A Short Guide to Ethical Risk

Carlo Patetta Rotta

• Publisher: Routledge
• Year: 2017
• Print ISBN: 9781138465626
• eBook ISBN: 9781351961752
• Topic: Business
• Subtopic: Business General
• Index: Business

Following corporate scandals and the recent bankruptcy of large financial institutions, the public believes that one of the responsibilities of governments, regulators and corporate executives is to do business in compliance with basic ethical values. It is now acknowledged that there has been a general decline in ethical standards in the business world, perhaps due in part to a celebrity culture that overvalues wealth and shallow notions of 'success'. Ethics used to be discussed only by philosophers and academics, but it is now apparent to business leaders that companies wishing to survive into the future have to develop effective protection against exposure to 'ethical risk'. This Short Guide, written by a professional with diverse international experience in auditing and fraud prevention who has specialised in ethics-related issues, serves as a resource for all who need a more complete view of the subject and practical guidance to inform their daily business decisions. Providing an overview of the theories of ethics that bear on today's business world, from Adam Smith's liberalism to stakeholder theory, the Guide explains the human behaviour that gives rise to fraud and corruption in terms of a "fraud triangle theory" according to which unethical behaviours happen when three risk components - psychological pressure, opportunity and rationalisation - are present. 'Pressure' is linked to the unfortunate superstar culture, while 'opportunity' can be reduced through application of adequate control mechanisms and corporate governance models. 'Rationalisation' has to do with the ability of an honest individual to justify a dishonest action in his own eyes. Ethics bears directly on this component and an ethical approach can prevent such self-justification. The adoption of appropriate company cultures and corporate governance models, the selection and retention of ethically sound staff and implementation of fair incentive systems are all advocated by the author, who describes the roles within an organisation of the Audit Committee and the Compliance Function. Additionally, the Guide offers a range of tools that can be applied by practitioners in the field, such as codes of conduct, compliance programmes, whistle blowing procedures and risk management processes.

1 Ethics According to Economists

DOI: 10.4324/9781315263670-1

1.1 Utilitarianism and Adam Smith

Greek philosophers, from Aristippus to Epicurus, had already described man as a passive, hedonistic, individualistic and fundamentally selfish being. Thomas Hobbes, an English philosopher who lived in the 17^th century, had supported the well-known pessimistic view of human nature, whereby homo homini lupus (man is a wolf to his fellow man).

Later, this line of thinking was supported by mercantilistic thought, as it did not have any confidence in the mind’s ability to come up with sound moral or political concepts. In particular, Bernard de Mandeville, a Dutch philosopher who lived in England in late 17^th century, brilliantly described in his famous satire The Fable of the Bees: or, Private Vices, Publick Benefits the problem of reconciling certain undesirable human characteristics, such as greed and malice, with the community’s interests. Using an exaggerated representation of the economic effect of the quest for self-interest, Mandeville concluded that the welfare of a people was dependent on the efficacy of selfish motives, which were considered to be the only stimuli of individual economic behaviour. So much so that he stated that trade and honesty were incompatible, because complying with the rules set by honesty led to the downfall of the community. “Nothing – says Mandeville – pushes men to be obliging if not their needs, and mitigating them is wise, but eliminating them would be foolish.”

Based on these assumptions, economic science used to adopt a neutral attitude towards any ethical logic. If economic activities by themselves aim at producing something good, we are implicitly saying that there is a sphere within social relations – pertaining to the market – that does not need to be morally judged at all. Unlike any other type of human action, economic actions have the undeniable advantage of evading morality without being against it. When pursuing their own interests, not only do individuals act properly for their own accord but they also optimise collective usefulness because the market automatically tends to settle any dispute in favour of a higher state of welfare.

In the 18^th century, Adam Smith, the Scottish philosopher considered to be the father of modern economics, developed an economic theory that was to be influential in centuries to come, too. Smith supported a laissez-faire policy where economic forces regulate themselves on condition that they are not influenced by external policies or intervention, such as government intervention. If his theory was completely different from mercantilism, where heavy state intervention was necessary to harness economic forces, from the point of view of ethics applied to economics, his vision was, and still is, rather unclear. In fact, it looks as if his (not so loyal) epigons have summarised his impressive volume of acute reflections in a single sentence from The Wealth of Nations that was to become the most authoritative consecration of utilitarian theory. In 1776, Adam Smith wrote:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.¹

1 Smith A., The Wealth of Nations, Penguin Books Ltd, 1999.

What did Adam Smith really mean to say here? Clearly, he maintains that pursuing selfish interests is sufficient to motivate and drive the exchange of goods, and we do not need to resort to ethics to explain why the baker wants to sell bread, why we want to buy it, and how this exchange would benefit both. This irrefutable statement cannot but confirm the plain observation that many of our actions are, in reality, driven by personal interest, and that some of them actually have a positive outcome. It would undoubtedly be an exaggeration to believe that Adam Smith reduced human behaviour in its entirety to servile selfishness. At any rate, over time this observation, however unquestionably true, has become instrumental in the estrangement of economics from ethics. This took place precisely and significantly at the same time as modern economics flourished. Furthermore, in comparison with alternative theories, from Smith’s days up to recent years, utilitarianism has greatly influenced the way in which economic transactions are conceived and dealt with. The utilitarian concept characterises the majority of economic subjects in today’s capitalist world.

1.2 Beyond Utilitarianism: Amartya K. Sen

In recent years, some economists and scholars have used sound arguments to openly criticise this narrow utilitarian vision, which has finally created a real opening within utilitarian absolutism for alternative theories and concepts. The most recent and significant argument has been put forward by Amartya K. Sen,² Nobel prize winner (1998), who fiercely and convincingly criticised a canonical interpretation of Smithsonian thinking on ethics applied to economics.

2 Amartya K. Sen’s main contribution to economics is a new notion of development that is different from the previous notion of growth. Economic development no longer coincides with an increase in income but with an increase in the quality of life. It is this focus on quality, rather than quantity, that characterises most of the studies of this economist.

In his opinion, the fact that over time commentators and scholars have only concentrated on selected passages written by Adam Smith and neglected the remainder of his vast output, means we are shown the father of modern economic science as a rather narrow-minded ideologist whose only aim is to extol the fundamental virtues of selfish behaviour. Amartya K. Sen wrote that:

While some men have been living in banality ever since they were born and some find themselves living in banality after being born, Smith had the misfortune of having a lot of banality thrown at him.³

3 Sen, Amartya K., La ricchezza della ragione. Denaro, valori, identità, il Mulino, Bologna, 2001, p. 93; this is a collection of five essays published in Italian discussing ethics in business.

Summarising Adam Smith’s thinking with the terse and incisive apologia of the selfishness that was attributed to him is, therefore, restrictive. Indeed, Adam Smith spent a great deal of his life maintaining the need for “sympathy” in behaviour that involved relating with others, and exploring the role of “moral sentiments” in building a better world. He devoted an entire book to these sentiments entitled “The Theory of Moral Sentiments” (1759), in which he carried out an in-depth study of the role of moral codes of behaviour – good reasons to go against the dictates of self-interest. In the book he describes and highlights the importance of feelings such as sympathy, generosity and a sense of community.

There would be no intellectual integrity in ignoring the fact that Adam Smith had assumed the existence of a fundamental system of “norms of civil and economic morality” to corroborate his argument, nor in believing that he meant that all economic operations involved simply an exchange. In relation to the first point, a more faithful interpretation of Smith’s universe demonstrates that the market has a strict need to be founded on rules of honesty and trust that do not slow down transactions disastrously. If they were in force, then the market would be able to function even if the ulterior motives of the individuals who are part of it were exclusively based on self-interest.

With regard to the second point, however, it would be both reductive and unrealistic to limit the discussion on economic transactions to exchange activities without taking into due account the starting point and key process: production. The motivational problems around production are quite separate from those relating to exchange and are often characterised by team spirit, diligence, reliability (when there are no checks), and efficiency. Can all these fundamental attributes be ignored by hoping to summarise them as one single selfish motive? Also, would it be realistic to neglect the fact that market efficiency is deeply influenced by the degree of trust between the parties involved? If self-interest were the only concern and the only driver of behaviour, there would certainly be many opportunities where leaving the other party in an exchange by themselves would undoubtedly be sensible. However, by behaving in this way, commercial activities would be based exclusively on a recourse to the law and would, as a consequence, become extremely expensive and painfully slow. Clearly, such a view of economics would be somewhat unrealistic and deeply undesirable.

Amartya Sen writes that:

A business world without moral codes would not only be poor from a regulatory point of view but also very weak in terms of performance.⁴

4 Sen, Amartya K., La ricchezza della ragione. Denaro, valori, identità, il Mulino, Bologna, 2001, p. 96; this is a collection of five essays published in Italian discussing ethics in business.

If one believes that economics should concern real people, then it is also worth reflecting on the fact that a partial and distorted interpretation of Smithsonian logic is not unimportant.

It is difficult to believe that real people can be totally uninfluenced by the magnitude of self-examination induced by the Socratic question: “How must we live?”. Is it possible that people studied by economics […] stick to the rudimentary stubborness that modern economics attributes to them?⁵

5 Sen Amartya K., On Ethics and Economics, Oxford, Basil Blackwell, 1987, Laterza, Roma-Bari, 1988, p. 8

1.3 Ethics for Modern Economists

Liberal thought developed in England in the 19^th century following the French Revolution, and subsequently both the industrial revolution and the popularity of Adam Smith’s studies. According to this school of thought, the market is a place for free enterprise, in that it prescribes the abolition of customs duties as one of its fundamental principles. State intervention in the economy is, at most, limited to building adequate infrastructure, roads and railways that can promote trade.

One of the most important supporters of liberalism was Nobel prize winner Milton Friedman, who died recently. Friedman’s thinking had an extraordinary popularity and characterised international economics throughout the 20^th century with extreme influence over both the American government at the time of Nixon and Reagan, and the Thatcher government in the UK. The fundamental points of the economic policies of these governments were: limited government intervention when regulating markets, control of inflation, reduction in the tax burden and strict monetary policies by central banks.

The following statements made by Milton Friedman clearly summarise his passionate and fervent vision of the need for a free market.

A free market gives people what they want instead of what a particular group thinks they ought to want. Underlying most arguments against the free market is a lack of belief in freedom itself. The existence of a free market does not of course eliminate the need for government. On the contrary, government is essential both as a forum for determining the “rules of the game” and as an umpire to interpret and enforce the rules decided on. What the market does is to reduce greatly the range of issues that must be decided through political means, and thereby to minimize the extent to which government need participate directly in the game.⁶

6 From Capitalism and Freedom by Milton Friedman, University of Chicago Press, 1962, chapter “The Relation Between Economic Freedom and Political Freedom”.

Milton Friedman took part in the debate on ethics in economics with “The Social Responsibility of Business is to Increase its Profits”,⁷ an article that caused quite a stir, particularly amongst contemporary economists. In this article, Friedman upholds a rather categorical and surprising thesis, according to which a company that fulfils its social responsibility does not behave in a morally desirable manner but commits an immoral act. When management executives, Friedman explains, decide to use company funds for a social cause, whose end is not that of maximising profits, they do not fulfil the responsibility they took on when they accepted the task of managing the company on behalf of its owners.

7 Milton Friedman’s article in question is “The Social Responsibility of Business is to Increase its Profits”, New York Times, 1970.

Over the years, long debates have been held about the responsibilities of company executives: should they be concerned only with maximising company profits or should they also consider initiatives that have a social purpose, such as supporting employees, safeguarding the environment, or assisting the community in which the company operates? The final answer to this question came from the judgement in Dodge v Ford⁸ in the United States, which involved two families at the beginning of the 20^th century who had created two of the largest stars-and-stripe car companies in the world: the only responsibility management has is to always maximise company profits for the benefit of shareholders. This judgement sanctioned, once and for all, the principle of “the best interest of the corporation”, which is now recognised internationally and included in the Company Law of most countries.

8 The Corporation, Joel Bakan, Constable, London 2004, p. 36.

Although Milton Friedman is a staunch enemy of corporate social responsibility, he himself specified that it has nothing to do with the notion of ethics.⁹ Since the only driving force of business is the principle of profit maximisation, trying to define it on an ethical plane does not make sense because, by definition, it is not ethical. Ethics is a characteristic that can only be associated with people. In this regard, Friedman states that ethical problems might appear difficult to solve. However, in his opinion, the real difficulty is that of applying their solutions.

Friedman considers whether the manufacturing of cigarettes is immoral. His personal answer is that it is not, because today’s consumers are informed about the damage caused by smoking, whether they find themselves in the position to freely decide to smoke or not. Here too, he seems to be wanting to safeguard the principle of freedom, by which he sets great store. Furthermore, he maintains that, if manufacturing cigarettes is thought to be unethical, then, similarly, cars, skis, swimming suits, etc. should not be manufactured because they are all goods linked to activities that, unless they are properly...

Table of contents

• Cover Page
• Half Title Page
• Title Page
• Copyright Page
• Table of Contents
• Acknowledgements
• Foreword
• Preface
• Introduction
• 1 Ethics According to Economists
• 2 Ethics Applied to Economics
• 3 The Roots of Ethical Uncertainty: A Change in Values
• 4 Ethical Risk and How to Manage It
• 5 Areas on Which to Focus Efforts
• 6 Company Functions Responsible for Monitoring and Overseeing Ethics
• 7 Tools to Make Companies More Ethical
• 8 Conclusions