This post is based on the executive summary of a Council of Institutional Investors white paper which was prepared by Robin A. Ferracone and Dayna L. Harris, Executive Chair and Vice President, respectively, at Farient Advisors, LLC; the white paper is available here.

Advisory shareowner votes on executive compensation were the big story of proxy season 2011, the inaugural year for “say on pay” at most U.S. public companies. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed into law in August 2010, requires U.S. public companies to provide their shareowners with a non-binding vote to approve the compensation of senior executives. The Securities and Exchange Commission’s (SEC) implementing rule, adopted on Jan. 25, 2011, requires say-on-pay votes to approve the compensation of the named executive officers (NEO) at larger companies at least once every three years. The SEC granted smaller companies a two-year exemption.

Say on pay gives shareowners a voice in how top executives are paid. Such votes are also a way for a corporate board to determine whether investors view the company’s compensation practices to be in the best interests of shareowners. Say-on-pay votes are purely advisory; U.S. companies are not required to change their executive compensation programs in response to the outcome. But SEC rules do require that in subsequent proxy statements, companies discuss how the most recent say-on-pay voting results affected their executive compensation decisions and overall programs. Such follow-on comments are to be included in the Compensation Discussion and Analysis (CD&A) section of the proxy statement.

Advisory votes on pay are not a new concept. Say on pay has been widely discussed in the United States as a way to hold directors accountable for runaway executive compensation for close to a decade, ever since the Enron (2001) and WorldCom (2002) scandals. The United Kingdom adopted mandatory say-on-pay votes in 2002, and Australia followed in 2004. Two U.S. companies — AFLAC and RiskMetrics — voluntarily held say-on-pay votes starting in 2008, with Motorola following in 2009, in response to strong investor support for shareowner resolutions requesting annual advisory votes on pay. The U.S. government required more than 350 companies that received federal bailout assistance after the 2008 global financial crisis to give their investors advisory votes on executive compensation, beginning with proxies filed after February 2009.

Analyzing Say on Pay

The Council of Institutional Investors, a leading advocate for say on pay, engaged Farient Advisors to analyze what motivated investors to vote against say on pay at companies where the proposal failed to receive majority support at 2011 annual meetings. The Council believes the report will benefit active investors by identifying compensation practices where support for change is greatest. It also could help them target initiatives for improved pay practices and provide useful input for structuring their voting policies. Companies will benefit, too, from knowing which compensation practices their owners view as detrimental to long-term shareowner value.

Between January 1 and July 1, 37 say-on-pay proposals fell short of majority support. Another 37 companies garnered significant, though less-than-majority opposition, with “against” votes of 40 to 50 percent. While 37 “failed” votes is a tiny fraction (less than 2 percent) of the 2,340 say-on-pay votes at U.S. companies in the first half of the year, the total was surprisingly large compared with the track record of say on pay in other countries.

Public attention has focused on the relatively high number of “failed” say-on-pay votes (proposals that failed to win majority investor support), the impact of proxy advisory firm recommendations on shareowner voting, the reasons for “against” vote recommendations by proxy advisers and, and most recently, shareowner derivative lawsuits at companies where say on pay garnered majority “against” votes. It is clear from our interviews and public filing research that some companies have changed or promised to change their pay levels and programs in anticipation of a strong vote against their say-on-pay proposals, or in response to a substantial percentage of “against” votes.

The report specifically examines:

• The driving factors that fueled majority opposition to say on pay at 37 companies
• The process investors used to determine how they would cast say-on-pay votes
• The influence that say on pay is having on executive compensation
• Potential next steps for shareowners to consider ahead of say-on-pay votes next year
• Potential next steps for companies where investor opposition to say-on-pay proposals was significant

Farient focused its investigation on advisory votes that failed to win majority shareowner support. Farient interviewed representatives from 19 Council member organizations (both U.S. pension fund and other members) about how they cast say-on-pay votes generally and more specifically at the 37 failed-vote companies. These investor participants consisted mostly of public employee pension systems (58 percent), followed by mutual fund firms (32 percent) and union pension funds (11 percent). (The total may not equal 100 percent due to rounding.)  Collectively, their assets under management exceed $7.9 trillion. Farient also interviewed proxy advisers and solicitors, and consulted its extensive database on executive compensation.

Farient found that investors cast advisory votes against executive compensation at the 37 companies for a variety of reasons, but the factors most frequently cited were:

• A disconnect between pay and performance (92 percent)
• Poor pay practices (57 percent)
• Poor disclosure (35 percent)
• Inappropriately high level of compensation for the company’s size, industry and performance (16 percent)

Other findings include:

• Investors were extremely thoughtful about evaluating executive compensation for say-on-pay votes
• Due to resource constraints, investors used proxy advisory firms’ analyses to varying degrees
• Investors considered multiple factors as well as inputs from various sources in determining their say-on-pay votes
• Investors evaluated performance and pay over multiple years, and focused primarily on total absolute shareholder return (TSR) over one-, three- and five-year periods
• Investors spent the most time and resources analyzing pay at “outlier” companies: those with large disconnects between pay and performance, high overall pay and/or low TSR in comparison to their industry or peers
• Investors focused on CEO pay, rather than the pay of other NEOs, and on the overall “reasonableness” of the level of compensation in view of the company’s size, industry and performance
• Investors mostly regarded the say-on-pay vote as an opportunity to voice their concerns about a particular pay program, not a referendum on directors’ oversight of compensation

Among majority “against” say-on-pay votes, about two thirds had opposition levels of 50–59 percent. The rest had “against” votes of 60–70 percent. About one-fourth (27 percent) were in real estate, homebuilding or construction-related businesses — industries that were hit hard in the economic downturn and mostly are still hurting. About one-fifth (19 percent) were energy-related companies. Nearly half were large companies, with annual revenues greater than $1 billion.

Moving Forward

This first year of mandatory say on pay has been a learning experience for all participants. Farient encourages investors to conduct a “post-mortem” of their voting processes, including an assessment of any additional resources needed to evaluate say-on-pay proposals fairly and efficiently. Concerned investors should follow up to see what steps, if any, companies take in response to failed say-on-pay proposals, and consider appropriate action.

Farient also offers two critical areas for improvement in deciding how to cast a say-on-pay vote:

• TSR should not be the sole filter investors use to determine which companies’ pay plans deserve the most scrutiny. Problematic pay practices lurk at mediocre to modestly performing companies, too
• Assessing performance-adjusted pay — compensation that top executives could receive after performance is taken into account — and in particular the performance-adjusted value of equity — is more appropriate than focusing on the grant date value of equity incentives. The value on the date of grant, as determined by the stock price that day for shares (or options, using an options pricing model), does not reflect the compensation that executives ultimately earn

Companies that failed to win majority support for say-on-pay proposals, or that garnered substantial opposition, should reach out to key investors and engage them in dialogue about executive pay programs. They should also make sure their pay disclosures are clear and thoughtful and that their compensation programs are aligned with company performance. That means having a combination of pay that is sensitive to changes in performance, pay levels that are appropriate overall, and a substantial proportion of pay that is performance-based. In particular, companies should consider setting the magnitude of pay changes in response to performance, so that the changes swing proportionately with strong or weak performance.

In Closing

Legislation has forced both investors and companies to pay more attention to executive compensation. Compensation committees and boards have become much more thoughtful about their executive pay programs and pay decisions. Companies and boards in particular are articulating the rationale for these decisions much better than in the past. Some of the most egregious practices have already waned considerably, and may even disappear entirely.

Say on pay is a non-binding advisory vote. Investors agree that they do not want to dictate executive pay arrangements. Rather, they want to ensure that the executive pay programs of their portfolio companies incentivize executives to increase shareowner value for the long term. Moreover, if the pay programs are not benefitting long-term owners, investors want the ability to influence their portfolio companies to make the necessary changes. This seems to be what say on pay is all about.

Ann Yerger is Executive Director of the Council of Institutional Investors. This post is based on the executive summary of a CII white paper which was prepared by Robin A. Ferracone and Dayna L. Harris, Executive Chair and Vice President, respectively, at Farient Advisors, LLC; the white paper is available here.

This article was first published on the Harvard Law School Forum on Corporate Governance and Financial Regulation and is re-published with the author's permission.

by James Hyatt

So your company hasn't had an OMG moment over Facebook ethics?

As they say, Good Luck With That.

It has been almost a decade since Congress passed the Sarbanes-Oxley Act in the wake of the Enron, Tyco and WorldCom scandals, seeking to put in place a variety of measures to protect investors and address standards of behavior. Over the years, once-controversial practices about disclosure and ethics have become generally accepted standards.

But the social media explosion - from email and Facebook to blogs and Twitter – is making a hash of once-resolved issues and creating all kinds of new dilemmas.

--Businesses have less and less control over how they communicate with the public, while 24-7 bloggers feel free to snipe away.

--Job seekers find their private lives may no longer be private and employees worry that the boss is electronically looking over their shoulders.

--Consumers can't be sure their account information remains safe and have no way to tell whether favorable on-line comments about products and businesses are legitimate.

--Professionals of all sorts -- psychiatrists, attorneys, school teachers, reporters, and even NFL players – are learning to live with new, often controversial, social media rules. A customer's irate blog can undo months and years of corporate image work. A careless email can sabotage delicate contract talks or M&A negotiations. Failure to protect customer information can result in years of costly litigation. An old party-hearty photo may block a chance at a new job. Hitting “send” without thinking can torpedo an executive’s career.

In just one recent week:

--an email circulating among male employees at the PricewaterhouseCoopers Dublin offices – rating the ‘top 10’ new female recruits, with headshots – quickly went “viral” and drew widespread criticism. (Some tut-tutting newspapers, however, also saw fit to run the headshots as news.)

--an executive at Pacific Gas & Electric in California was put on paid leave after seeking to join, under an assumed name, an online discussion group critical of the utility’s plans to install “smart meters.”

--labor lawyers across the country warned clients that a  National Labor Relations Board (NLRB) office planned an unfair labor practice complaint against an ambulance company for firing an employee who posted negative Facebook comments about her supervisor.

--Britain’s financial regulator, seeking to address insider trading, ordered financial services firm to keep records of employee cellphone calls.

No wonder companies are rushing to build new defenses and adopt new policies to reinforce ethical behaviors and learning how to use social media to react to real-time problems. At the same time, individuals are rethinking their casual attitude about exposing personal information on the Web. And in Washington, government agencies are adopting new guidelines defining acceptable social media behavior.

Defining social media behavior is clearly a work in progress

A year ago, the Society of Corporate Compliance and Ethics and the Health Care Compliance Association looked at what organizations are doing about social media issues. Twenty-four percent of those surveyed said an employee had been disciplined in their organization for activities on Facebook, Twitter or LinkedIn, more often in the not-for-profit sector. But half of the respondents said their organization had no policy regarding employee online activity outside of work.

Technology search firm Robert Half in April asked chief information officers about social networking policies; 38% said their companies have tightened social networking policies, while 17% say the policies have eased. And 55% reported “no change”.

A recent survey by Deloitte of about 1,700 companies found that 26% said they had no social media policy which 34% answered “not applicable/don’t know” even though 84% thought every company should have a social media policy in place.

Your Social Media Profile Can Affect Your Job Prospects

A survey commissioned by Microsoft in December 2009 found that 79% of hiring managers and job recruiters reviewed online information about job applicants, and 70% of U.S. hiring managers surveyed said they’d rejected candidates based on what they found online. “Chances are you already have a reputation online, even if you don’t want one,” Microsoft says.  And three-fourths of the U.S. recruiters and HR professionals said their companies have formal policies requiring hiring personnel to research applicants online.

The survey firm declared that “Now, recruiters can easily and anonymously collect information that they would not be permitted to ask in an interview, and the survey found that recruiters are doing just that.”

Corporate and union attorneys went on alert early in November 2010 when word spread of the NLRB’s unfair labor practices complaint involving the Facebook posting. The NLRB said the company’s social media policies were “overly broad.”  The LegalTimes blog quoted the company as saying “although the NLRB’s press release made it sound as if the employee was discharged solely due to negative comments posted on Facebook, the termination decision was actually based on multiple, serious issues.”

Although an administrative law judge will have to rule in the case, Philadelphia-based law firm Morgan, Lewis & Bockius LLP declared that “all private sector employers should take note of this issue, regardless of whether their workforce is represented by a union.”

You Need a Social Media Policy

Social media behavior “can have real legal and economic consequences for businesses,” writes attorney Michelle Sherman in a Social Media Law Update Blog for law firm Sheppard Mullin Richter & Hampton LLP.

“A post may seem as innocent as an employee expressing a personal opinion.  However, if the person describes herself as working for a particular company, and then speaks on a highly controversial subject, her post could damage the ‘good will’ of the company. Or, the poster may be recommending a product to all of her Facebook friends without sharing that she happens to work for the product manufacturer in violation of fair advertising practices.”

Sherman says adopting a social media policy can show compliance with Federal Trade Commission guidelines about endorsements, and can better protect brand value “by ensuring that employees do not post unflattering material in association with the business.”

One of the most remarkable studies is the 130-plus-page Social Media White Paper, now in its second edition, prepared by Reed Smith LLP.  The paper review 13 areas where social media is impacting business – from advertising and marketing to trademarks – and declares “the key lesson is that rather trying to control, companies must adopt an altered set of rules of engagement.” Well worth a visit.

It has become increasingly common for major companies to issue specific directives on social media behavior.  While most encourage employee efforts to put companies in a positive light, they also spell out acceptable conduct. For example:

(Wells Fargo): “By posting content on this Blog, you expressly grant Wells Fargo (and its affiliates) the right to use or distribute the posted content in any form, worldwide, and in perpetuity.”

(Kaiser Permanente): “Be mindful of the world’s longer memory – Everything you say is likely to be indexed and stored forever, either via search engines or through bloggers that reference your posts.”

(FedEx): By posting to the FexEx Citizenship Blog “you agree not to post or transmit anything unlawful, threatening, libelous, defamatory, obscene, inflammatory or pornographic, or anything that infringes upon the copyright, trademark, publicity rights or other rights of a third party.”

(Mayo Clinic): “Where your connection to Mayo Clinic is apparent, make it clear that you are speaking for yourself and not on behalf of Mayo Clinic. In those circumstances, you may want to include this disclaimer: ‘The views expressed on this [blog; website] are my own and do not reflect the views of my employer.”

(Microsoft): “As a general rule, Microsoft does not review, edit, censor, or, obviously, endorse individual posts. You should ‘be smart’ and, as an employee of the company, you should not only think about how your blog reflects on you as an individual, but also about how your blog affects Microsoft as a whole.”

Concerns go well beyond defining proper behavior and move into legal areas. FINRA, the successor to the National Association of Securities Dealers Inc., stresses that social media postings can violate industry rules about promoting investments and soliciting customers. FINRA says securities firms should take steps to be sure that employees using social media sites for business are “appropriately supervised” and “do not present undue risks to investors.”

The Social Media Business Council, a group of large companies that explore social media issues, posts a free “Disclosure Best Practices Toolkit” online suggesting checklists to help companies and employees “learn the appropriate and transparent ways to interact with blogs, bloggers, and the people who interact with them.”

It makes recommendations on how to deal with bloggers, on how employees should handle personal and unofficial blogging, on how to be transparent in providing rewards or incentives to bloggers, on best practices for third parties acting on behalf of a company, and on best practices for “artistic/entertainment situations where temporarily obscuring the sponsor of a site is necessary and appropriate.” For instance, it is okay to use a pretend blog where someone writes that they may have discovered aliens in their house to promote a science fiction movie. But it is not okay to create “a fake customer blog where the ‘author’ writes: ‘I’d love to go see this movie.’ “

This is the first of a two-part series.   The second part is available here.

James Hyatt, a retired reporter and editor for The Wall Street Journal, has been writing about business ethics and social responsibility issues since 2005.

by Kenny Moore
www.kennythemonk.com

Before I came to work in corporate America, I spent 15 years in a monastic community as a Catholic priest.  Actually the work’s proven to be quite similar, only the pay’s now a lot better.  With all the recent scandals plaguing the business world, the question of integrity often arises: How can I tell if an executive is trustworthy? What are the signs to look for in promoting leaders in this new era of doubt and suspicion?  With over 20 years in the workplace, here’s my litmus test for gauging executive credibility and trust.

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1 – How do they treat waiters?

Character is revealed by how we treat those with no power.  Watch how executives act around folks who have a vulnerable stature in the community: waiters, secretaries and bathroom attendants.  People who are powerless draw out our internal dispositions.  No one watches how you treat those on the margins.  If what we do when nobody’s watching reveals character, start paying closer attention.  Executive assessment has now become as plain as day.

If you can’t join your corporate bosses for lunch, do the second best thing: observe how they act around children.  Johnny Carson never liked having kids on The Tonight Show because they stole the limelight and often got more laughs.  People who are focused on themselves and require absolute control and personal adoration don’t mix well with children.  So at the next company picnic, be vigilant about how your leaders respond to the kids in the crowd.  It’s more statistically significant than 360-degree feedback.

2 – Can they pass the “Carl Sandburg test”?

This Chicago poet was the champion of ordinary folks, the common men and women of the workplace.  Pay attention to how executives relate to the folks who make up the rank and file of organizations.  These are not your high potentials that get chauffeured away for Executive Development. They’re the ones who do the chauffeuring or stay behind and get the work done.  Corporate success resides in engaging their passion and commitment.  Sam Walton’s spirit must have plummeted when news reached Heaven about rogue Wal-Mart managers locking store doors and forcing their laborers to work unpaid overtime.   I wonder if there’s an Enron in the making somewhere in that corporate culture?

Look closely at how executives treat their daily laborers.  Do they talk with them and invite them to any of their employee meetings?  Do they have a personal relationship with a few and know something about their families?  It gives me hope when I see my leaders authentically relate to our entry-level workers.  If it were up to me, Sandburg’s “The People, Yes” would be required reading for climbing the corporate ladder.  I believe most of the world would respond favorably to a C.E.O. who could quote poetry.

3 – What’s their “interior” business conversation?

Part and parcel of business life is making decisions.  Whenever I can, I listen for the hidden dialogue that’s used in pondering and resolving ethical business issues.  What goes into the executive’s moral judgement-call?  Is it only about profit, sales and career advancement?  Is there any semblance of an “interior life” that exists within this business leader?  Some  consideration of purpose, meaning or legacy?  Are there other facets being viewed: impact on the customer, the environment and the local community?  Was some thought given to corporate values, ethical principles or (God forbid!) employees’ feelings?

I still remember the day when I was hosting an executive meeting and we were informed that one of our managers had just died of cancer.  As the President shared the news with the group, he then asked for a minute of silence for him and his family.  Moments later, we composed ourselves and continued the meeting.  This small gesture said volumes about how the executive viewed his workers and their contributions.  I think that was the juncture where I fell in love with my company.  Something inside me realized that corporations are truly human systems - they live, breathe and grow.  And I decided that they’re worthy of my affection.  It’s sort of like being with family.  Not that I always like what they do, but I work at loving them just the same.

4 – Do they occasionally see themselves as part of the problem?

I’ve grown weary of hearing every C.E.O. who gets before the media, glibly announce: “We have no ethical problems in my company.”  Huh?  If we’ve learned anything in these recent months - it’s that all man-made systems are flawed and full of mistakes.  As long as organizations are comprised of people, they’re not going to be infallible institutions.  This is something even the Catholic Church, experts on infallibility, have recently come to appreciate.  The revealing executive question is: “What is your contribution to the problem that you’ve come here to explain away?”  If they see none, then we’re in for trouble.

Not that I’m asking all executives to bare their corporate souls in public, but business leaders need to create the environment for surfacing flawed practices and taking decisive action.  This line of thinking has a confessional aspect to it, and the priest in me likes it.  I find that those who have the humility to acknowledge corporate shortcomings offer us some hope that business justice will eventually be served.

5 - Can they make the workplace friendly for artists?

My favorite definition of integrity is “… a firm adherence to moral and artistic values.” The moral part of this discussion is obvious.  The artistic side often gets lost in business.  Executives can’t rely solely on accountants and engineers to safeguard the integrity of our corporate institutions.  We need artists to complement their efforts.  They are the ones who have the language, mythology and requisite skills for building the spiritual side of business.  In large part, it is the voice of the artist that has remained silent during these corporate failures.  It is they, however, who are the shamans of the 21^st century.

Business and religious leaders have left us feeling violated and without hope.  We need spokespeople for the Sacred and the True, which co-exists within the world of commerce.  Our organizational charts long for those who can use word, color and brush to reveal that the world has became surprisingly small.  That my individual action reverberates across the globe.  Artists  remind us that misdeeds done by a few can injure the many.  Just as we look to our internal “adult” for moral direction, we should look externally to the poets, painters and mystics in our places of work to shore up the frailty of the human condition in the marketplace.  Like Walt Whitman of old, I believe that present day artists will usher in a new era of celebration in business … revealing the sacredness of the human spirit, its vast potential for world good and its rectitude in the face of deceit and transgression.

It’s a message of hope.   The Corporate world could use more of it these days.  I believe it’s a legitimate demand to place upon our leaders.

P.S.  If you’re thinking about writing me, give in to the temptation.   I love getting mail ... and being influenced by what you have to say.  Please e-mail me at kennythemonk@yahoo.com.

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Kenny Moore (www.kennythemonk.com) is co-author of The CEO and the Monk: One Company’s Journey to Profit and Purpose (John Wiley and Sons), rated as one of the top ten best selling business books on Amazon.com and based on his experiences as a Human Resources executive for a large international energy company where he reported directly to the Chairman and CEO.  Kenny’s numerous writings have been published in Warren Bennis’ Leadership Excellence magazine, OD Practitioner and The Journal for Quality and Participation. He is also an "Executive in Residence" to the Institute for Corporate Productivity (i4cp).

Prior to his corporate career, Kenny spent 15 years in a monastic community as a Catholic priest.   He is now President of Kenny Moore Consulting, LLC and is a well-regarded keynote speaker, executive coach and business consultant in the areas of Leadership Development, Change Management and Employee Engagement. Kenny Moore can be reached at kennythemonk@yahoo.com.

Criticisms of business seeing value creation only in terms of achieving short-term, unsustainable results and how business schools prepare future leaders predate the financial meltdown. Warren Bennis and Jim O’Toole talked about the need to reform business education several years ago. The crisis simply made it more obvious that business as usual isn’t working, either in the classroom or boardroom.

The piece of management education reform that involves the role of ethics has added importance not only because trust in business has fallen so far, but also because it is tied to how leaders behave and the impact that has on a company culture as well as society.

When students return to campus in coming weeks, dialogue and debate on the purpose of management education and how ethics is handled will continue, impacted by initiatives that seek to help reinforce high ethical standards. Some examples are the MBA Oath project, and programs giving students experience practicing values and integrating ethics into other organizational risk considerations.

While well-regarded companies that have recently suffered reputation meltdown are real-world examples for the classroom, even more important is learning about other models for doing business, like Pepsico, a company that is intentionally setting high ethical standards for itself while still making significant profit.

For many companies ethics has a walk-on part—not much focus beyond the compliance function and website rhetoric about how a company describes its values. If integrating ethical considerations into strategic business decisions was the norm, we wouldn’t keep enduring debilitating crises where consequences of actions apparently aren’t clear to leaders until a regulator shows up or media headlines send stock prices lower.

Performance with Purpose

The reality is that crises at Toyota, Goldman Sachs and BP – to name a few -- involved ethical failures as potent as the business miscalculations and addiction to gaining ever-higher quarterly profits, where choices and shortcuts harmed stakeholders. Just as the ethical debacle of Enron was a wake up call met by additional regulation and beefed up ethics focus in companies, the corporate crises so far this year offer another kind of wake up call that companies and management education would do well to heed. How many more examples do we need of value creation only being about profit at the expense of society?

Indra Nooyi, Pepsico’s chairman and CEO, told students at Yale’s School of Management in May 2010 that “performance with purpose is how we run the company.”  She explained that “Performance with purpose is about how you can intimately link what a company can do with what the needs of society are and together deliver great performance.”

“Pepsico wants to be the model of the good company,’ she continued, “an example of how business should be done in the 21^st century.” This sets the bar very high at Pepsico. The business model requires integrating ethical considerations into the mix of business considerations, aligning decisions with purpose, and acting in a manner that inspires employees to do their best work. The result, if made a reality, establishes trust with stakeholders.

It is the inconsistencies that often trip a company up. Simon Webley, Research Director at the Institute of Business Ethics in London, makes a distinction between doing ethical things (like philanthropy and environmental activities) and doing things ethically. Doing the former is no substitute for doing things ethically, he says, mentioning a company in the U.K. known for the wonderful things it does for the community, but yet it doesn’t pay its suppliers on time. “It is easier to do CSR (corporate social reposnibility) than to integrate high ethical standards throughout the organization.”

Adhering to high ethical standards is at the heart of the Oath Project started at Harvard Business School last year as a grassroots movement of students and faculty. The voluntary pledge to “create value responsibly and ethically” seeks to create a community of MBAs (signers are from more than 250 schools) who share a high standard for ethical and professional behavior. Nitin Nohria, who became Dean of Harvard Business School this month, has been a strong supporter of the project.

Role of Values

Will signing a piece of paper change anything? It depends. We should consider how change occurs; it starts with a personal act of intention, followed by action, gaining reality through repetition and reinforcement until it becomes how things are done by an individual, and a collection of individuals. It is too soon to know the success of the movement or its influence on the companies graduates join. However, it is a start. The Oath Project is supported by many organizations, including Aspen Institute’s Business and Society Program (BSP).

Part of expressing high ethical standards is the ability to speak up in support of those values. Over 100 business schools globally are participating in an innovative, cross-disciplinary business curriculum called Giving Voice to Values (GVV) created by Mary Gentile. The program raises different kinds of questions than the case study approach: “Rather than asking ‘what is the right thing to do?’ she says, “we ask ‘how can I get the ‘right thing’ done?’” In GVV, students go on to answer other questions raised including: “What do I say to whom, what will they say back, and then what do I say? What data do I need? What allies do I need, etc.”

In GVV, Gentile says, “we ask students to create and practice literal scripts and action plans so that the program goes beyond awareness building and analysis to action.” The relatively new program was incubated at the Aspen’s BSP and also sponsored by Yale School of Management before moving to Babson College last year.

To help students practice integrating ethics into the decision-making mix, Loyola Marymount University (LMU) has developed an invitational intercollegiate business ethics case competition which attracts international participation. It is also sponsored by the Ethics and Compliance Officer Association, a professional group for corporate compliance officers, whose members serve as judges. MBA and undergraduate teams make presentations showing their understanding of the legal, ethical and financial dimensions of problems.

“Every decision you make in business generally occurs when you are under pressure, without all the information or time you’d like, and in the midst of competing factors – usually financial, legal or ethical issues,” says Thomas White, professor and director of the Center for Ethics and Business, who created the competition. “There needs to be more emphasis on ethics education in MBA programs (however it is done) because individuals need more technical ability in recognizing and resolving ethical issues, which are as sophisticated and complex as any financial problem, and getting more so.”

The success of business education reform has many champions, and is coming up again at a time when there is crisis fatigue as well as examples of successful companies with a value proposition that puts a priority on social good. Will current business leaders support training new leaders in skills and competencies that support new models of business or will we need to endure more business as usual?

Gael O’Brien is a Business Ethics Magazine columnist. Gael is a thought leader on building leadership, trust, and reputation and writes The Week in Ethics, a weekly column at http://theweekinethics.wordpr

In a decision with far-reaching implications for the prosecution of corruption and fraud cases in the United States, the U.S. Supreme Court ruled that the federal government's "honest services" law could be constitutionally applied only to cases involving bribery and kickbacks.

The court's ruling was a partial victory for two high-profile corporate defendants who had been charged under the honest services statute - Jeffrey Skilling, former CEO of Enron, and Conrad Black, former chairman of Hollinger International.

The court's reasoning in the Skilling case influenced its decision in the case involving Mr. Black and a third case involving Bruce Weyhrauch, a former Alaska lawmaker convicted under the honest services statute.

In opinions written by Justice Ruth Bader Ginsburg, the court sent the cases back to different lower courts to determine whether portions of the respective convictions should be thrown out.

With regard to Enron's Mr. Skilling, Justice Ginsburg wrote: "The Government charged Skilling with conspiring to defraud Enron’s shareholders by misrepresenting the company’s fiscal health to his own profit, but the Government never alleged that he solicited or accepted side payments from a third party in exchange for making these misrepresentations...Because Skilling’s alleged misconduct entailed no bribe or kickback, it does not fall within" the Court's confined definition of what is proscribed by the law.

The full text of the Court’s ruling in Mr. Skilling’s case can be found here. The ruling in Mr. Black’s case can be found here.  The ruling in Mr. Weyhrauch's case can be found here.

The Court's decision was not surprising.  During oral arguments before the court last December, a number of justices attacked the honest services law as broad and vague.

Chief Justice John Roberts Jr. declared at the time that the public "has to be able to understand the law, and if it can't, it is invalid." Justice Stephen Breyer imagined an employee shirking an honest day's work in order "to read the Racing Form," adding that this statute potentially criminalizes "100 million workers in the United States.”

Chapter 18, section 1346 of the U.S. Code, makes it a crime to use the mail or wire services in a scheme “to deprive another of the intangible right of honest services.”   The law was passed by Congress in 1988 in response to a Supreme Court decision the year earlier (McNally v United States) which struck down the honest services theory, ruling that it was an impermissible interpretation of the mail and wire fraud statutes at that time.

The problem, according to many legal observers, is that neither the 28-word provision nor the legislative history shed light on what “the intangible right of honest services” means or to whom it is owed.

Broad Impact Anticipated

The court was unanimous in narrowing the honest services statute, while three justices - Antonin Scalia, Clarence Thomas and Anthony Kennedy - would have declared the law unconstitutional even for bribery and kickback cases.

The court's ruling is likely to have a broad impact on pending and future white collar criminal fraud cases.

By limiting the statute to cases involving bribery and kickbacks, the decision "will sharply limit the number and types of cases" where the honest services statute is prosecuted, said John J. Falvey, Jr., a white collar criminal defense attorney with the firm of Goodwin Procter LLP.

Mr. Falvey, who in the past criticized the statute as "vague and capable of seemingly endless elasticity,"  today praised the court's opinion because "it effectively takes a bludgeon out of the hands of aggressive federal prosecutors who viewed every conflict of interest as a theft of honest services."

The court's ruling means prosecutors must now demonstrate "palpable conduct" by someone charged with honest services fraud, Mr. Falvey said.  In his own practice, he added, "there are several pending investigations that might be abandoned or narrowed because of the much narrower definition of the standard."

"This strikes me as a very reasonable middle-ground decision," said law professor Randall D. Eliason, former Chief of the Public Corruption/Government Fraud section of the U.S. Attorney’s office in the District of Columbia.  The core of the honest services theory historically has been cases involving bribery and kickbacks, he said, and "the Court has returned and confined the honest services theory to that core."   The decision, he added, addresses "the vagueness and overbreadth concerns about some of the more sweeping and aggressive applications of that doctrine that we have seen in recent years."

Mr. Eliason cautioned that the court's decision "does not mean that there are all these cases out there that are now not going to get prosecuted."   In most high-level corruption cases - as with Mr. Skilling and Mr. Black - prosecutors bring multiple charges based on several different theories of a case.   The court's decision is likely only to totally exclude "cases that are on the margins," he said.

Gerry Moohr, a professor at the University of Houston Law Center, said, "We used to say that the honest services law was a stradivarius, and prosecutors played it well before the jury.   Well, now they don't have that instrument to play anymore."

Ms. Moohr noted that the court's ruling does not change fraud law, involving theft of money or property.   As a result, she said, "there's a chance we'll see prosecutors being a little more creative about saying something is property than they have in the past."   Employers could allege, for example, that corporate information is property with real value, and "that because you deprived me of the value of my information, my property, you are therefore guilty of fraud."

Those who argued for a broader interpretation of the law said the court's ruling was a setback.  "Today's decision deprives prosecutors of an important tool in their efforts to fight public corruption," said Melanie Sloan, executive director of Citizen for Responsibility and Ethics in Washington (CREW), a non-profit organization that had filed an amicus brief in Mr. Black's case urging the Court to uphold the honest services fraud statute.

Ms. Sloan said the court's ruling means previous convictions may be vacated and "corrupt officials will have an easier time escaping accountability for their misdeeds.”  In anticipation of the ruling, CREW has been advocating a legislative fix. "Federal law currently prohibits executive branch employees from taking any official action that affects their personal financial interest," Ms. Sloan said. "This statute could easily be extended to cover members of Congress and state and local officials to ensure Americans are protected from government officials who sacrifice the public interest for their own private gain.”

In a footnote to the court's opinion in the Skilling case, Justice Ginsburg noted that if Congress were to take up the enterprise of criminalizing “undisclosed self-dealing by a public official or private employee" it "would have to employ standards of sufficient definiteness and specificity to overcome due process concerns."

The opinion concluded: "That formulation, however, leaves many questions unanswered. How direct or significant does the conflicting financial interest have to be? To what extent does the official action have to further that interest in order to amount to fraud? To whom should the disclosure be made and what information should it convey? These questions and others call for particular care in attempting to formulate an adequate criminal prohibition in this context."

“Affected firms have worse stock performance, worse accounting performance, a greater likelihood of an extreme negative return, a greater likelihood of a restatement, and a greater likelihood of being sued by their shareholders” following surprise outside director departures in difficult business circumstances, the study found.

Governance advocates and regulators have long argued that independent directors improve corporate decision-making and business performance.  Listing standards of U.S. stock exchanges require that boards have a majority of non-executive or so-called “outside” directors.  The requirements were amended following high-profile scandals at companies such as Enron and WorldCom and enactment of the Sarbanes-Oxley Act of 2002.  Guidelines for non-executive board members vary in other countries but most also recommend active roles for independent directors.

The study - The Dark Side of Outside Directors: Do They Quit When They Are Most Needed? - was based on analysis of 332,327 “outside director-firm-years” involving 10,513 distinct firms and 64,105 distinct directors from 1989 through 2004.  It was conducted by finance and business professors Rüdiger Fahlenbrach, of the Ecole Polytechnique Fédérale de Lausanne; Angie Low of Nanyang Technological University; and René M. Stulz of Ohio State University.

The study’s authors assert that an inside director who resigns from a board most likely also has to resign from his or her job, creating an incentive for them to stay on the board and work to improve the firm’s performance.

“In contrast, an outside director in the same situation who does not resign faces the risk of experiencing a loss of reputation as an outside director when the bad news breaks,” the authors write. “Such a loss of reputation may make it harder for the director to obtain other board seats and perhaps even to keep the seats she already has.”   Additionally, the director would likely face an increase in his or her workload as the firm undergoes change and restructuring.

A highly anticipated decision by the U.S. Supreme Court on the constitutionality of the federal honest services law, expected within weeks, could have major implications for hundreds of criminal cases involving public officials and business executives convicted or charged with fraud.

As an example of the stakes involved, U.S. Supreme Court Justice John Paul Stevens on Friday gave federal prosecutors a week to respond to former Illinois Gov. Rod Blagojevich's request to delay the June 3 start of his corruption trial.

Mr. Blagojevich’s lawyers argue that the trial should be delayed until the high court decides on the constitutionality of the honest services law, which forms the basis for a number of charges against Blagojevich and his brother.  The two allegedly used Blagojevich’s power as Governor to fill U.S. Senate vacancies to sell or trade the Senate seat vacated by Barack Obama following his November 2008 election to the White House.

(Update 5/28: The Supreme Court denied Mr. Blagojevich's request to delay the June 3 start of his trial.)

The honest services law has been an issue in three cases argued before the Supreme Court this term, involving former Enron chief executive Jeffrey K. Skilling, Hollinger International chairman Conrad Black and former Alaska lawmaker Bruce Weyhrauch.

The statute has also figured prominently in convictions of dozens of prominent public officials and business executives, including former Alabama Governor Don E. Siegelman, found guilty of violations related to campaign contributions, and Washington lobbyist Jack Abramoff,  who is now serving a four-year prison term on corruption charges.  Only two weeks ago, a federal judge sentenced former New York State Senate majority leader Joseph Bruno to two years in prison but then suspended the sentence pending a Supreme Court decision.

Defining Honest Service

The high court could uphold the honest services law, strike it down completely or limit its application.  While it is always risky to handicap the court’s decision-making process, many lawyers and legal scholars expect the court to take some action.

During oral arguments before the court last December, a number of justices attacked the honest services law as broad and vague.

Chief Justice John Roberts Jr. declared that the public "has to be able to understand the law, and if it can't, it is invalid." Justice Stephen Breyer imagined an employee shirking an honest day's work in order "to read the Racing Form," adding that this statute potentially criminalizes "100 million workers in the United States.”

Chapter 18, section 1346 of the U.S. Code, makes it a crime to use the mail or wire services in a scheme “to deprive another of the intangible right of honest services.”   The law was passed by Congress in 1988 in response to a Supreme Court decision the year earlier (McNally v United States) which struck down the honest services theory, ruling that it was an impermissible interpretation of the mail and wire fraud statutes at that time.

The problem, according to attorneys John J. Falvey Jr. and Ryan E. Ferch of the Goodwin Procter law firm, is that neither the 28-word provision nor the legislative history sheds light on what “the intangible right of honest services” means or to whom it is owed.  “Prosecutors love the honest-services statute for the same reasons many courts hate it: It is short, vague and capable of seemingly endless elasticity,” they say.

Adam Hoffinger, of the law firm Morrison & Foerster, has called the law “the most brazen and obvious attempt to criminalize behavior that may be bad, but that would not otherwise be considered criminal.”

Randall D. Eliason, former Chief of the Public Corruption/Government Fraud section of the U.S. Attorney’s office in the District of Columbia, writes that in a typical federal corruption case, honest services fraud will be “easier to charge and prove than bribery or gratuities, will apply to a wider range of conduct, and will carry a greater potential penalty. From the prosecutor’s standpoint, what’s not to like?”

Such vagueness can be dangerous, argues Geraldine Szott Moohr, a professor at the University of Houston Law Center. In a recent column in the Houston Chronicle, she asks: “Is following a supervisor's order to write an unlawful contract an instance of dishonest services to the firm? Does sending a personal e-mail from an employer's computer violate the obligation to provide honest services? What about calling in sick to attend a ball game? Given the vagueness of the statute, juries today can readily answer ‘yes’ to these questions — even though the employees may have no idea (or fair notice) that they were embarking on criminal conduct.”

The Supreme Court has received criticism of the law in friend-of-the-court briefs from both sides of the political spectrum, including the U.S. Chamber of Commerce and the more left-leaning National Association of Criminal Defense Lawyers.

In arguing for the federal government on behalf of the law in December, Deputy Solicitor General Michael R. Dreeben said it would "devastate a core area of public corruption" law if the measure were thrown out.  Citizens for Responsibility and Ethics in Washington, a non-profit organization, filed a brief with the court which called the statute “an indispensable prosecutorial tool for fighting public corruption.”

Limiting the Law

In the event the Supreme Court upholds the honest services statute, the drumbeat for reform of the law is likely to continue.

Former federal prosecutor Mr. Eliason said in a 2009 paper that he believes “(t)he best solution is for Congress to restore the proper balance in the law concerning federal corruption by amending the bribery and gratuities statute and providing a precise definition of honest services fraud.” He believes the current situation leaves the standards concerning public corruption “impossibly vague and subject to constant judicial or prosecutorial revision.”  As a result, he writes, “it is past time for Congress to act.”

In Houston, where Enron’s bankruptcy left thousands without jobs and ravaged investment portfolios and retirement plans, victims “understandably want former CEO Mr. Skilling to serve every bit of his 24-year sentence,” says Ms. Szott Moohr of the University of Houston Law Center.  But she adds, “(u)ntil our highest court rights this constitutional wrong, all employees remain vulnerable to arrest and conviction for honest services fraud.”

She believes the Court is “likely to render the honest services statute less vague and pull it back into the constitutional realm, perhaps by limiting offenses to well-defined conduct such as taking bribes or kickbacks.” Alternately, the court could simply declare the law unconstitutional for its ambiguity, inviting Congress to rewrite the statute.  In either case, she concludes, Mr. Skilling could be tried again for traditional property fraud, on evidence that he deceived shareholders in order to defraud them of money or property.

“Either ruling from the Supreme Court would be a good thing not only for this particular felon, but also for every American in the workplace,” she says.

One of the keys to the fraud that brought down Enron Corporation almost a decade ago was a series of off-balance sheet financial entities that allowed the giant energy company to hide mounting losses and orchestrate corporate earnings reports.  Andrew Fastow, the company’s ambitious chief financial officer, named some of these investment vehicles “Raptors".

In “Enron,” the new semi-musical just opened on Broadway, the raptors are physically portrayed by actors as Jurassic Park-like beasts that voraciously gobble debt from briefcases.   As Enron’s tale of greed and corruption unfolds, Fastow’s relationship with the raptors becomes more harried and manic.  The raptors become ill, unable to digest any more of the phony financials.   The scheme unravels, forcing Enron into bankruptcy, the largest on record at the time.  Billions are lost.  Countless investors and employees are hurt in the process.

“Enron” the play tries hard to stimulate, dazzle and entertain. The problem is that it tries too hard.  In the process it dilutes the authentic drama and power of the story behind Enron the company, a real-life corporate tragedy that really needed no embellishment.

It’s not that playwright Lucy Prebble hasn’t done her homework – in fact, “Enron” does a pretty good job of explaining the many layers of questionable practices that led to the downfall of the company and its senior executives.   An ambitious young president, Jeffrey Skilling (played by Norbert Leo Butz), impresses company founder Kenneth Lay (Gregory Itzin) with the notion of “mark to market” accounting, abusing the practice to inflate earnings and asset values.  Skilling encourages CFO Fastow (Stephen Kunken) in the creation of Enron’s “special purpose entities,” including the notorious LJM partnerships that were named using the initials of Fastow’s wife and children.

"Changing the World"

While the play focuses on Skilling and Fastow, there’s plenty of blame to go around. Enron founder Lay is a glad-handing chairman who orchestrates the company’s board (portrayed by three blind mice).  Wall Street firms make cash investments in Fastow’s dubious financial shenanigans, and their research analysts write favorable reports on Enron, out of fear that they will miss out on lucrative stock underwriting and financing deals.  The esteemed accounting firm of Arthur Andersen signs off on all of it and is forced into bankruptcy when the scandal unfolds.

Feeding the Enron frenzy, of course, was a booming 1990’s stock market, rich with hot technology and Internet startups.  Prebble’s script captures some of that fact and flavor:  Enron’s attempt to cast itself as a broadband Internet access provider, despite a complete lack of resource and experience in the field, is one of many examples of the hubris that afflicted Skilling.  As young Enron executives party to a techno-beat, ringing in the next millennium at a New Year’s party in 2000, Skilling exults: “We are changing people’s lives!   We are changing the world!”  He seems to believe it.

The biggest problem with "Enron" is that it doesn’t work as a play.  Promoted in part as a musical, the show has a handful of numbers by a well-intentioned but forgettable chorus.  There’s no danger that any audience member will leave the theater humming a memorable tune, because there are none.  In the end, “Enron” seems to be talking down to its audience, using stage effects to make financial concepts more palatable.   That probably isn’t necessary, certainly after the last couple of years.  Most Americans, unfortunately, now understand a good financial scandal when they see one.

Whistle-blowing by employees and insiders is a “useful mechanism” for uncovering corporate misbehavior, with clear economic and governance impact on the companies involved, according to a new academic study.

“Whistle-blowing allegations had an immediate negative economic consequence for target firms,” the study found.  On average, the stock price of a target company fell 2.8 percent in the five days around the day an allegation became public and even more severely – an average of 7.3 percent - when the whistle-blower alleged “earnings management.”

The paper – Whistle-Blowing: Target Firm Characteristics and Economic Consequences – was written by Robert Bowen and Shiva Rajgopal, Professors of Accounting at University of Washington, and Andrew Call, Assistant Professor of Accounting at the University of Georgia.  Highlights of the paper were first posted on the Harvard Law School Forum for Corporate Governance and Financial Regulation.

In the wake of scandals at Enron, WorldCom and other companies, the Sarbanes-Oxley Act of 2002 incorporated provisions to encourage and protect whistle-blowers, including requirements for whistle-blowing “hotlines” that facilitate employee reporting.  The paper addresses critics who have argued that whistle-blowers often misjudge a situation and “indulge in trivial or frivolous complaints.”

“Our results suggest whistle-blowing is far from a trivial nuisance for targeted firms,” the paper reports, and provide “indirect evidence on the efficacy” of whistle-blowing protections in the Sarbanes-Oxley Act.

The researchers found that whistle-blowing generally led to more earnings restatements, more shareholder lawsuits, and “relatively poor operating and stock return performance” compared to other firms.  “Whistle-blower allegations appear to be an early indicator of future negative economic consequences for targeted firms,” the study found.

On average, whistle-blowing targets exposed in the press “improved several dimensions of governance relative to the year before the whistle-blowing event” and relative to a matched sample of control firms.   Those governance improvements were not apparent for firms subject to whistle-blowing allegations that were not widely disseminated, the researchers said.

High-growth companies and those with strong stock market performance are more likely to encounter whistle-blowing, according to the study, as are those that have recently made reductions in work force.  “Employees, especially former employees who have been let go, are more likely to make public allegations following layoffs,” the paper says. “Further, layoffs can increase the animosity between the firm and existing employees, and if existing employees perceive their job as being less secure, the potential cost of blowing the whistle decreases.”

Listen to Gillespie as he discusses the issues with Michael Connor in a Business Ethics podcast. You can download an MP3 file of the interview with John Gillespie here.