Business 303 Business Ethics Society Jerry Sheppard Introduction

Beyond the Text I. III. How we Broke the World Brook’s Business Ethics in Canada Stone’s Where the Law Ends 2

I. HOW WE BROKE THE WORLD Change in Regulation Sen. Phil Gramm (R, Texas), Rep. Jim Leach (R, Iowa), & Rep. Tom J. Bliley, (R, Va. ) Sen. Carter Glass (D-Va. ) and Rep. Henry B. Steagall (D-Ala. ), Co-sponsors of the 1932 Glass. Steagall Act. Co-sponsors of the 1989 Gramm– Leach–Bliley Act. • The Glass-Steagall Act in the early 1930 s stabilized the U. S. banking system, protected depositors, and restricted bank activity out of the securities and insurance industries. • The Gramm–Leach–Bliley Act ended Glass-Steagall and allowed banks the opportunity to enter the securities and insurance industries. 3

Early Warnings The case for preserving the Glass-Steagall Act included the following arguments. • Conflicts of interest characterize the granting of credit - lending - & the use of credit - investing - by the same entity. • Depository institutions enormous power… must be limited to ensure soundness and competition in the market for funds. • Securities activities can be risky, leading to losses that may threaten the integrity of deposits government insures & may be required to pay in the face of collapse from such losses. William D. Jackson to Congress Specialist in Financial & Finance • Deposit institutions are supposed to be. Government managed to limit 4

What the banks did • The banks moved into insurance and securities business, as the law now allowed. • Banks also became involved in a range of new investments. Of major concern should have been: – Mortgage Backed Securities (MBSs) – essentially bonds that have real estate assets as collateral. – Credit Default Swaps (CDSs) – basically insurance against a loan going bad (actually a bet). • EXCEPT a CDS can be written for an investment you do not own, or can be written several times over. – Concept of Too Big to Fail – The notion that a bank is too big to fail and that in the event of major losses the government will bailout the institution to prevent general 5 economic collapse.

What Happened • The banks would issue mortgages, many of which were loans to high credit risks on overvalued property. • The mortgages were then bundled together as collateral for mortgage backed securities and sold to unsuspecting investors. • They then created Credit Default Swaps on the Securities that were likely to go bad. • Insurance companies invested the money they made on CDSs in MBS that were bad. • The banks forgot everyone else might issue bad MBS and also invested in them. 6

The Problem • As mortgages went bad, foreclosures rose, put homes on the market & depressed housing prices. • As housing prices dropped, it made sense for folks to walk away from their upside down homes. • This made more bad MBSs & more CDS payouts. • Insurers like AIG thus did not have the cash to payout on CDSs & the government had to step in to prop up insurers & banks with bad MBSs. • The banks now had no incentive to lend since it made more sense to deny a loan & bet on a CDS that the company would fail (e. g. G. M. s bankruptcy). • Hence, Theft of public funds for private use and the 7 slow recovery in the U. S.

The Point: Adverse Selection & Moral Hazard • The result is that there is a market failure in the form of Adverse Selection and Moral Hazard. Adverse Selection Moral Hazard General Definition Information is hidden from the insurer prior to the transaction. Volvos Reckless drivers are more likely to buy Volvos. Big eaters are more Hidden actions occur after the transaction that are costly to the insurer. Once you own a Volvo All you can eat restaurants BANKS you will drive more recklessly. Once you’re in, it likely to go to these restaurants. Banks who write bad makes sense to overeat. Knowing you are too loans are more likely to seek out Credit Default Swaps. big to fail & the government will bail 8 you out, you are more

II. Brook’s BUS. ETHICS IN CANADA • Business in Canada has not been subject, to a powerful national institutional framework such as the US Securities and Exchange Commission & the Foreign Corrupt Practices Act. • Consequently, business ethics in Canada have developed primarily in response to broader sociopolitical and socio-economic factors than in the US, and will probably continue to do so. • The issues, policies and practices developed in Canada may provide insights for US corporations as they respond to broadened pressures. 9

Pressures from responsible investors • Social Audits for Corp. Social Performance • Task Force on Churches & Corp. Resp. (TCCR) – Issues put before management included: Apartheid in South Africa, human rights, military exports, international lending, corp. disclosure, aboriginal issues, environmental protection, corp. governance, and responsible investment. • Ethical Mutual Funds & large responsible investors. 10

Pressure from directors & consultants • Directors insuring Long Run Profitability by insuring sustainability, human resource equity. • Groups like Ethic. Scan & Corp. Ethics Monitor. • Canadian Centre for Ethics & Corp. Policy (CCECP) – Provided forums for discussion of ethical issues. • Centre for Corp. Social Performance & Ethics (U of T) – A university-based centre which undertakes both academic research and consulting to business. – Collects & computerizes corp. code data, provides consulting services on creation / revision of ethics codes, develops training programs, analyzes corp. governance systems, – The Centre organized invited conferences on “Stakeholder Theory & the Management of Ethics in the Workplace. ” 11

III. Stone’s WHERE THE LAW ENDS Christopher D. Stone. 1975. Where the Law Ends: The Social Control of Corporate Behavior. New York: Harper & Row, Publishers, 273 pages. • Much of my review summarizes D. L. Arthur, 1976, Administrative Science Quarterly, 21 (2): 356 -358. • Basically this book is a good introduction into what the Law is, and is not, capable of doing to control corp. behaviour in the public’s interest. • Written early on in the development of the area of “Social Issues in Business, ” the book directed academics and practitioners toward more detailed suggestions toward good governance. 12

Stone Summary (1 of 2) • In Dartmouth vs Woodward (1819) the U. S. Supreme Court declared: "A corp. is an artificial being, invisible, intangible, and existing only in contemplation of law. ” • Subsequent to that decision most theories, policies, and laws pertaining to corporations consistently have acknowledged the "being" quality of corporations and ignored the "artificial. ” – This is reflected in contemporary theories & laws which assume corporations respond to econ. & legal incentives in a manner similar to individuals.

Stone Summary (2 of 2) • Stone develops the notion that corporations are not people & there are important differences between human & artificial beings. – Stone's theme is that social incentives which effectively channel the behavior of individuals in a socially desirable direction are not effective in channeling the behavior of corporations. • The intellectual significance here is that he focuses attention on an important, but neglected, area of social inquiry: the influence of external forces on the conduct of corp. members. 14

Stone: Part 1 of 4 Corporations & the Law Develop – But Not Apace • The first four chapters look at the division that has occurred in the evolution of the corporate form and the legal environment intended to control it. • In the first chapter Stone notes: – ”the law ought constantly to be searching out and taking into account the special institutional features of business corporations that make the problems of controlling them (and… men-in-them) a problem distinct from that of controlling human beings in ordinary situations. " • The next 3 chapters detail how early corp. law failed to distinguish between human and artificial beings. – So by the end of the 1800 s there was a widening gap between what the law needed to consider to impact corp. 15

Stone: Part 2 of 4 The Historical Legacy [& more recent legal approaches to social control of corp. ]law, Stone notes why • Mixing behavioral sci. the & case efforts to control the corp. & its members have failed. • Laws have not taken into account "special institutional features" of the corp. not applicable to human indiv. s. – For example human beings may be influenced by feelings of shame & guilt and by external controls such as prison. – Corp. s are unaffected by traditional social control techniques 16

Stone: Part 2 of 4 The Historical Legacy (Continued) [& more recent legal approaches to social control of corp. ] • Considerations of thethe good a Corp. can do may be weighed against punitive measures & a corp. goes unpunished (MER/29). – This has changed somewhat (e. g. A. H. Robins, Johns Manville). • Criminal Penalties aimed at individuals are difficult to pursue because identifying a truly purposeful actor who may have committed the wrong within the Corporation is difficult. 17

Stone: Part 3 of 4 The Corporate Social Responsibility Debate • Stone considers, in succession: efficacy of "markets" & then "responsibility" in controlling corp. conduct. • Through careful analysis of actual corp. behaviour Stone looks at how the "market" is unable to protect against corp. mis-conduct (e. g. its reactive nature & information asymmetries). – He concludes that "responsibility" is necessary because the law & the market are inadequate controls. • This conclusion is the opposite of that held by Milton Friedman (who believes corp. s need not be socially respon-sible since they are constrained by the law 18 and the market).

Stone: Part 4 of 4 Controlling Corporations: Putting the Model to Work • Stone makes suggestions which should result in more effective social control of corp. misconduct. • Corp. should be considered distinct from its members. • Corp. behavior is best understood from a process point of view rather than as individual behavior. – To control the corporation one must control the process. • To this end he suggests changes in: – the composition & responsibilities of certain corp. directors, – public access to corp. info. of public consequence, and – direct public monitoring of corp. activities in situations where there is the likelihood of corporate misconduct. • Stone’s recommended reforms are suggestive rather than definitive, but are logical derivatives of analysis.

Stone Conclusion • “If one considers only the narrative in each of the 4 parts it is quite possible that the essence of the book will be over-looked. – “Each of the 4 parts is interesting, well organized, & thought 20 provoking.

Stone Conclusion • “However, the lasting achievement of the book is its insightful glimpse into the complexities of the interrelationship between the external and internal environments of the corporation. – “From the studies of law and economics one can obtain a conceptual understanding of the external environment of the corporation. – “From the study of organizational theory and behavior one can acquire insight into the internal dynamics of the corporation. D. L. Arthur, 1976, Administrative (2): 358. a new • “What Professor Stone's. Science book Quarterly, does is 21 suggest field which examines interface [of business and • That field became the study of governance & ethical Society]. ” within the business organization: Business, behaviour End Society & Ethics.