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Tone at the Top: The Ethical Standards Set By Senior Management

on behalf of the

Overview Of Tone At The TopJustin P. Klein

Partner, Ballard Spahr

• The ethical atmosphere that is created in the workplace by a company’s senior management.

• The message a company’s leaders communicate to employees, through their words and actions, about the importance of ethical conduct.

What is Tone At The Top?

Overview Of Tone At The Top

“The object is to instill in employees the notion that these issues are important – or, as [former SEC] Chairman

Donaldson has said, to make ethics part of thecompany’s DNA.”

– “Tone at the Top: Getting it Right,” speech by Stephen Cutler, Director, Division of Enforcement, U.S. Securities and Exchange Commission, at Second Annual General Counsel Roundtable, December 3, 2004.

What is the Goal?

Overview Of Tone At The Top

• The tone set by management has a trickle down effect on employees and directly impacts corporate culture;

• If the tone set by management stresses ethics and integrity, employees are more likely to adhere to the same standards;

• If management ignores ethical standards and focuses solely on the bottom line, employees are more likely to see meeting short-term goals as more important than any commitment to ethical conduct.

Why is it important?

Overview Of Tone At The Top

• “Violations of the securities laws are very frequently the product of both individual failings and a deficient corporate culture. Among other things, a complex accounting fraud rarely can be accomplished by one or two rogue employees, acting on their own.”

• Failures in corporate culture can – and have – resulted in fines that impact the company's bottom line and far exceed “the cost of doing business.”

• “Tone at the Top: Getting it Right,” speech by Stephen Cutler, Director, Division of Enforcement, U.S. Securities and Exchange Commission, at Second Annual General Counsel Roundtable, December 3, 2004.

Why is it important?

Overview Of Tone At The Top

• The Ethics Resource Center conducted a National Business Ethics Survey of ethics and compliance in the workplace for 1994-2005. The principal findings were: – On a national level, formal ethics and compliance programs are on the rise,

but expected positive outcomes are not;

– Ethics and compliance programs do have an impact, but organizational culture is more influential in determining outcomes;

– Once a strong culture is in place, formal programs do not have much of an impact on outcomes.

Why is it important?

Overview Of Tone At The Top

• National Business Ethics Survey: 1994-2005

– Behavior of Management: where top management displays ethics in four important ways (talks about the importance of ethics, informs employees, keeps promises, and models ethical behavior), employees are 50% less likely to observe misconduct;

– Behavior of Peers: employees who observe their peers acting ethically are more likely to act ethically; employees who observe their peers engaging in misconduct are more likely to engage in misconduct themselves.

– Accountability: when employees perceive that others are held accountable for their actions, their overall job satisfaction increases.

Why is it important?

Overview Of Tone At The Top

• The Treadway Commission

– National Commission on Fraudulent Financial Reporting (“Treadway Commission”);

– Formed in 1985 in the aftermath of several bank failures and amid industry claims of a crisis in public confidence;

– With a mission “to identify causal factors that can lead to fraudulent financial reporting and steps to reduce its incidence.”

Not A New Concept

Overview Of Tone At The Top

• Findings

– The tone set by top management . . . is the most important factor contributing to the integrity of the financial reporting process.

– Fraudulent financial reporting usually occurs as the result of certain environmental, institutional, or individual forces and opportunities.

– These forces and opportunities add pressures and incentives that encourage individuals and companies to engage in fraudulent financial reporting.

The Treadway Commission Report

Overview Of Tone At The Top

• Factors The Influence Tone At The Top – Unrealistic budget pressures - emphasis on short-term financial goals; – Employee bonus incentives tied to short-term financial goals; – Marketplace and analysts’ expectations; – Decreases in revenue or market share; – Lack of code of ethics and company-wide training; – Absence of a board of directors or audit committee that vigilantly oversees

the financial reporting process;– Weak or non-existent internal accounting controls; and– Ineffective internal audit staffs.

The Treadway Commission Report

Overview Of Tone At The Top

– In 1987, the Treadway Commission Report found – and recent events confirm – that a focus on short-term financial goals creates pressures for individuals and companies to engage in fraudulent financial reporting.

– A 2004 survey of chief financial officers revealed that a majority of managers were willing to sacrifice long-term profits for the sake of making quarterly numbers.

Relevant Today -- Emphasis On Short-term Goals

Overview Of Tone At The Top

• Short-termism refers to the excessive focus on short-term, quarterly earnings and a lack of attention to long-term value creation;

• “An excessive short-term focus combined with insufficient regard for long-term strategy can tip the balance in value-destructive ways for market participants, undermine the market’s credibility, and discourage long-term value creation and investment.”

– “Breaking the Short-Term Cycle: Proceedings of the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics Symposium Series on Short-Termism” (2006).

Shift Away From Short-termism

Overview Of Tone At The Top

• Develop long-term incentives by tying compensation to the achievement of long-term strategic and value-creation goals;

• Communicate frequently with management and employees about company strategy and long-term prospects; and

• Educate all market participants about the benefits of long-term thinking and the pitfalls of short-term thinking.

– From “Breaking the Short-Term Cycle: Proceedings of the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics Symposium Series on Short-Termism” (2006)

• Consider the impact of providing quarterly earnings guidance– Some companies have ended the practice of providing quarterly earnings guidance– Coca Cola, McDonalds, Mattel, and Gillette

Focus on Long-Term Financial Goals

Overview Of Tone At The Top

• National Investors Relations Institute 2006 Survey

– The proportion of companies providing earnings guidance declined to 66% from 71%;

– The percentage furnishing annual earnings guidance increased significantly to 82% from 61% in the previous survey;

– Some 52% provide quarterly earnings guidance, down from 61%;

– The proportion of companies that provide only annual earnings guidance rose to 43% from 28%.

Focus on Long-Term Financial Goals

Overview Of Tone At The Top

• Warren Buffet, Chairman Berkshire Hathaway

– In the 2000 annual report, Buffet said he and his vice chairman, Charlie Munger, "think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble."

– "The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to 'make the numbers.'" (emphasis added)

Focus on Long-Term Financial Goals

Overview Of Tone At The Top

• Talk the Talk– Senior management should communicate directly and honestly with employees about the

company’s operating philosophy and commitment to honesty and good moral behavior;– Ideally, “this talk should extend beyond your company’s own walls – to those with whom your

company does business – vendors, consultants, customers, contractors, etc.” • “Tone at the Top: Getting it Right,” speech by Stephen Cutler, Director, Division of Enforcement, U.S.

Securities and Exchange Commission, at Second Annual General Counsel Roundtable, December 3, 2004.

– Senior Management should reference corporate values in making and explaining business decisions.

• Walk the Walk– Senior management should model ethical conduct;– The company should enforce and reinforce these standards; and– The company should find ways to make character and a commitment to ethical conduct a part of

its hiring criteria.

Doing Well By Doing Good

Overview Of Tone At The Top

• The Result– Positive Tone At The Top

– Long-Term Financial Success

Doing Well By Doing Good

Overview Of Tone At The Top

Nuts & Bolts of An Effective Compliance Program

Susan Schmidt Pié

Chief Compliance Officer, Sunoco, Inc.

Nuts & Bolts of Effective Compliance Program

• Business Conduct Policies and Code of Conduct• Training• Certification• Hotline• Investigations

Federal Sentencing Guidelines

• Due Diligence to Prevent and Detect Criminal Conduct

• Promote Culture that Encourages Ethical Conduct and Compliance with Law

• Sets forth seven specific guidelines

Chief Compliance Officer

• Broad authority• Access to the CEO and Board of Directors• Sufficient resources• Independence• No fear of reprisal• Connection to company operations

Chief Compliance Officer (cont’d)

• Authority to have recommendations taken seriously

• Integrated in corporate management• If role is properly structured, promotes proper

“tone at the top”• If window dressing, will do more harm than good• One size does not fit all

Chief Compliance Officer (cont’d)

• Strong relationship with Corporate Audit• Strong relationship with financial reporting

governance• Participant in important management

committees• Strong relationship with commercial lawyers with

day to day responsibility

Policies

• Up to date• Accessible• Schedule for revision• Process for revision

Training

• Live training• On-line from vendor• Customized• Relevant• Reach new employees• Determine frequency

Certification

• Requirement to certify understanding and compliance

• Opportunity to report problems• Serious follow up on reported problems• 100% completion, no excuses

Hotline

• Compliance hotline to report concerns• Confidential treatment of reported concerns• Opportunity to report anonymously• Ability to track and categorize concerns• Report to Audit Committee with call categories

and status

Hotline (cont’d)

• Third party administrator preferable– Anonymous whistleblower

– Retaliation prevention

– Objective recording of concerns

– Opportunity to benchmark

Internal Investigations

• Concerns not always raised through the hotline• Need ability to react quickly• Prepare management for what happens in an

internal investigation• Partner with Corporate Audit, Security, IT• When to go outside for counsel and forensic

accounting• When to report to Audit Committee, full Board

Recent Examples of Poor Tone At the Top

John C. Grugan

Partner, Ballard Spahr

Recent Examples Of Poor Tone At The Top

• Fannie Mae– Senior management – hit earnings every year

– Employed accounting rules that “work for us”

Recent Examples of Poor Tone at The Top

• By now every one of you must have 6.46 branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46 . . . After all, thanks to Frank [Fannie Mae’s former CEO], we all have a lot of money riding on it . . . We must do this with a fiery determination, not on some days, not on most days, but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%. Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.

Recent Examples of Poor Tone at The Top

• Freddie Mac• McAfee• Krispy Kreme• GMH Realty

Tone at the Top and the Audit CommitteeRobert Cepielik

Partner

Deloitte Financial Advisory Services, LLP

Tone at the Top and the Audit Committee

• Audit Committee as ‘Cultural Watchdog’• When an investigation is needed• When, if ever, should the audit committee

actively manage the investigation?• Goals for the investigation• Outside assistance• Best practices and common mistakes

Audit Committee as ‘Cultural Watchdog’

• Establish clear signals from ‘the top’• Maintain healthy skepticism• Engage in risk management activities• Assess financial reporting culture

When an investigation is needed

• Understand the source of the information• Assess the nature for the allegations• Evaluate the impact of financial statements and

quality of earnings• Understand the level of employees involved• Evaluate the impact of internal controls• Consider appearance and objectivity

When, if ever, should the audit committee actively manage the investigation?

• Allegations regarding financial reporting– Materiality

• Allegations regarding senior management• Allegations regarding Company’s reputation

Goals for the investigation

• Report wrongful conduct• Report ‘size of the breadbox’

– Financial– Internal Controls

• Identify remedial steps

Outside assistance

• Legal• Forensic and advisory• E-Discovery

Best practices and common mistakes

• Consider needs of the Company

• Keep an open mind

• Involve appropriate internal and external consultants

• Keep communications lines open with counsel and forensic investigators

• Maintain an open and communicative relationship with all interested parties … as deemed appropriate

• Make constructive recommendations

• Self-correction cannot start too early

The Consequences of Poor Tone At the TopJohn C. Grugan

Partner, Ballard Spahr

Two Focuses

• Tone At the Top Impacting Internal Investigations

• Tone At the Top Impacting Charging Decisions and Sentencing

The Treadway Report

• Focuses on fraud prevention and detection

Poor Tone at The Top Affecting Internal Investigations

• Hewlett-Packard

– Business objectives clouding judgment

Witness Liability

• 18 U.S.C. § 1512(c)(2)– Enacted post–Enron

– Criminalizes obstruction and attempted obstruction of “any official proceeding”

• United States v. Kumar (“Computer Associates”)• United States v. Singleton (“El Paso Corp.”)• United States v. Gerald Jones (“Collins &

Aikman”)

McNulty Memorandum, December 12, 2006 “Principles of Federal Prosecution of Business Organizations”

1. Nature and seriousness of the offense

2. Pervasiveness of wrongdoing

3. Corporation’s history of similar conduct

4. Corporation’s timely and voluntary disclosure and willingness to cooperate

5. Existence and adequacy of the corporation’s pre-existing compliance

6. Corporation’s remedial actions

7. Collateral consequences

8. Adequacy of the prosecution of individuals responsible

9. Adequacy of remedies

Charging a Corporation: Factors to be Considered

Federal Sentencing Guidelines

• Sentencing Guidelines now advisory, not mandatory

• Provide credit for effective compliance and ethics programs

• Credit inapplicable if high-level personnel participated in, condoned, or was willfully ignorant of the offense

Effective Compliance Programs

• Under the Federal Sentencing Guidelines, a compliance program is effective if it allows the business organization to:– Prevent and detect criminal activity through the exercise of

due diligence; and

– Promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law.

Seven (7) Keys to anEffective Compliance Program

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is proud to sponsor

Tone at the Top: The Ethical Standards Set By Senior Management

on behalf of the