Risk & Compliance

Ethics and the Bottom Line

A company's ethical lapses can be far more costly than executives imagine, says one expert.
Marie LeoneJune 8, 2010

On Monday, Marianne Jennings avoided the standard warm and fuzzy lecture about ethics and went straight for the corporate-finance jugular. “Lapses in ethics hurt the cost of capital,” declared Jennings, a professor of legal and ethical studies at Arizona State University. Speaking at the Institute of Management Accountants’s annual meeting in Baltimore, she contended that although breakdowns in corporate ethics can be costly, executives never make ethics “part of a strategic business plan” until they understand the scope of potential losses.

Jennings conceded that facing up to an ethics failure can be difficult. In most cases, she said, executives are keenly aware of problems but develop strategies to deal with them. As an example, Jennings pointed to Chiquita Brands International. Since 1997, Chiquita had been paying a mercenary group to protect its operations in Colombia, not an uncommon practice in that part of the world. However, in 2001, the U.S. government classified the group, Autodefensas Unidas de Colombia (AUC), as a foreign terrorist organization, making the payments illegal under the Patriot Act of 2001.

Chiquita eventually disclosed the payments to the Department of Justice and was told to discontinue funding the terrorist group. But the company determined that stopping the payments was dangerous, and dealt with the situation by switching from checks to hard-to-trace cash. In March 2007, Chiquita pleaded guilty to making payments to a terrorist organization and paid a $25 million fine, among other reparations. Soon after that, Chiquita closed its Colombia operations, citing a volatile and dangerous political environment.

Jennings believes that most executives have noble reasons, whether genuine or imaginary, for unethical actions. Chiquita executives, for example, cited safety as the reason for the AUC payouts. But noble reasons don’t put a cap on the monetary and reputational costs of breaking the law, she added.

In the case of German industrial conglomerate Siemens AG, which paid $800 million in fines in December 2008 to settle U.S. bribery charges, the price tag for its unethical conduct also includes the cost of rebuilding the company’s stock price and internal expertise, said Jennings. Peter Loescher, the new CEO brought in to clean up the mess, predicted in 2008 that it would take five years for Siemens’s stock price to recover, she noted. Loescher also said that because the company had relied on bribery as a business model, its infrastructure had been weakened: it no longer had the skill set for drafting proposals to win contracts or successfully compete for business.

Jennings held up the example of Merck and its arthritis drug Vioxx as a debacle that could have been avoided had ethics prevailed. As the pharmaceutical company was developing the drug, scientists discovered risks involving users who suffered from certain cardiovascular conditions. Essentially, taking Vioxx doubled the risk of heart attacks and strokes in some people. But Vioxx was the only major drug in the company’s pipeline, and it was sent to market without the proper risk disclosures.

When Merck pulled the drug from the market in 2004, widespread lawsuits followed, and investors lost $28 billion as Merck’s stock price plummeted. This year, Merck is making its last payment into a $4.85 billion fund that was set up to handle about 50,000 claims against Vioxx. (Other lawsuits are pending.) Had Merck disclosed the risks up front, said Jennings, its revenues from the drug would have shrunk, but it would have saved billions in cash outlays and avoided a costly reputational black mark, one not easily removed.

For some companies, ethical lapses have become commonplace, said Jennings; paying “the million-dollar fine has become a way of life.” Yet the cost of operating a business in ethical gray areas eventually catches up to them, she added. Jennings said she has been lecturing for three years about the shoddy maintenance programs at BP that came to light via accidents previous to the Deepwater Horizon disaster. BP “has always gone to the edge without thinking of the risks and consequences of [substandard] maintenance,” she said. Now, the oil giant faces untold billions in costs stemming from the catastrophic oil leak in the Gulf of Mexico.

In the end, Jennings said, when a company crosses the ethical line and fosters mistrust among investors, customers, employees, and the public, the effect on its cost of capital can be severe. “When you fool with trust,” she warned, “you fool with the capital markets.”