 has developed one of the highest regarded and sought after information security certificates called, Certified Information Systems Security Professional (CISSP) certification. Books that help you study for the CISSP, such as CISSP for Dummies by Lawrence Miller and Peter Gregory, are broken down into what is know as the Common Body of Knowledge (CBK) domains. Ten domains illustrate the vast range of topics that must be master to earn the CISSP certification. The domains are (excerpted from CISSP for Dummies):

Access Control – is about securing the perimeter; many security breaches result from inadequate Access Controls.

Telecommunications and Network Security – This domain is easily the most extensive and encompasses topics like networking models, protocols, standards, services, technologies, and vulnerabilities.

Information Security and Risk Management – This domain gets to the heart of Information Security Concepts and Risk Management concepts.

Application Security – essential concepts to understand in this domain are principles of applications, applications, application development, and databases.

Cryptography – you must fully understand the basic operation of cryptographic systems and how they apply in real-world applications.

Security Architecture and Design – this domain requires knowledge of security models, embedded systems, and basic computer architecture.

Operations Security – this domain details resources that must be protected, who should be restricted, control mechanisms available, the potential for abuse of access, appropriate controls, and good practices.

Business Continuity and Disaster Recovery Planning – detailed knowledge of Business continuity Planning and Disaster Recovery Planning are needed.

Legal, Regulations, Compliance, and Investigations – in this domain you must know what a computer crime is, how to conduct an investigation and collect evidence, and understand what laws may have been violated and the (ISC)2 Code of Ethics.

Physical (Environmental) Security – understand the various threats to physical security. Elements include planning and design, physical security controls, and administrative controls, physical security controls, access controls and technical controls.

By: Joseph Dustin

Principles of Fraud Examination 2nd edition by Joseph T. Wells

2010-02-25T15:43:00.005-06:00

Joseph T. Wells is a master at communicating fraud examinations techniques to those interested in Occupational Fraud and Abuse. The Book, Principles of Fraud Examination, starts off with a basic overview of the history of Occupational Fraud and Abuse. Touching up on subjects like Donald Cressey’s Fraud Triangle, Dr. W. Steve Albrecht’s Fraud Scale, Richard C. Hollinger’s and the Hollinger-Clark Study, and a ton of statistics from the 2006 National Fraud Survey conducted by the Association of Certified Fraud Examiners. (ACFE)

The book is well laid out with three main categories of occupational Fraud and Abuse (Corruption, Asset Misappropriations, and Fraudulent Statements). The book then breaks each section down further into specific areas to help Fraud Examiners categorize each type of fraud. Each chapter ends with a summary, essential terms, review questions, discussion issues, and endnotes. Perhaps the most useful tool for fraud examiners is the addition of Proactive Computer Audit Tests for detecting the many of the different types of fraud. These tests will provide details that can help an organization detect occupational Fraud and Abuse.

While some books about fraud can get boring, Principles of Fraud Examination 2^nd edition, keeps you entertained by giving real world examples pulled from different areas in the financial world. Joseph T. Wells brings Occupational Fraud to life with his enthusiasm and dedication in Fraud Examination. I would recommend this book to anyone who wants a better understanding of Occupational Fraud and Abuse.

By: Joseph Dustin