Final Exam Cheat Sheet - Business Ethics | PHIL 1040, Study notes of Business Ethics

Download Final Exam Cheat Sheet - Business Ethics | PHIL 1040 and more Study notes Business Ethics in PDF only on Docsity! Class Notes Limitations of the “Invisible Hand” 1. Completely “free” enterprise historically leads to monopolies and “robber barons”. 2. It also leads to “spoiling of the commons” since there is a strong monetary incentive to dump one’s trash and poisons. 3. Following on the first point, it tends toward a maldistribution of wealth (as the rich get richer) and a final tendency towards depression as the buying power of the public diminishes. 4. Experience shows the necessity of government regulation. Note the results of the recent tendency to deregulate the financial markets. Also, the practical need to regulate food and drugs, worker and consumer safety, pollution, anti- competitive practices, etc. 5. The market often tends to favor the shabby and sleazy and base over quality. E.g., low-class TV shows, drugs, tobacco, porn, alcohol, gimmicky products etc. Get rich by aiming low. 6. Salesmanship and marketing tend to trump production and quality and usefulness. Appearance over substance. A large percentage of the business life consists essentially of talking people out of their money. 7. There’s a strong motive to favor short-term results over long-term results, especially in some cases, e.g., where there are no repeat customers, where one can get quickly wealthy before the shabby product is found out. 8. For varying reasons the profit motive does not work well in some areas. Public utilities (e.g., electric dams require too much capital and the payoff is excessively long). Health care (we cannot leave the poor to die). Education (the poor should have access to education). Long term pollution problems. Etc. 9. Wealth is often separated from value. People whose chief aim is to make a fortune often can do so. They may trade stocks or land or financial instruments or specialize in marketing. They may wind up with enormous amounts of money. People who wish to do charitable work or teach children or help the handicapped or enter several of the important professions or raise children may never achieve much wealth. The gulf can be enormous and it is worth considering the different social or moral or human values involved in these various occupations. Business is Bad  Normal morality includes courage, intelligence, kindness, compassion, honesty, loyalty, respect for others, mutual aid, non-malfeasance, truthfulness, charity, public service, faithfulness, and the like.  None of these except maybe courage and intelligence are properly valued in the business world. (But is intelligence a moral virtue?)  Business seldom evinces kindness, which it sees as foolishness or betrayal, nor is it dismayed at the loss experienced by others.  Every factor pushes toward maximizing profits. The highest profit enterprise will outbid others for resources; laggards will expire.  All people around one are used as means—coworkers, vendors, customers. All benevolence is foreclosed.  A purchasing agent would not share unhelpful information with his suppliers. A business would rejoice in the collapse of a chief competitor. Any customers one wins over are not spending money on someone else’s product so a person’s success often comes with someone else’s loss.  There’s no place for considerations of social benefit or damage. Tobacco, etc. And there’s not just meeting needs for bad things, but inciting demand for such things.  Our obligation to truth is contradicted by the whole process of negotiation where misleading statements are routine. (The old lady who only requests “what’s fair”.)  Will we develop permanent attitudes of hardness, shrewdness, intensity?  “Free enterprise” is not free because all decisions are compelled by highest profit considerations.  We must make a choice between giving first priority to virtue or money.  The system works economically and can only be improved by understanding.  Mitigating considerations: o There is some slack in the system. o Many, perhaps most, situations are win-win. o The well-known rules of the game justify actions that would otherwise be immoral Business is Good  On the big and small screen rich businessmen are often portrayed as villains.  Bad phrases often used in talk about business: a killing; cutthroat; out foxing; ax to the max; survival of the fittest; Machiavellian; fear, not love; well-oiled machine, poker, jungle; war; zero-sum game; greed is good; it’s not personal; business is business.  At the heart of business is concern with the wants and needs of others.  Cooperation, not competition; trust, not deceit.  Camaraderie, fellowship of the workplace. Often badly missed in retirement.  Competition is to make better goods and services.  Adventure. Excitement of ideas, challenge of projects, promise of success.  The company man; not the entrepreneur, not the solitary hero. The founder of a company may not be the best manager of a company. Company men need to be stable, dependable, somewhat cautious, team players.  Business is the greatest civilizing influence. War used to be the way to wealth, now too destructive. Business success requires compromise, mutual gain, innovation.  Profit is best achieved as a side-effect. As with medicine, teaching, journalism, engineering, etc., money should not be the main purpose.  Business is a game with many winners and with many degrees of winning.  For all of its harshness it can generate great wealth.  The bad apples get the publicity. There are very bad people and practices in all the professions. Nevertheless, there is too much emphasis on profit at the expense of other important values. This is a conventional emphasis, not intrinsic to business practice, and this convention can be changed. The Money Game  Is Warren Buffet greedy? Or Bill Gates? They have accumulated tens of billions of dollars. That is far beyond what anyone can use. Isn’t this greed?  Maybe not. Maybe they are just playing the money game. Poker players aim for as much money as they can win. In football, basketball, baseball, tennis, people aim to win by a large margin. (But some shame attached to “running up the score”.) Henry Ford wanted to sell as many cars as possible and he was not interested in the profits.  People get fixated on activities in life. It becomes life’s meaning for them. A military person may want more and more do-dads on his coat. Sunday school or elementary school kids may want more and more stars on their chart.. We become psychologically involved in board games or picnic names and give our all to these activities. It isn’t greed but intense fixation.  People who become fixated may lose all sense of proportion or relative value. Steroids and all sorts of other techniques for cheating or near cheating on and off the playing field. Kneecaping one’s opponent! Bending every nerve to increase sales or increase profits, using every method available, pushing the illegal or immoral line and often crossing the line altogether. This becomes a way of life for many people, and they cannot imagine life without this project which gives their lives meaning.  The Enron executives were playing the money game to the extreme. There is a good chance that many of them did not think of themselves as greedy, but as aggressive, clever businessmen. Ken Lay was famous for giving company money to various good works. Money becomes primarily a way of keeping score.  A famous basketball player made $40M in a recent year. Would he have played less hard for $15M? Or at a for-charity game? Or if there were a high progressive tax? Surprisingly, when there is less money left over after high taxes, many people are more motivated to make extra money to raise the amount that is left for them! They are not less motivated by the fact that taxes are high. But most people want to raise their income for the sake of running up a high score. They are not doing it so they can buy a fourth mansion. They buy extra houses because they have bunches of money, not because they wanted them so much they worked their hearts out to get the money. How to Determine the Right 1 Check conscience first and last. First impressions have some importance, but conscience’s last informed verdict is final. 2. Be clear about all the facts—non-moral facts—involved in the case. 3. Inquire of sensitive people. (But can’t you usually imagine what they would say?) 4. Can what you are thinking about doing be universalized? What if everyone did it? (Would it work practically? Would you really approve morally?) Would I want this done to me? 5. Note conventions and social traditions. 6. In what moral direction does this tend? Merely tending does not necessarily make something wrong. It depends how bad the thing you may be tending toward is and on how steep the slope is toward that bad end. Talking over the possibilities with a hit man evinces a bad tendency even though you haven’t yet done anything. 7. Is this in keeping with human dignity? An important if somewhat vague consideration. 8. Are there morally superior alternatives? Obviously it is wrong to choose the inferior alternative if all other things are equal. 9. Vividly imagine the deed and its consequences and note one’s moral reaction. We need a sensitive imagination concerning what we are about to do. 10. Can it be disclosed? Would you want this in the news? A pretty good indicator. 11. Consider honestly if one is fully committed to do the right thing no matter personal gain or loss, or whether one is perhaps not so fully committed and is maybe hoping to rationalize one’s way toward a preferred outcome. Much “moral reflection” is likely to actually be rationalizing. Kinds of Moral Problems 1. Choosing between evils. A. Consequences vs. Consequences. On purely utilitarian grounds, some acts may produce more good than another. It may be very hard or maybe impossible to judge which consequence will be “heavier”, especially as short term vs. long term considerations must be considered. Then too, we may face the apples vs. oranges” problem. That is, pleasures may be of very different types, e.g., the pleasure of swimming vs. the pleasure of a concert. B. Principles vs. Consequences. Not stealing vs. saving starving children. Respecting parent’s rights vs. leaving a very sick child with parents who reject medical treatments. C. But remember that maximizing happiness is itself a principle! So stealing to save children is not necessarily a case of preserving a high principle (not stealing) vs. a low and base concern with mere human happiness (getting food to children). It is a case of which principle trumps. Which one would? 2. Where do you draw the line? Spendthrift vs. frugal. Overwork vs. lazy. Respectful vs. fawning. Etc. Aristotle recommends “the Golden Mean”. Look for a middle or moderate position. (But of course we do not commit theft or murder “in moderation”). Care and money spend for dying people. 3. Morality and Conventions. Conventions may sometimes excuse some behaviors, e.g., marketing exaggerations in advertising. But beware of the excuse “everyone is doing it”. 4. Morality and the Law. Many laws are just practical (which side of street to use). But many are grounded in moral considerations, especially our “negative right” to not be harmed by others. But moral considerations may sometimes conflict with the law. It is usually thought that morality should trump since the law’s proper authority is itself grounded in morality. In such cases one should be prepared to face the legal penalties. 5. Morality and Religion. Religion sometimes calls for a higher standard than ordinary morality (turn the other cheek) and sometimes calls for allegiance to certain doctrines. Should religion’s higher moral standards be incorporated into civil law, e.g., no divorce, no fornication? Once again, civil disobedience based on religious principles should be prepared to face the legal penalties. Government Related Items 1. Defense. Just wars. Are all defensive wars prudent? Consider the Roman Empire. What constitutes a natural nation? 2. Justice. All nations require a police function. Worst is when criminal element takes over the police, judicial system. 3. Democracy. The best form of government? Most governments at least fake it. May it be unsuited for some cultures? Variations on it: elective or random representative, direct participatory (referenda), etc. 4. Checks and Balances. Almost universally approved. 5. Progressive tax structure. Always and everywhere wealth tends to accumulate in fewer and fewer hands. Prosperity is based on consumer spending. 6. Education. Importance of. Different levels according to wealth of nation. Free college? 7. Infrastructure. Roads, air and water ports, utilities, airwaves. Pay for themselves. Privatize them? 8. Welfare. Some safety net for people at the bottom. Rob a store and get free room and board and medical care! 9. Rules of the game. Government sets all the rules for commerce. Someone has to decide what side of the road everyone must drive on. Chapter 10: Marketing, Advertising, and Product Safety Case 10.1 Selling Hope In 1986, an outdoor billboard in a depressed community on the west side of Chicago offered hope. The message was, “Your way out.” The promised ticket for these desperately poor people? The Illinois state lottery. Although most lottery advertising is less blunt, the appeal of a life-changing event is a common theme. Lotteries are a big business for the 38 states that operate them. These games produce about $34 billion in revenue, which, after an average payout of 55%, leaves more than $15 billion. Lotteries present a marketing challenge. As a legal monopoly, they have no competitors, and so they cannot attract consumers away from competing brands, which is a major aim of much advertising. This leaves two objectives: recruiting new players and encouraging existing players to increase their activity. Lottery advertising focuses mainly on the latter, inducing confirmed gamblers to play more games and spend more money on each one. State sponsorship of lotteries is widely criticized, first, for being a regressive form of taxation that takes a disproportionate amount from those who can least afford to lose the money, and, second, for being an improper role for government. Although lottery revenue supports other state services, it is the only state activity that is not aimed directly at improving people’s lives. Lottery advertising is not regulated by the Federal Trade Commission, as is all private-sector advertising, and critics complain that ads for state lotteries could not meet federal standards. The main criticism of lottery advertising focuses on the question of deception. Although many ads highlight the maximum award, they seldom disclose the odds of winning it. In one Connecticut ad, the odds of winning any prize was correctly listed as 1 in 30, but the 1 in 13 million odds of winning the prominently displayed jackpot were nowhere to be found. To counter awareness of the long odds, lottery advertising often includes profiles of winners and slogans. Defenders of lotteries and lottery marketing argue that the poor are heavier users of games because they have more to gain, and that for this reason any restrictions would deprive them of life-changing opportunities. Introduction Marketing is an essential function in any business. As the marketing theorist Theodore Levitt observes, “There can be no effective corporate strategy that is not marketing oriented, that does not in the end follow this unyielding description: The purpose of business is to create and keep a customer.” However, Levitt should add that businesses must also develop products and services that customers want at prices they are willing to pay. Marketing includes making decisions about what products or services to put on the market, who are the potential customers for these goods, how to reach the target markets and induce them to buy, how to price the product or service to make it attractive to these customers, and how to deliver the goods physically to the ultimate customers. These matters are often expressed as the four Ps of marketing: product, price, promotion, and placement. Marketing Marketers have strong incentives to sell products and services as well as powerful means for doing so. Despite the doctrine of consumer sovereignty-the notion that consumers are “kings” in the economy because they ultimately decide whether to buy a company’s products- individual consumers are still vulnerable given the vast power of companies to determine what goods are offered and, through advertising, what consumers want. Because selling is so important for business and such powerful means are available, ethical problems are inevitable. A Framework for Marketing Ethics Most of the ethical problems in marketing involve three concepts: fairness (or justice), freedom, and well-being. Fairness is a central concern because it is a basic moral requirement of any market transaction-and the result of successful marketing is always a market transaction. In a market transaction, each party gives up something of value in return for something they value more. And such exchanges are fair (and mutually beneficial) as long as each party acts freely and has adequate information. The need for information in a fair market transaction is problematic, though, because a seller does not have an obligation to provide all relevant information to a buyer, and a buyer has some obligation to become informed about what is being bought. The question of who has the obligation to disclose or acquire what information leads to two traditional doctrines in marketing, namely, caveat emptor (let the buyer beware) and caveat venditor (let the seller beware). Under caveat emptor the buyer has full responsibility to judge the quality of goods absent any warranty or representation made by the seller. By contrast, the doctrine of caveat venditor places a responsibility on the seller to fully reveal the quality of the goods sold. In practice, the responsibility for ensuring adequate information is divided between buyers and sellers. Buyers have good economic reasons to become informed (to protect themselves) and sellers, to provide information (to attract buyers). Beyond this, the main principle is who can provide the information at the lowest cost. A great deal of consumer law assumes that because sellers can provide the necessary information more cheaply than consumers can acquire it, the responsibility rests largely with the sellers. Generally, consumer laws require only the disclosure of information that buyers need to make rational purchasing decisions. Freedom is at issue in marketing with respect to having a range of consumer options. Freedom is denied when marketers engage in deceptive or manipulative practices, and, in particular, take advantage of vulnerable populations, such as children, the poor, and the elderly. In channels of distribution, large retailers have been accused of using their power to force small suppliers into accepting unfavorable agreements. Freedom is also an issue in marketing research that invades privacy of subjects against their will. Finally, well-being is a consideration in evaluating the social impact of products and advertising, as well as product safety. These three principles of fairness, freedom, and well-being can be expressed in the four-point bill of rights for consumers that President John F. Kennedy proclaimed in 1962, as a movement for consumer rights was developing in American society. These rights are: 1. The right to be protected from harmful products (well-being). 2. The right to be provided with adequate information about products (fairness). 3. The right to be offered a choice that includes the products that consumers truly want (well-being and freedom). 4. The right to have a voice in the making of major marketing decisions (freedom). These rights are needed because the mere right not to buy (consumer sovereignty) provides inadequate opportunities for consumers to satisfy their needs and desires. The first two of these rights are now embodied to some extent in consumer protection legislation. The Consumer Product Safety Act (1972), for example, created an independent regulatory body, the Consumer Product Safety Commission, which has the power to issue standards, require warnings, and even ban dangerous products entirely. The Fair Packaging and Labeling Act (1966) requires that containers disclose the ingredients of the product, the amount, and other pertinent information. The Magnuson-Moss Warranty Act (1975) specifies the information and the minimum conditions that must be included in a full warranty and requires that all warranties be written in comprehensible language. Sales Practices and Labeling Although companies rely on advertising to reach mass markets, most transactions are completed by personal selling. More than 16 million people in the U.S. are employed as sales personnel, 30 times the number who work in advertising. Most people experience personal selling as part of sales to individual customers (B2C marketing), but business to business selling (B2B marketing) also involves personal selling insofar as sales-force members call on the people at other businesses who are responsible for buying. With respect to customers, the main moral obligation of a salesperson is to facilitate the conditions for a fair transaction, which, are that the customer act freely and with adequate knowledge. Manipulation is distinguished from deception in that it typically involves no false or misleading claims. Instead, it consists of taking advantage of consumer psychology to make a sale. More precisely, manipulation is noncoercively shaping the alternatives open to people or their perception of those alternatives so that they are effectively deprived of a choice. An example of manipulation is “bait and switch,” a generally illegal practice in which a customer is lured into a store by an advertisement for a low-cost item and then sold a higher priced version. Often the low-cost item is not available, but even if it is, the advertised product may be of such low quality that customers are easily “switched” to a higher- priced product. Bait and switch is manipulative not only because consumers are tricked into entering the store but because they enter in a frame of mind to buy. Labeling Many consumer purchases occur without any contact with a salesperson. When a consumer merely takes a product off a shelf, the main contact between that consumer and the manufacturer is the print on the package. The label becomes a means not only for selling a product but also informing the consumer. What appears on the label is important, therefore, in judging the fairness of the transaction. The Fair packaging and Labeling Act was passed by Congress in 1966 to enable consumers to make the meaningful value comparisons. Specifically, the act requires that each package list the identity of the product; the name and location of the manufacturer, packer, or distributor; the net quantity; and the number of servings, applications, and so on. The rationale for this legislation is that certain information is important for making an informed consumer choice and consumers have few means for securing the information if it is not provided by the manufacturer. The Nutrition Labeling and Education Act (NLEA) of 1990 further requires that the labels on packaged food products contain information about certain ingredients, expressed by weight and as a percentage of the recommended daily diet in a standardized serving size. Manufacturers offer a number of reasons for not providing more information. A detailed listing of amounts of ingredients might jeopardize recipes that are trade secrets; listing the kind of fat would prevent them from switching ingredients to take advantage of changes in the relative prices of different oils; product dating is often misunderstood by consumers, who reject older products that are still good. Still, the bottom line is that consumers should have sufficient information to make rational buying decisions. Pricing and Distribution The price of any good should reflect all available information about its value and thus enable market participants to make rational economic choices. The moral (and legal) issues in pricing fall into two categories. They are anticompetitive pricing and unfair pricing. Anticompetitive Pricing When a single company (a monopoly) or a few companies (an oligopoly) dominate a market, the lack of competitors allows such firms to charge artificially high prices. There are four different ways the type of pricing can occur and they are as follows: 1. Price-Fixing – Price-Fixing is an agreement, either explicit or implicit, among two or more companies operating in the same market to sell goods at a set price. 2. Resale Price Maintenance – This is a practice whereby products are sold on the condition that they be resold at a price fixed by the manufacturer or distributer. Resale price maintenance is thus a form of vertical price-fixing as described above. 3. Price Discrimination – Sellers engage in price discrimination when they charge different prices or offer different terms of sale for goods of the same kind to different buyers. Often this occurs when buyers are located in different geographical regions or vary in size or proximity to other sellers. 4. Predatory Pricing – Predatory pricing consists of reducing prices to unreasonably low or unprofitable levels in order to drive competitors out of business. Once this occurs, the company is in a monopoly position and can recoup its losses by charging above-market rates. a. Predatory Pricing is often difficult to prove because, first, a company like Wal-Mart with a low cost structure might be able to make a profit selling goods at prices that would be unprofitable for competitors. Second, a company might sell goods at a loss in order to reduce inventory that otherwise would not be sold at all. Third, some companies may sell at a loss in order to gain market share and become competitive. Unfair Pricing Pricing can be done in ways that treat consumers unfairly. The main types of such unfair pricing are unconscionably high prices (price gouging) and misleading prices, including prices that are difficult to determine and compare. The adage “Charge what the market will bear” is good advice under ordinary market conditions but not in all circumstances. For one, temporary shortages of critical goods create opportunities for charging very high prices. In the absence of shortages, it is difficult for companies to sell overpriced products to well-informed consumers with ample choices. However, there are some products that are difficult to evaluate and that people can be persuaded to buy. Unless force or fraud is employed, the sale of these products is generally legal, but consumer advocates still object that they are overpriced. Examples include highly profitable extended warranties for appliances and collision damage waivers for rental cars. Psychological research shows that people make nuanced judgments about when it is fair to raise prices. Taking advantage of natural disasters is generally regarded as unfair. Misleading prices are a form of deception in which customers are induced to buy because they believe the good is a bargain. The most common form of misleading prices is selling goods at prices reduced from a supposed regular price or the manufacturer’s suggested retail price (MSRP). In order to get around state laws, some stores offer goods at full price for a short period of time before reducing them to “sale” prices for the rest of the selling season. When customers are accustomed to paying a certain price for a product, like a candy bar, manufacturers often reduce the size in order to maintain the same price, a practice known as customary pricing. The proliferation of products at different quantities and prices makes it difficult for consumers to compare even those from the same manufacturer. To ensure that consumers are aware of the price of goods, there are laws in some parts of the country that require prices to be displayed on each item (item marketing) and not merely on the shelf. In addition, some products have hidden costs that aren’t mentioned. Distribution Distribution, which is the means by which products are delivered from the manufacturer to the ultimate consumer, is a necessary function of marketing that is of increasing importance. The main ethical issues in distribution are abuse of power in channeling relations, slotting allowances to gain access to shelf space in stores, and gray markets that arise from diverting and parallel importing. Three illegal abuses of power in distribution are reciprocal dealing, exclusive dealing, and tying arrangements. Reciprocal dealing involves a sale in which the seller is required to buy something in return, as when an office supply firm agrees to buy a computer system only on the condition that the computer firm agrees to purchase supplies from the office supply firm. In an exclusive dealing agreement, a seller provides a product – a brand of sportswear, for example – on the condition that the buyer not handle competing brands. These practices are anticompetitive because they force transactions that do not make economic sense. A tying arrangement exists when one product is sold on the condition that the buyer purchase another product as well. An example of a tying arrangement is an automotive supply firm that requires as a condition for selling tires to a service station that the buyer also purchase batteries from the seller. A kind of tying arrangement but one that is generally legal is full-line forcing, in which a retailer is forced to carry a manufacturer’s full line of products as a condition for carrying any product from that manufacturer. Full-line forcing is ethically questionable because it freezes out other manufacturers when a retailer can reasonably carry only one or a few lines, and it limits consumer choice at any given retailer. Manufacturers often employ this practice to take advantage of the popularity of a few products and to secure outlets for products with a higher margin. One of the most controversial practices in distribution is the payment of slotting allowances, which are payments by manufacturers to retailers to secure space on store shelves. This practice makes store shelves a kind of real estate that retailers lease to the highest bidder. Some critics of slotting allowances regard the practice as a kind of shakedown of manufacturers, made possible by retailers’ increasing power. In addition, the fees prevent smaller manufacturers from getting stock on retailers’ shelves, and the added savings to retailers are not always passed along to consumers, who may end up paying higher prices. Gray markets result when products are sold outside the channels of distribution authorized by a manufacturer. This may be due to diverting, which occurs when a wholesaler sells goods to unauthorized intermediaries who in turn sell them to unauthorized retailers in the same market area. Another cause of gray markets is parallel importing, in which goods intended for one market (say Asia) are distributed without authorization in another market (say Europe). In both cases, a company may find that the products sold through authorized channels are competing with the same products sold in a gray market, almost always at a lower price. Gray markets have several undesirable effects. First, they make it more difficult for manufacturers to maintain channels of distribution with reliable and responsible distributers. Second, they force manufacturers to unbundle warranties and after-sale service, which deprives consumers of these benefits as well as the manufacturers, for whom these are often profitable items. Third, gray markets create consumer dissatisfaction and erode brand value when buyers of gray market goods blame the company for lack of warranty and after-sale service. On the other hand, gray markets drive down prices, and for mass-market goods that do not require the benefits of authorized channels of distribution, this may be in the consumers’ and ultimately the manufacturers’ interest. Advertising A typical definition of advertising is that it is “a paid nonpersonal communication about an organization and its products that is transmitted to a target audience through a mass medium.” So defined, advertising is only one kind of promotional activity. The others are publicity, sales promotion, and personal selling. Advertising is also used to “sell” ideas, attitudes, and behaviors in order to benefit the targeted individuals and society generally. This kind of advertising on behalf of better health, environmental protection, and the like is called social marketing. Advertising is widely criticized. Exaggerated claims and outright falsehoods are the most obvious target for complaints, followed closely by the lack of taste, irritating repetition, and offensive character. Other critics complain about the role advertising plays in creating a culture of consumerism. Advertising encourages people not only to buy more but also to believe that their most basic needs and desires can be satisfied by products. Deceptive Advertising An advertisement is deceptive if it has a tendency to deceive. On this definition, the deceptiveness of an ad does not depend solely on the truth or falsity of the claims it makes, but also on the impact the ad has on the people who see or hear it. It is possible for advertising to contain false claims without being deceptive and for advertising to be deceptive without containing any false claims. Theodore Levitt defends literal falsehoods and meaningless babble of advertising. He compares advertising to poetry by arguing that both are created to influence an audience, to convince and seduce. The Definition of Deception Unfortunately the FTC has yet to offer a precise legal definition, and none of the attempts by marketing theorists and others to define deception in advertising has been entirely successful. An adequate definition of deception must overcome several obstacles. First, we need to consider whether the deception is due to the ad or the person. Is an ad deceptive if it creates a false belief in relatively few, rather ignorant consumers or only if it would deceive more numerous, reasonable consumers? Second, an ad may not actually create a false belief but merely take advantage of people’s ignorance. Central to any definition of deception in advertising is the concept of rational choice. Deception is morally objectionable because it interferes with the ability of consumers to make rational choices, which requires adequate information. A proposed definition of deception is the following: “Deception occurs when a false belief, which an advertisement either creates or takes advantage of, substantially interferes with the ability of people to make rational consumer choices.” Whether an ad “substantially interferes” with the ability of people to make rational consumer choices assumes some view of what choices they would make if they were not influenced by an ad. At least two factors are relevant to the notion of substantial interference. One is the ability of consumers to protect themselves and make rational choices despite advertising that creates or takes advantage of false beliefs. The second factor is the seriousness of the choice that consumers make. False beliefs that affect the choices we make about our health or financial affairs are of greater concern than false beliefs that bear on inconsequential purchases. Irrational Persuasion In 1957, Vance Packard frightened Americans with his best-selling book The Hidden Persuaders, which revealed how advertisers were turning to motivational research to discover the subconscious factors that influence human action. A pioneer in this area, Dr. Ernest Dichter, declared in 1941 that advertising agencies were “one of the most advanced laboratories in psychology” and that a successful advertiser “manipulates human motivations and desires and develops a need for goods with which the public has at one time been unfamiliar – perhaps even undesirous of purchasing.” The key to success in advertising, according to Dr. Dichter, is to appeal to feelings “deep in the psychological recesses of the mind” and to discover the right psychological “hook.” The main concern of philosophers with advertising is whether the influence it exerts on consumers is consistent with a respect for personal freedom or autonomy. Possible Threats to Free Choice An advertising technique that might be faulted for interfering with freedom of choice is subliminal communication. The ethical argument against the use of subliminal communication in advertising, if it were effective in influencing consumer behavior, is quite simple. Richard T. DeGeorge expressed it in the following way: Subliminal advertising is manipulative because it acts on us without our knowledge, and hence without our consent. Related forms of unconscious, if not subliminal, communication are product placement, which is the conspicuous placement of brand-name products in movies, and buzz marketing, in which people who are natural trendsetters volunteer to create “buzz” about a product by casually talking about it, without revealing their purpose. In all of these cases, the main complaint is that certain advertising techniques do not allow people to use their capacity for critical evaluation, which is essential for freedom of choice. In the view of many philosophers, a choice is free to the extent that a person makes it on the basis of reasons that are considered by that person to be good reasons for acting. Freedom, in this view, is compatible with persuasion, but only as long as the techniques used do not undermine the ability of people to evaluate reasons for or against a course of action. The Dependence Effect John Kenneth Galbraith coined the term dependence effect to describe the fact that present-day industrial production is concerned not merely with turning out goods to satisfy the wants of consumers but also with creating the wants themselves. If wants depend on output, then production cannot be justified by the familiar claim of producers, “We only give the public what it wants.” These words are hollow if, as Galbraith claims, these same producers determine what the public wants. The dependence effect, in Galbraith’s formulation, involves a distinction between wants that originate in a person and those that are created by outside forces. F.A. von Hayek has pointed out that almost all wants beyond the most primitive needs for food, shelter, and sex are the result of cultural influences. Thus, desires for art, music, and literature are no less created than desires for any consumer product. Even if it is not morally objectionable to create wants, advertising can still be criticized for creating desires by making irrational appeals. Consumer behavior suggests, however, that people really do make certain purchases because they want status. Vance Packard reported that in the 1950s, people expressed reluctance to buy small cars because they were less safe. However, people really wanted large cars for reasons of status but disguised their true motivation as a concern for safety. Defenders of advertising point out that nonrational appeals are not necessarily unethical. In many ads, both rational and nonrational elements are combined for greater effect without reducing people’s freedom of choice. The Impact of Advertising The Impact on Persons In getting us to buy, advertising also shapes us as persons – in our beliefs, attitudes, and values. Its impact on personality formation rivals that of parents, teachers, and religious leaders. Critic Marya Mannes states “and if you reflect us incorrectly, as I believe you are doing, you are raising a generation of children with cockeyed values as to what men and women and life and family really are. You may be training them as consumers, but you are certainly not educating them as people.” But how are we being trained? First, critics charge that advertising does not merely lead us to consume more than we would otherwise, but also makes us into consumers who work in order to spend. Richard W. Pollay writes, “At the least, advertising is seen as inducing us to keep working in order to be able to keep spending, keeping us on a treadmill, chasing new and improved carrots with no less vigor, even though our basic needs make be well met.” In short, advertising has successfully identified products with our conception of the good life so that consumption becomes an end in itself. To live is to consume. A second charge is that advertising does not educate people to grapple with the complex problems of life. Life as presented in advertisements consists of simple, stereotypical situations for which the solution is some product. This is far different from the novel and complicated challenges of life that require interaction with other people. Third, critics allege that advertising has harmful effects on people’s conception of themselves, which in turn affect their self-esteem and confidence. This charge has been leveled especially against ads that depict an ideal of female beauty that few women can meet. This kind of advertising, called image advertising has been blamed for a sense of inadequacy in women that has led to eating disorders, and violence against women. Fourth, Some psychologists find that a society with pervasive advertising leads people to view themselves as marketable commodities in a process called the “objectification of the self.” This phenomenon, known in personality theory as a “marketing orientation,” is described by Erich Fromm as follows: man experiences himself as a thing to be employed successfully on the market. His body, his mind, his soul are his capital, and his task in life is to invest it favorably to make a profit of himself. The Impact on Society Advertising has the power to affect not only persons individually but groups in society. Thus, particular ads have been criticized for presenting damaging stereotypes of the elderly, women, and racial and ethnic groups. The greatest area of concern about the social impact of advertising has been in marketing to the poor, who, as a group, are targeted not only with harmful products but also with advertising that heavily promotes them. The products in question are mostly tobacco and alcohol. Social Marketing Advertising has the potential to impact society positively as well as negatively. Aside from the useful economic role that advertising plays in promoting products and service, its techniques of persuasion can also be used to address social problems. Social marketing is defined as the application of commercial marketing technologies to the analysis, planning, execution, and evaluation of programs designed to influence the voluntary behavior of target audiences in order to improve their personal welfare and that of their society. However, there are a few ethical challenges of social marketing. The first ethical issue is this, since social marketers seek to change people’s beliefs, attitudes, and behaviors in ways that benefit themselves and society, they must evaluate the desirability of these changes and be sure that an advertising campaign will produce them. Second, the social problems addressed by social marketing are ones on which public discussion may be desirable. Third, social marketing may be effective in changing individuals’ behavior, but the solutions to many social problems require more sweeping social, political, and economic change. Fourth, since advertising techniques are designed to persuade without necessarily enabling the target audience to understand what they are being asked to do or why, social marketing runs the risk of being manipulative. Product Safety Three theories are commonly used to determine when a product is defective and what is owed to the victims of accidents caused by defective products. Theses are the due care theory, the contractual theory, and strict liability theory. Each of these theories appeals to a different ground for its ethical justification, and as legal doctrines, they each have a different source in the law. The Due Care Theory Generally, manufacturers have an obligation to exercise due care, which means that they should take all reasonable precautions to ensure that products they put on the market are free of defects likely to cause harm. According to this due care theory, manufacturers are liable for damages only when they fail to carry out this obligation and so are at fault in some way. One ethical justification for this view is the Aristotelian principle of corrective justice: something is owed by a person who inflicts a wrongful harm upon another. The legal expression of this theory is the view in the law of torts that persons are liable for acts of negligence. Negligence is defined in the Second Restatement of Torts (Section 282) as “conduct which falls below the standard established by law for the protection of others against unreasonable risk of harm.” Standards of Due Care The standards of due care for manufacturers or other persons involved in the sale of a product to a consumer, including wholesalers and retailers, cover a wide variety of activities. Among them are the following: 1. Design – The product ought to be designed in accord with government and industry standards to be safe under all foreseeable conditions, including possible misuse by the consumer. 2. Materials – The materials specified in the design should also meet government and industry standards and be of sufficient strength and durability to stand up under all reasonable use. 3. Production – Due care should be taken in fabricating parts to specifications and assembling them correctly, so that parts are not put in the wrong way or left out. 4. Quality Control – Manufacturers should have a systematic program to inspect products between operations or at the end to ensure that they are of sufficient quality in both materials and construction. 5. Packaging, Labeling, and Warnings – The product should be packaged so as to avoid any damage in transit, and the packaging and handling of perishable foodstuffs, for example, should not create any new hazard. Also, the labels and any inserts should include instructions for correct use and adequate warnings in language easily understood by users. 6. Notification – Finally, the manufactures of some products should have a system of notifying consumers of hazards that only become apparent later. The Concept of Negligence The major difficulty with the due care theory is establishing what constitutes due care. Manufacturers have an obligation to take precautions that are more stringent than the “reasonable person” standard, but no means exist for determining exactly how far the obligation of manufacturers extends. The courts have developed a flexible standard derived from Justice Learned Hand’s famous formulation of the negligence rule. In this rule, negligence involves the interplay of three factors: (1) the probability of harm, (2) the severity of the harm, and (3) the burden of protecting against the harm. Thus, manufacturers have a greater obligation to protect consumers when injury in an accident is more likely to occur, when the injury is apt to be greater, and when the cost of avoiding injury is relatively minor. As a legal doctrine, the due care theory is difficult to apply. The focus of the theory is on the conduct of the manufacturer rather than on the condition of the product. In addition, common law allows for two defenses under the due care theory: contributory negligence and assumption of risk. Just as a manufacturer has an obligation to act responsibly, so too does a consumer. Similarly, if consumers know the dangers posed by a product and use it anyway, then to some extent they assume responsibility for any injury that results. The Contractual Theory A second theory is that the responsibility of manufacturers for harm resulting from defective products is that specified in a sales contract. The relation between buyer and seller is viewed in this theory as a contractual relation, which is subject to the terms of a contract. Even in the absence of an explicit, written contract, there may still be an implicit, understood contract between the two parties that is established by their behavior. This fact is recognized by the Uniform Commercial Code (UCC), Section 2-204(1), which states that “A contract for sale of goods may be made in any manner sufficient to show agreement, including conduct by both parties which recognizes the existence of such a contract.” One of the usual understandings is that a product be of an acceptable level of quality and fit for the purpose for which it is originally used. These implicit contractual provisions are part of what is described in Section 2-314 of the UCC as an implied warranty of merchantability. Manufacturers have both a moral and a legal obligation, therefore, by virtue of their contractual relation, to offer only products free from dangerous defects. There is also an implied warranty of fitness for a particular purpose when the buyer is relying on the seller’s expertise in the selection of the product. In addition, an express warranty is created, according to Section 2-313 of the UCC, as follows: “Any affirmation of fact or promise made by the seller to the buyer which relates to the goods and becomes part of the basis of the bargain creates an express warranty that the goods shall conform to the affirmation or promise.” The ethical basis for the contractual theory is fairness in commercial dealings. Agreements to buy or sell a product are fair only when they are entered into freely by the contracting parties. Objections to the Contractual Theory One objection to the contractual theory is that the understandings in a sales agreement, which are the basis for implied and express warranties, are not very precise. In practice, the theory leaves consumers with little protection, except for grossly defective products and products for which the manufacturer makes explicit claims that constitute express warranties. Second, a sales agreement may consist of a written contract with language that sharply limits the right of an injured consumer to be compensated. If buyers and sellers are both free to contract on mutually agreeable terms, then the sales agreement can explicitly disclaim all warranties, express or implied. Section 2-316 of the UCC provides for the exclusion or modification of an implied warranty of merchantability as long as (1) the buyer’s attention is drawn to the fact that no warranty is being give, with expressions such as “with all faults” or “as is”; (2) the buyer has the opportunity to examine the goods; and (3) the defect is one that can be detected on examination. If a consumer signs a contract with limiting language or explicit disclaimers, then, according to the contractual theory, the terms of that contract are binding. (I.E. Henningsen v. Bloomfield Motors) The Strict Liability Theory A third theory, now gaining wider acceptance in the courts, holds that manufacturers are responsible for all harm resulting from a dangerously defective product even when due care has been exercised and all contracts observed. In this view, which is known in law as strict liability, a manufacturer need not be negligent nor be bound by any implied or express warranty to have responsibility. The mere fact that a product is put into the hands or consumers in a defective condition that poses an unreasonable risk is sufficient for holding the manufacturer liable. A more precise account of the theory of strict liability is given in Section 402A of the Second Restatement of Torts as follows: 1. One who sells any product in a defective condition unreasonably dangerous to the user or consumer or to his property is subject to liability for physical harm thereby caused to the ultimate user or consumer, or to his property, if (a) the seller is engaged in the business of selling such a product, and (b) it is expected to and does reach the user or consumer without substantial change in the condition in which it is sold. 2 The rule stated in Subsection (1) applies although (a) the seller has exercised all possible care in the preparation and sale of his products, and (b) the user or consumer has not bought the product from or entered into any contractual relation with the seller. Is Privity Necessary? Generally, lawsuits under either theory have required that the victim of an accident be in a direct contractual relation with the manufacturer. This relation is known in law as privity. Suppose an accident is caused by a defective part that is sold to a manufacturer by a supplier, and the finished product is sold to a wholesaler, who sales it to a retailer. The consumer, under a requirement of privity, can sue only the retailer, who can sue the wholesaler, who in turn can sue the manufacturer and so on. The main blow to privity in the contractual theory came in Baxter v. Ford Motor Company (1934). The Supreme Court of Washington State held that a driver who was injured by flying glass when a pebble struck the windshield has a right to compensation because all Ford cars were advertised as having Triplex shatterproof glass. Hence, the wording of Ford’s advertisements creates a warranty, in the view of the court, even without a direct contractual relation. Legal Issues in Strict Liability The definition of unreasonably dangerous is “The article sold must be dangerous to an extent beyond that which would be contemplated by the ordinary consumer who purchases it, with the ordinary knowledge common to the community as to its characteristics” This definition is inadequate, however, because it implies that a product is not unreasonably dangerous if most consumers are fully aware of the risks it poses. The Ethical Arguments for Strict Liability The ethical arguments for strict liability rest on the two distinct grounds of efficiency and equity. One argument is purely utilitarian and justifies strict liability for securing the greatest amount of protection for consumers at the lowest cost. The second argument is that strict liability is the fairest way of distributing the costs involved in the manufacture and use of products. When product safety is viewed as a matter of cost, two questions arise: (1) How can the total cost to both manufacturers and consumers be reduced to the lowest possible level? (2) How should the cost be distributed between manufacturers and consumers? The efficiency argument holds that “responsibility be fixed wherever it will most effectively reduce the hazards to life and health inherent in defective products that reach the market.” By this principle, manufacturers ought to bear this responsibility, because they possess greater expertise than consumers about all aspects of product safety. The principle involved in the equity argument is expressed by Richard A. Epstein as follows: “The defendant who captures the entire benefit of his own activities should also bear its entire costs.” Insofar as manufacturers are the beneficiaries of their profit-making activity, it is only fair, according to this principle, that they be forced to bear the cost. The distribution of the cost of compensating the victims of product-related injuries is fair, then, if this cost is distributed among all who benefit in the proportion that they benefit, so that it is not borne disproportionately by accident victims. The Problem of Fault The major stumbling block to the acceptance of strict liability is that the theory ignores the element of fault, which is a fundamental condition for owing compensation on the Aristotelian conception of compensatory justice. The response of some advocates of strict liability is that it is not unjust to require those who are faultless to pay the cost of an activity if everyone benefits by the use of an alternative method of paying compensation. Under a system of strict liability, consumers give up a right they have in the due care theory – namely, the right not to be forced to contribute to the compensation of accident victims when they (the consumers) are not at fault. Prices are also higher under a strict liability system in order to cover the cost of paying compensation. But consumers gain more than they lose by not being required to spend money protecting themselves and making up their own losses. They also require a new right: the right to be compensated for injuries from defective products without regard to fault. Thus, everyone is better off under a strict liability system than under a negligence system. Objections to Strict Liability Critics reject many key assumptions in the two arguments for strict liability. First, product liability covers man different kinds of accidents, and the most efficient or equitable system for one kind may not be efficient or equitable for another. Careful studies need to be made of the consequences of competing theories for each kind of accident. Second, the view that corporations are able to distribute the burden of strict liability to consumers effortlessly is not always true. Other complaints of critics are that the threat of liability suits stifles innovation because new and untested products are most likely to be defective, and that a patchwork of state laws with differing theories and standards creates uncertainty for manufacturers. For these reasons, many business leaders have pressed for uniform product liability laws, upper limits on awards, restrictions on class-action law suits, and other steps to ease the impact of product liability on manufacturers. The due care theory is based on the Aristotelian principle of compensatory justice; the contractual theory, on freedom of contract; and strict liability, largely on utilitarian considerations. Each one embodies something we consider morally fundamental, and yet the three theories are ultimately incompatible. The contractual theory is the least satisfactory because of the power of manufacturers to write warranties and other agreements to their own advantage and to offer them to consumers on a “take it or leave it” basis. The main shortcoming of the due care theory is the difficulty of deciding what constitutes due care and whether it was exercised. Strict liability, despite the absence of fault, is arguably the best theory. It provides a powerful incentive for manufacturers to take great precautions and creates a workable legal framework for compensating consumers who are injured by defective products. For strict liability to be just, however, the costs have to be properly distributed, so that they are fair to all parties. Chapter 11: Ethics in Finance Case 11.1 Merrill Lynch and the Nigerian Barge Deal The investment bankers at Merrill Lynch were considering an unusual offer from the treasurer at Enron. Daniel Bayly, the global head of the investment banking division at Merrill Lynch, had been approached by Jeffrey McMahon at Enron about the purchase of three electrical generating barges in the waters of Nigeria. Enron was coming to the end of 1999 and desperately needed to book more revenue to keep up the company’s high-flying stock price, and this deal would earn Enron a much-needed $12 million profit. The plan, as conceived by Enron executives, was for Merrill Lynch to purchase three barges for $28 million. Three-quarters of this amount, $21 million, would be loaned to Merrill Lynch by Enron, so that Merrill Lynch would need to put up only $7 million of the purchase price. In return, Enron would promise to find a buyer for the barges or else buy them back within six months with a guaranteed return of 15% on Merrill Lynch’s $7 million outlay. All that was needed was for Daniel Bayly to sign off on the deal. Mr. Bayly had some reasons for concern. If Enron was committed to buying back the barges with no risk for Merrill, then was this a true sale? Would Merrill Lynch be the real owner during this time? If not, then the “sale” would be more a disguised loan. Such a loan should be recorded in Enron’s books as debt, but the purpose of the deal was clearly to enable Enron to report $12 million in revenue. Enron might thus be engaging in accounting fraud, but, if so, was this Merrill Lynch’s responsibility? In the end, the deal was accepted. Merrill Lynch invested $7 million; Enron recorded $12 million in revenues; and six months later, Enron repurchased the barges for $7.525 million. In 2003, the Securities and Exchange Commission (SEC) brought a suit alleging fraud. Messrs. Bayly, Brown, and Furst were convicted along with another Merrill Lynch employee and one low-level Enron employee. Before these individuals were tried, Merrill Lynch settled with the SEC, paying $80 million for the Nigerian barge deal and another transaction with Enron. Financial Services The financial services industry still operates largely through the personal selling by stockbrokers, insurance agents, financial planners, tax advisors, and other finance professionals. Personal selling creates innumerable opportunities for abuse, and although finance professionals take pride in the level of integrity in the industry, misconduct still occurs. Deception The ethical treatment of clients requires salespeople to explain all of the relevant information truthfully in an understandable, nonmisleading manner. Deception is often a matter of interpretation. It can also occur when essential information is not revealed. The securities Act of 1933 requires that the issuer of a security to disclose all material information, which is defined as information about which an average prudent investor ought to reasonably to be informed or to which a reasonable person would attach importance in determining a course of action in a transaction. In general, a person is deceived when that person is unable to make a rational choice as a result of holding a false belief that is created by some claim made by another. That claim may be either a false or misleading statement or a statement that is incomplete in some crucial way. Consider two cases of possible broker (mis)conduct: 1. A brokerage firm buys a block of stock prior to issuing a research report that contains a “buy” recommendation in order to ensure that enough shares are available to fill customer orders. However, customers are not told that they are buying stock from the firm’s own holdings, and they are charged the current market price plus the standard commission for a trade. 2. A broker assures a client that an Initial Public Offering (IPO) of a closed-end fund is sold without a commission and encourages quick action by saying that after the IPO is sold; subsequent buyers will have to pay a seven percent commission. In fact, a seven percent commission is built into the price of the IPO, and this charge is revealed in the prospectus but will not appear on the settlement statement for the purchase. In the first case, one might argue that if an investor decides to purchase shares of stock in response to a “buy” recommendation, it matters little whether the shares are bought on the open market or from a brokerage firm’s holdings. The price is the same. In the second case, however, a client might be induced to buy an initial offering of a close-end mutual fund in the mistaken belief that the purchase would avoid a commission charge. The broker made the claim with an intent to deceive, and a typical, prudent investor is apt to feel that there was an attempt to deceive. Churning Churning is defined as excessive or inappropriate trading for a client’s account by a broker who has control over the account with the intent to generate commissions rather than to benefit the client. The brokerage industry contends that churning is a rare occurrence and is easily detected by firms as well as clients. The ethical objection to churning is straightforward: It is a breach of a fiduciary duty to trade in ways that are not in a client’s best interests. Churning, as distinct from unauthorized trading, occurs only when a client turns over control of an account to a broker, and by taking control, a broker assumes a responsibility to serve the client’s interests. Although churning is clearly wrong, the concept is difficult to define. Some legal definitions offered in court decisions are: “the excessive trading by a broker disproportionate to the size of the account involved, in order to generate commissions,” and a situation in which “a broker, exercising control over the frequency and volume of trading in the customer’s account, initiates transactions that are excessive in view of the character of the account.” The courts have held that for churning to occur a broker must trade with the intention of generating commissions rather than benefiting the client. The legal definition of churning contains three elements, then: (1) the broker controls the account; (2) the trading is excessive for the character of the account; and (3) the broker acted with intent. The most difficult issue in the definition of churning is the meaning of “excessive trading.” First, whether trading is excessive depends on the character of the account. Second, high volume is not the only factor; pointless trades might be considered churning even if the volume is relatively low. Third, churning might be indicated by a pattern of trading that consistently favors trades that yield higher commissions. Suitability In general, brokers, insurance agents, and other salespeople have an obligation to recommend only suitable securities and financial products. However, suitability, like churning, is difficult to define precisely. The rules of the National Association of Securities Dealers include the following: In recommending to a customer the purchase, sale, or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such a customer upon the basis of the facts, if any, disclosed by such customer as to his other security holding and as to his financial situation and needs. The most common causes of unsuitability are (1) unsuitable types of securities, that is, recommending stocks, for example, when bonds would better fit the investor’s objectives; (2) unsuitable grades of securities, such as selecting lower-rated bonds when higher-rated ones are more appropriate; (3) unsuitable diversification, which leaves the portfolio vulnerable to changes in the market; (4) unsuitable trading techniques, including the use of margin or options; and (5) unsuitable liquidity. Financial Markets Equity and Efficiency Much of the necessary regulatory framework for financial markets is provided by law. The Securities Act of 1933, the Securities Exchange Act of 1934, their many amendments, and the rules adopted by the SEC constitute the main regulatory framework for markets in securities. The main aim of financial market regulation is to ensure efficiency, but markets can be efficient only when people have confidence in their fairness or equity. Fairness in Markets Fairness is not a matter of preventing losses. Markets produce winners and losers, and in many cases the gain of some persons comes from an equal loss to others. In this respect, playing the stock market is like playing a sport. The regulation of financial markets protects not only individual investors, but also the general public. Everyone is harmed when financial markets do not fulfill their main purpose but become distorted by speculative activity or disruptive trading practices. The deleterious effect of stock market speculation is wryly expressed by John Maynard Keynes’s famous quip: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” Fraud and Manipulation One of the main purposes of securities regulation is to prevent fraudulent and manipulative practices in the sale of securities, The common-law definition of fraud is the willful misrepresentation of a material fact that causes harm to a person who reasonably relies on the misrepresentation. Insider trading is prosecuted as fraud on the grounds that any material, nonpublic information ought to be revealed before trading. Manipulation generally involves the buying or selling of securities for the purpose of creating a false or misleading impression about the direction of their price so as to induce other investors to buy or sell the securities. Like fraud, manipulation is designed to deceive others, but the effect is achieved by the creation of false or misleading appearances rather than by false or misleading representations. Equal information A “level playing field” requires not only that everyone play by the same rules, but also that they be equally equipped to compete. Competition between parties with very unequal information is widely regarded as unfair because the playing field is tilted in favor of the player with superior information. One argument against insider trading holds that an insider has not acquired the information legitimately but has stolen information that rightly belongs to the firm. Insider trading can also be criticized on the grounds that others do not have the same access to information, which leads us to the second sense of equal information, namely equal access. Markets are more efficient when information is readily available, so we should seek to make information available at the lowest cost. Equal Bargaining Power The fairness of bargained agreements assumes that the parties have relatively equal bargaining power. Unequal bargaining power can result from many source, including unequal information, other sources include the following factors: 1. Resources – In most transactions, wealth is an advantage. The rich are better able than the poor to negotiate over almost all matters 2. Processing Ability – Even with equal access to information, people vary enormously in their ability to process information and to make informed judgments. 3. Vulnerabilities – Investors are only human, and human beings have many weaknesses that can be exploited. Unequal bargaining power that arises from these factors is an unavoidable feature of financial markets, and exploiting such power imbalances is not always fair. The success of financial markets depends on reasonably wide participation, and so if unequal bargaining power were permitted to drive all but the most powerful from the marketplace, then the efficiency of financial markets would be greatly impaired. Efficient Pricing Fairness in financial markets includes efficient prices that reasonably reflect all available information. A fundamental market principle is that the price of securities should reflect their underlying value. The mandate to ensure “fair and orderly” markets has been interpreted to authorize interventions to correct volatility or excess price swings in stock markets. Insider Trading Insider trading is commonly defined as trading in the stock of publicity held corporations on the basis of material, nonpublic information. The principle established in the Texas Gulf Sulphur case is that corporate insiders must refrain from trading on information that significantly affects stock price until it becomes public knowledge. The rule for corporate insiders is, reveal or refrain! The key points are that a person who trades on material, nonpublic information is engaging in insider trading when (1) the trader has violated some legal duty to a corporation and its shareholders; or (2) the source of the information has such a legal duty and the trader knows that the source is violating that duty. The corresponding rule for outsiders is: Don’t trade on information that is revealed in violation of a trust. Arguments against Insider Trading Two main rationales are used in support of a law against insider trading. One is based on property rights and holds that those who trade on material, nonpublic information are essentially stealing property that belongs to the corporations. The second rationale is based on fairness and holds that traders who use inside information have an unfair advantage over other investors and that, as a result, the stock market is not a level playing field. On the property rights or “misappropriation” theory, only corporate insiders or outsiders who bribe, steal, or otherwise wrongfully acquire corporate secrets can be guilty of insider trading. The fairness argument is broader and applies to anyone who trades on material, nonpublic information no matter how it is acquired. Inside Information as Property One difficulty in using the property rights or misappropriation argument is to determine who owns the information in question. The main basis for recognizing a property right in trade secrets and confidential business information is the investment that companies make in acquiring information and the competitive value that some information has. A second difficulty with the property rights argument is that if companies own certain information, they could then give their own employees permission to use it, or they could sell the information to favored investors or even trade on it themselves to buy back stock. So the violation of property rights in insider trading cannot be the sole reason for prohibiting it. The Fairness Argument Fairness in the stock market does not require that all traders have the same information. The main difficulty in the fairness argument is to determine what information ought to be revealed in a transaction. Some economists argue that the stock market would be more efficient without a law against insider trading. If insider trading were permitted, they claim, information would be registered in the market more quickly and at less cost than the alternative of leaving the task to research by stock analysts. They also argue further that a law against insider trading preserves the illusion that there is a level playing field and that individual investors have a chance against market professionals. In 1997, the U.S. Supreme Court ended a decade of uncertainty over the legal definition of insider trading. In a 6-3 decision, the Supreme Court reinstated the conviction of Mr. O’Hagan and affirmed the misappropriation theory. According to the decision, a person commits securities fraud when he or she “misappropriates confidential information for securities trading purposes, in breach of a fiduciary duty owed to the source of the information.” Hostile Takeovers Hostile takeovers – which are acquisitions opposed by the management of the target corporation – appear to violate the accepted rules for corporate change. Peter Drucker observed that the hostile takeover “deeply offends the sense of justice of a great many Americans.” However, many economists, most notably Michael C. Jensen, defend hostile takeovers on the grounds that they bring about needed changes that cannot be achieved by the usual means. The ethical questions in hostile takeovers are threefold. First, should hostile takeovers be permitted at all? Insofar as hostile takeovers are conducted in a market through the buying and selling of stocks, there exists a “market for corporate control.” Second, ethical issues arise in the various tactics that have been used by raiders or incumbent management, often at the expense of shareholders. Third, hostile takeovers raise important issues about the fiduciary duties of officers and directors in their responses to takeover bids. The Market for Corporate Control Defenders of hostile takeovers contend that corporations become takeover targets when incumbent management is unable or unwilling to take steps that increase shareholder value. The raiders’ willingness to pay a premium for the stock reflects a belief that the company is not achieving its full potential under the current management. Just the threat of a takeover serves as an important check on management, and without this constant spur, defenders argue, managers would have less incentive to secure full value for the shareholders. Any steps to restrict hostile takeovers, the defenders argue, would entail an unjustified reduction of shareholders’ rights. Critics of hostile takeovers argue that targets of successful raids are sometimes broken up and sold off piecemeal or downsized and folded into the acquiring company. In the process, people are thrown out of work and communities lose their economic base. The debate over hostile takeovers revolves largely around the question of whether they are good or bad for the American economy. The effect on the economy aside, the benefit of hostile takeovers must be viewed with some caution. First, not all takeover targets are underperforming businesses with poor management. Second, some of the apparent wealth that takeovers create may result from accounting and tax rules that benefit shareholders but create no new wealth. Some takeovers result in direct losses. Among the losers in hostile takeovers are bondholders, whose formerly secure, investment- grade bonds are sometimes downgraded to speculative, junk-bond status. Takeover Tactics In a typical hostile takeover, an insurgent group, often called a “raider” makes a tender offer to buy a controlling block of stock in a target corporation from its present shareholders. The offered price generally involves a premium, which is an amount in excess of the current trading price. In the usual course of events, the raiders replace the incumbent management team and proceed to make substantial changes in the company. Corporations have many resources for defending against hostile takeovers. These tactics, collectively called “shark repellants” include poison pills, white knights, lockups, crown jewel options, the Pac-Man defense, golden parachutes, and greenmail. Because of these “shark repellants” and antitakeover statutes, a merger or acquisition is virtually impossible to conduct today without the cooperation of the board of directors of the target corporations. Tender Offers Before 1968, takeovers were sometimes attempted by a so-called “Saturday night special,” in which a tender offer was made after the close of the market on Friday and set to expire on Monday morning. The “Saturday night special” was considered to be coercive because shareholders had to decide quickly whether to tender their shares, with little information. Congress addressed these problems with tender offers in 1968 with the passage of the Williams Act. The guiding principle of the Williams Act is that shareholders have a right to make important investment decisions in an orderly manner and with adequate information. A tender must be open for 20 business days, in order to allow shareholders sufficient time to make a decision and tendering shareholders have 15 days in which to change their minds. Takeover Defenses 1. Crown Jewel Option – A form of lockup in which an option on a target’s most valuable assets (crown jewels) is offered to a friendly firm in the event of a hostile takeover. 2. Golden Parachute – A part of the employment contract with a top executive that provides for additional compensation in the event that eh executive departs voluntarily or involuntarily after a takeover. 3. Greenmail – The repurchase by a target of an unwelcome suitor’s stock at a premium in order to end an attempted hostile takeover. 4. Lockup Option – An option given to a friendly firm to acquire certain assets in the event of a hostile takeover. Usually, the assets are crucial for the financing of a takeover. 5. Pac Man Defense – A defense in which the target makes a counteroffer to acquire the unwelcome suitor. 6. Poison Pill – A general term for any device that raises the price of a target’s stock in the event of a takeover. A common form of poison pill is the issuance of a new class of preferred stock that shareholders have a right to redeem at a premium after a takeover. 7. Shark Repellant – A general term for all takeover defenses. 8. White Knight – A friendly suitor who makes an offer for a target in order to avoid a takeover by an unwelcome suitor. Golden Parachutes The most common argument for golden parachutes is that they reduce a potential conflict of interest. Managers who might lose their jobs in the event of a takeover cannot be expected to evaluate a takeover bid objectively. Michael C. Jenson observes, “It makes no sense to hire a realtor to sell your house and then penalize your agent for doing so.” A golden parachute protects managers’ futures, no matter the outcome, and thus frees them to consider only the best interests of the shareholders. Critics argue, first, that golden parachutes merely entrench incumbent managers by raising the price that raiders would have to pay. In this respect, golden parachutes are like poison pills. Critics complain that golden parachutes are often secured by executives from complaint boards of directors that they control. If golden parachutes are in the shareholders’ interests, then executives should be willing to obtain shareholder approval. Otherwise, they appear to be self-serving defensive measures that violate a duty to serve the shareholders. Second, some critics object to the idea of providing additional incentives to do what they are being paid to do anyway. Philip L. Cochran and Steven L. Wartick observe that managers are already paid to maximize shareholder wealth. “To provide additional compensation in order to get managers to objectively evaluate takeover offers is tantamount to management extortion of the shareholders.” Peter G. Scotese writes, “Why reward an executive so generously at the moment his or her contribution to the company ceases? The approach flies in the face of the American work ethic, which is based on raises or increments related to the buildup of seniority and merit.” Greenmail In some instances, target corporations have repelled unwelcome assaults by buying back the raiders’ shares at a premium. The play on the word “blackmail” suggests that there is something corrupt about offering or accepting greenmail. Although control repurchases are legal, many people think that there ought to be a law. There are three main ethical objections to control repurchases. First, control repurchases are negotiated with one set of shareholders, who receive an offer that is not extended to everyone else. This is a violation, some say, of the principle that all shareholders should be treated equally. To buy back the stock of raiders for a premium is unfair to other shareholders. This argument is easily dismissed. Managers have an obligation to treat all shareholders according to their rights under the charter and bylaws of the corporation and the relevant corporate law. There is no obligation for managers to treat shareholders equally. Second, control repurchases are criticized as a breach of the fiduciary duty of management to serve the shareholders’ interests. If managers use shareholders’ money to pay raiders to go away merely to save their own jobs, they have clearly violated their fiduciary duty. Third, some critics object to greenmail or control repurchases on the grounds that the payments invite pseudobidders who have no intention of taking control and mount a raid merely for the profit. The ethical wrong, according to this objection, lies with the raiders’ conduct, although management may be complicitous in facilitating it. The Role of the Board of Directors There are two critical issues involving the Board of Directors. First, who has the right to determine the value of a corporation? Is this a job for the board of directors and their investment banking firm advisors? And second, does the interest of the shareholders lie with quick, short-term gain or with the viability of the company in the long run? The Delaware State Supreme Court decision in Paramount Communications Inc. v. Time Inc. addressed both issues by ruling that the Time board of directors had a right to take a long-term perspective in evaluating a takeover bid and had no obligation to submit the Paramount proposal to the shareholders. A majority of the states have now adopted laws that permit the board of directors to consider the impact of a takeover on a broad range of nonshareholder constituencies. As a result of other constituency statutes, decisions about the future of corporations depend more on calm deliberations in boardrooms and less on the buying and selling of shares in a noisy marketplace. Chapter 12: Corporate Social Responsibility Introduction Although corporations are primarily business organizations run for the benefit of shareholders, they have a wide-ranging set of responsibilities, to their own employees, to customers and suppliers, to the communities in which they are located, and to society at large. Many companies have institutionalized corporate social responsibility (CSR) as an integral part of their operations. In addition, there are many outside groups, including non-governmental organizations (NGOs), socially responsible investors, and consultancy firms, that monitor companies’ CSR activities and provide their services. At issue in the discussion of CSR are three questions: First, why do corporations have a social responsibility? That is, what is the basis for such a responsibility? Second, what is the extent of this responsibility, or what exactly do corporations have a responsibility to do? Third, and perhaps most important, how should corporations decide what CSR activities to undertake, and what is required to implement CSR programs effectively? The focus of business today is no longer on whether to engage in corporate social responsibility but how to do it. The most progressive companies effectively use CSR to protect their reputations and to develop and implement corporate strategy. The Meaning of CSR All accounts of corporate social responsibility recognize that business firms have not one but many different kinds of responsibilities, including economic and legal responsibilities. Corporations have an economic responsibility to produce goods and services and to provide jobs and good wages to the work force while earning a profit. In addition, business firms have certain legal responsibilities. One of these is to act as a fiduciary, managing the assets of a corporation in the interests of shareholders, but corporations also have numerous legal responsibilities to employees, customers, suppliers, and other parties. The concept of corporate social responsibility is often expressed as the voluntary assumption of responsibilities that go beyond the purely economic and legal responsibilities of business firms. More specifically, social responsibility, according to some accounts, is the selection of corporate goals and the evaluation of outcomes not solely by the criteria of profitability and organizational well-being but by ethical standards or judgments of social desirability. In 1971, the Committee for Economic Development issued a report that characterized corporate social responsibility. They are the following: 1. The Inner Circle – Includes the clear-cut basic responsibilities for the efficient execution of the economic function (products, jobs, and economic growth) 2. The Intermediate Circle – Encompasses responsibility to exercise this economic function with a sensitive awareness of changing social values and properties: for example, with respect to environmental conservation; hiring and relations with employees; and more rigorous expectations of customers for information, fair treatment, and protection from injury. 3. The Outer Circle – Outlines newly emerging and still amorphous responsibilities that business should assume to become more broadly involved in actively improving the social environment. Society is beginning to turn to corporations for help with major social problems such as poverty and urban blight. Examples of Social Responsibility 1. Choosing to operate on an ethical level that is higher than what the law requires 2. Making contributions to civic and charitable organizations and nonprofit institutions 3. Providing benefits for employees and improving the quality of life in the workplace beyond economic and legal requirements. 4. Taking advantage of an economic opportunity that is judged to be less profitable but more socially desirable than some alternatives 5. Using corporate resources to operate a program that addresses some major social problem. Corporate Social Responsiveness An important aspect of corporate social responsibility is the responsiveness of corporations, that is, the ability of corporations to respond in a socially responsible manner to new challenges. Thus, a socially responsive corporation uses its resources to anticipate social issues and develop policies, programs, and other means of dealing with them. The content of a response is also important because it represents the outcome of being socially responsible. Donna Wood has combined all three elements, the principle of being socially responsible, the process of social responsiveness, and the socially responsible outcome, in the concept of corporate social performance. Corporate Citizenship Corporate citizenship is similar to CSR but it sometimes has a broader meaning to include the impacts of a business organization on all groups in society, on society as a whole, and on the environment. According to one definition, “corporate citizenship is the process of identifying, analyzing and responding to the company’s social, political, and economic responsibilities as defined through law and public policy, stakeholder expectations, and voluntary acts flowing from corporate values and business strategies.” In contrast to CSR, corporate citizenship focuses on the integration of social and environmental concerns into a company’s policies and practices, so that all business is done as a “good citizen.” The language of citizenship implies a set of obligations that arises in virtue of membership in a larger community to with something is “owed” in return for enjoying certain privileges. The Normative Case for CSR The Classical View Expressed by James W. McKie: 1. Economic behavior is separate and distinct from other types of behavior, and business organizations are distinct from other organizations, even though the same individuals may be involved in business and nonbusiness affairs. Business organizations do not serve the same goals as other organizations in a pluralistic society. 2. The primary criteria of business performance are economic efficiency and growth in production of goods and services, including improvements in technology and innovations in goods and services. 3. The primary goal and motivating force for business organizations is profit. The firm attempts to make as large a profit as it can, thereby maintaining its efficiency and taking advantage of available opportunities to innovate and contribute to growth. In the classical view, corporations should engage in purely economic activity and be judged in purely economic terms. Social concerns are not unimportant, but they should be left to other institutions in society. Business activity, in the classical view, is justified partly on the ground that it secures the well-being of society as a whole. The crux of this argument is the efficacy of Adam Smith’s invisible hand in harmonizing self-interested behavior to secure an end that is not a part of anyone’s intention. This justification also depends on the ability of the rest of society to create the conditions necessary for the invisible hand to operate and to address social problems without the aid of business. The Moral Minimum of the Market First, a certain level of ethical conduct is necessary for the invisible hand to operate, or indeed for business activity to take place at all. Milton Friedman speaks of the “rules of the game,” by which he means “open and free competition, without deception or fraud.” Theodore Levitt says that aside from seeking material gain, business has only one responsibility, and that is “to obey the elementary canons of everyday face-to-face civility” The moral minimum of the market also includes an obligation to engage in business without inflicting injury on others. Thus, corporations in a free market have an obligation not to pollute the environment and to clean up any pollution they cause. It may also be in the best interest of a corporation to operate above the moral minimum of the market, Corporations that adhere only to the moral minimum leave themselves open to pressure from society and regulation by government. By “internalizing” the expectations of society, corporations retain control over decision making and avoid the costs associated with government regulation. Power and Responsibility Second, corporations have become so large and powerful that they are not effectively restrained by market forces and government regulation, as the invisible hand argument assumes. Some self-imposed restraint in the form of a voluntary assumption of greater social responsibility is necessary. Keith Davis cites what he calls the Iron Law of Responsibility: “in the long run, those who do not use power in the manner which society considers responsible will tend to lose it.” The need for greater social responsibilities by corporations, then, is an inevitable result of their increasing size and influence in American society. Holders of the classical theory argue in reply that precisely because of the immense power of corporations, it would be dangerous to unleash it from the discipline of the market in order to achieve vaguely defined social goals. Giving a Helping Hand to Government Third, the classical view assumes that business is best suited to provide for the economic well-being of the members of a society, whereas noneconomic goals are best left to government and the other noneconomic institutions of society. This sharp division of responsibility is true at best only as a generalization, and does not follow that corporations have no responsibility to provide a helping hand. Corporations cannot attempt to solve every social problem, of course, and so some criteria are needed for distinguishing those situations in which corporations have an obligation to assist other institutions. John G. Simon, Charles W. Powers, and Jon P. Gunnemann propose the following four criteria: 1. The urgency of the need; 2. The proximity of a corporation to the need; 3. The capability of a corporation to respond effectively; 4. The likelihood that the need will not be met unless a corporation acts. Friedman’s Argument against CSR Perhaps the best-known critic of CSR is Milton Friedman. Friedman’s main argument against CSR is that corporate executives, when they are acting in their official capacity and not as private persons, are agents of the shareholders of the corporation. As such, executives of a corporation have an obligation to make decisions in the interests of the shareholders, who are ultimately their employers. When corporate executes perform in CSR activities they take on a role of imposing taxes and spending the proceeds that properly belongs only to elected officials. They become, in effect, civil servants with the power to tax, and as civil servants, they ought to be elected though the political process instead of being selected by the stockholders of private business firms. Criticism of Friedman’s Argument