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Corporate Fraud Prevention

High-Integrity Management and Fraud Prevention: The Wrong Way

Scott Langlinais | July 1, 2007

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Businessman with a magnifying glass

"Show those numbers to the damn auditors and I'll throw you out the [expletive] window." This is how the accounting director at WorldCom responded to an accountant inquiring about an odd discrepancy. From 1999 though 2002, WorldCom booked more than $9 billion in false accounting entries at the direction of upper management.

Bernard Ebbers, CEO, fed Wall Street expectations of double-digit growth despite having received internal information contradicting his projections. As true profits declined, CFO Scott Sullivan orchestrated the booking of false accounting entries to make the financial statements look as though the company had achieved its goals. Several accountants were aware that the entries were unethical, but they still booked the entries and failed to do anything other than complain about why their supervisors were not taking action. Because executives were directing the fraud, most of the accountants rightly believed they would lose their jobs if they reported concerns.

WorldCom had no Code of Ethics, which Mr. Ebbers considered a "colossal waste of time." When financial personnel did raise questions, they were suppressed with bullying emails like the one quoted above. Clearly unethical behavior by the executives, but why did so many accountants participate? In their Report of Investigation, the Special Investigative Committee stated that the fraud propagated in part "due to a lack of courage to blow the whistle on the part of others in WorldCom's financial and accounting departments." 1

Despite the report's claims, there may be more at work here than a lack of courage or fear of losing a job. Our mental hardwiring and social conditioning to obey authority stack the deck against our own personal ethics.

The Milgram Study

A psychological study performed in the 1960s, The Milgram Study, demonstrated that people will set their own ethics aside to obey authority, even if their actions cause physical harm to others. Subjects believed they were taking part in a memory study involving two volunteers and a researcher in a grey lab coat who led the experiment. The volunteers drew lots to determine who would be the teacher and who would be the learner. The role of the learner was to answer the teacher's questions while strapped to a chair and attached to electrodes. If the learner provided a wrong answer, the teacher would administer a shock. Small at first, the shocks would only be irritating. But with each wrong answer, the voltage would increase by 15 volts.

Unknown to the teacher, they were the only true subject of the study, and it was not a memory study. The learner was an actor, and the shocks delivered by the teacher were not real. But surprising to the researchers was the consistency in which the teachers would continue to administer "shocks" to the learners, even after the supposed voltage became so high that the learners pleaded for the teacher and researcher to stop the study. Even though some of the teachers protested, held their heads, dug their fingernails into their skin, and even pleaded with the researcher to let them stop, two-thirds pulled every one of the 30 shock switches up to the maximum of 450 volts when the researcher ended the experiment. The conclusion was that we have a sense of duty to authority that overwhelms our own conscience. 2 It also explains why one unethical executive can trump an entire department of ethical subordinates.

Several studies stemming off of the Milgram study have demonstrated the clear danger of unethical behavior by authorities. If an authority is able to convince someone to override their conscience to inflict pain on another, then it is no great leap to conclude it would be even easier for an authority to convince a subordinate to execute a fraudulent transaction.

Though it is too simple to claim that the WorldCom accountants acted unethically just because of an innate or socially ingrained predisposition toward obeying authority without question, it is likewise too simple to attribute the ethical lapses to a lack of courage. Perhaps there was a lack of courage. Perhaps some of the accountants were not confident enough in their own technical expertise to challenge their bosses, or maybe they feared asking questions that might make them appear ignorant. Some might have truly been concerned about their physical safety, and others may yet have considered the risk of losing their jobs too great. The point is that executives cannot underestimate their power to influence subordinates, and employees must guard against doing something unethical or illegal because a superior told them to do so.

The Gray in the Middle

What about the vast gray area of not ethical but not unethical behavior? On February 2, 1987, two internal auditors marched into a meeting with compelling evidence that two executives from a commodity trading unit had siphoned millions of dollars of company money into a personal account. The auditors demonstrated to the CEO that millions of company dollars had been wired to an unauthorized "company" account, on which the executives were the only two signers, and that about half of the money that flowed through that account was subsequently transferred to the personal account of one of the executives.

The perpetrators submitted a defense that they opened the account to facilitate off-the-books transactions that would allow their trading division to shift income from the highly profitable 1986 into 1987. One of the perpetrators had acknowledged transferring money to a personal account, but he claimed the money would be returned when the off-book transactions settled. Despite the auditor thinking that the explanation was ridiculous because the executives were justifying one illegal act (stealing) with another illegal act (shifting earnings), the CEO ordered that the transactions be undone but there would be no other consequences. The auditors continued to press by demonstrating that the perpetrators had altered bank statements, but there was an explanation for that as well. The CEO stated that he didn't want to see something like that happen again, though he asked the auditors privately to continue their investigation.

The internal auditors later visited the trading division. One of the original two perpetrators met the auditors at the door and ordered them not to stir up his employees. After 3 days of being stonewalled, the chief auditor approached one of the perpetrators and demanded support for the odd transactions. That perpetrator called the company's president to complain about the auditors' disruptions. So the auditors were ordered to return home, and the case was turned over to the external auditors. In the meantime, the internal auditors discovered even more evidence of wrongdoing.

When the report was finally made to the audit committee, the external auditors failed to report that a fraud occurred, failed to report on the altered bank statements, and failed to mention the additional evidence that the internal auditors had uncovered. The report did mention a danger that one of the perpetrators was exceeding his trading limits. The CEO decided it was best to not disrupt their trading operations by firing anyone; the division had been too profitable to risk any harm.

Several months later, when the CEO learned that the trading division had potentially incurred hundreds of millions in trading losses, he finally decided to fire the lead perpetrator and shut down the trading division. The two perpetrators were eventually charged with fraud, as they, not the CEO who retained them, were going to be the fall-guys for the trading debacle. The CEO who retained the perpetrators was a man named Kenneth Lay, and the company that suffered the losses was Enron. 3

It can be argued that Enron's corporate ethic was set years before its ultimate collapse. What is particularly interesting is that Mr. Lay technically did not do anything illegal in this instance. He did not perpetrate the fraud, nor did he appear to attempt a cover-up, attack the internal auditors, or stop the investigation. There was no mandate for him to punish the perpetrator. He certainly did not do what was right as dictated by ethics or common sense, but it does not seem that he did anything wrong, especially if you remove the context of our knowing what would eventually happen to him and Enron.

One of my former clients underwent a SEC investigation for improper revenue recognition. In one particularly instructive exchange, the client's executive vice president of sales sent the following email (titled "Rev Rec BS") to the CFO.

We have totally confused our sales force on what is and what is not bookable or revenue recognizable. I feel that we are having a great quarter and that we are playing games with the numbers … [w]e are so out of touch with reality and when we start cooking books on new ideas or new rules of conservatism then you confuse everyone.

To which the CFO responded with the following voice mail.

Saw your email on rev rec. Will give you a response but not in much detail. I don't think it is healthy to be sending back and forth detailed emails on things like rev rec.

The SEC's complaint against the company continues to list numerous such exchanges between the executives. 4 Whether or not the CFO's intent was nefarious, he certainly missed an opportunity to put an ethical stamp on the exchange. And though this case and the first Enron example lacked the sense of cover-up, hostility, and intimidation present at WorldCom, the amoral attitudes enabled bad behavior to infect the organization and cause larger problems.

The Right Way

Along with the psychological studies that demonstrate the power of authority to affect bad behavior, there are also studies demonstrating the power of authorities to affect good behavior. The most famous is a series of studies on what is called "The Pygmalion Effect," which maintains that a person's expectations of another can modify the other's behavior in conformity with expectations. In the earliest studies, researchers concluded that teachers behave better toward students for whom they have higher expectations, and thus the students performed at a higher level. The teacher's expectations became, essentially, self-fulfilling prophesies.

Though there is a dearth of Pygmalion studies in for-profit work environments, the effects in classroom and military environments demonstrate strong correlations between an authority's expectations and a subject's performance. 5

One of my former clients, a $35 billion energy company, is well known for its outstanding internal control system. "Hit it in the middle of the fairway" is the CEO's catch phrase often reinforced by his managers. One of the company's most outstanding controls is the weekly budget meetings with the CEO. In those meetings, the sin is not in reporting bad news. The sin, for which there is no excuse, is covering up bad news or reporting bad news that is stale and should have been reported in the prior weeks. Walking the halls of this client, I was particularly struck by the sense of solidarity among the executives and managers regarding their pleasure in working for the company and their unanimous support of the corporate ethic.

A company can employ many different tactics to fight fraud, such as enact and enforce strong policies and procedures, establish an internal audit department that reports to an independent audit committee, and implement an anonymous fraud hotline, but a single unethical executive can undermine all of it.

The good news is that if executives outwardly demonstrate ethical behavior, then the troops will follow. A strong ethical environment is one of disclosure and transparency, in which the executives display zero tolerance for cover-up or intimidating treatment of subordinates. High-integrity executives seize responsibility for fighting fraud and exercising ethical behavior in their organization and embed that responsibility into the company's core philosophy. They exercise stewardship over company assets so that their spending patterns are never brought into question. They make it clear that they want to know immediately about allegations and what is being done to resolve them, and they do not retain known perpetrators of fraud.

Executives do not have the power to stop all fraud; no company is immune from unethical behavior. But a company led by high-integrity executives is more likely to detect fraud before it becomes too damaging because their subordinates will follow their lead by taking strange and curious transactions seriously and following up on those transactions appropriately. As the two researchers who studied the Pygmalion Effect on the Israeli military concluded, "The sarcastic adage that managers get the subordinates they deserve might be stated more constructively in Pygmalion terms: Managers get the performance they expect." 6

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1 Special Investigative Committee of the Board of Directors of WorldCom, Inc., Report of Investigation, (March 31, 2003).
2 Robert B. Cialdini, PhD., Influence: The Psychology of Persuasion, Revised Edition, (Quill, New York, 1993).
3 Kurt Eichenwald, Conspiracy of Fools, (Broadway Books, New York, 2005).
4 United States District Court for the Northern District of Texas Dallas Division, "Civil Action Complaint,"
5 Brian D. McNatt, "Ancient Pygmalion Joins Contemporary Management: A Meta-Analysis of the Result," Journal of Applied Psychology 85 (2000): 314-22.
6 Dov Eden and Abraham B. Shani, "Pygmalion Goes to Boot Camp: Expectancy, Leadership, and Trainee Performance," Journal of Applied Psychology 67 (1982): 199.