September 2003

Hear-No-Evil, See-No-Evil "Ethical Investing"

by Jon Entine

Jon Entine argues that there should be no distinction between ethical and legal responsibility

Although most of us – and even most corporate CEOs – would probably agree to that sentiment in theory, in practice it takes a rough battering. Consider the continued fall out from the Enron scandal. In the latest headline, the two largest banks in the United States, Citigroup and JP Morgan Chase, agreed to pay almost US$300 million in fines and penalties to settle accusations that they enabled Enron to mislead investors about its financial condition before the house of cards collapsed. That settlement follows on the heels of the US$80 million in fines paid out by Merrill Lynch resulting from its Enron misdealings.

The latest fraudulent twist to the Enron debacle is particularly intriguing because it revolves around ethical issues and not strictly legal transgressions. For the most part, the transactions met legal and accounting requirements but still led to what regulators say was misleading information in financial reports.

The settlement suggests that there’s much more to business ethics – or at least should be – than following the letter of the law. But these are not modest ethical slip-ups of omission, mind you. As one Morgan executive noted in a 1998 email, the company knew exactly what it was doing, ethics be damned: "Enron loves these deals as they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred rev[enue] or (better yet) bury it in their trading liabilities."

Manhattan District Attorney Robert Morgenthau says these companies, "knowingly structured the prepaid transactions in a way that allowed Enron to engage in fraudulent accounting and to make its financial statements less transparent."

These disclosures about Citibank, Morgan, Merrill Lynch and other Enron-era bankers are not news. Details about their self-interested transactions have been widely reported in the press for years, detailed in Congressional investigations galore and documented in detail in a study by Neal Batson, the bankruptcy court appointed examiner.

Neck-deep
That makes it all the more curious why such companies, miscreant behaviour and all, are stars in the "socially responsible" investing universe. For example, Citigroup is the largest investment of Enterprise Global Socially Responsive Fund and a top holding in dozens of other SRI portfolios. Michael Jantzi Research in Toronto ranks Canadian Imperial Bank of Commerce an ethical highflyer, yet it is neck-deep in the Enron scandal for creating and then loaning Enron US$115.2 million to create a shell fund. Morgan and Merrill Lynch remain two of the brightest stars in the Domini Social Index, based on ratings generated by the Boston-based firm KLD Research & Analytics.

Now, Citigroup has at least publicly acknowledged that its practices were wrong, and even before this settlement it began implementing internal changes to guard against hear-no evil, see-no-evil lending. Contrition does not appear to be on the radar screen for Merrill or Morgan, however. Sounding like an unreformed – and unreformable – corporate desperado, and in an indication of its hubris, Morgan "neither admitted nor denied the SEC’s allegations". In effect, the bank’s official position is that it did nothing wrong, although it swears it will not do it again. This is hardly reassuring about the bank’s sense of responsibility, especially because the settlement depends on the bank’s willingness to consider its lending decisions in the light of more than the letter of the law.

Now troll over to the Domini site on the Internet, and check out its analysis of Morgan. According to the Domini Fund, the bank received an award in 2001 for its "comprehensive initiatives" to advance women. And gee, it supports affordable housing and has a generous family leave programme.

Not a peep about its unethical practices that have defrauded innocent investors, including church pension funds, the elderly and the infirm. And more than likely, as is typical in fraud cases, this is the tip of the proverbial iceberg of shady loan practices at banks and other financial services companies.

Which brings us to another provocative question: how did this sector of the investing universe come to be considered, as an industry, exemplars of "socially responsible" behaviour, when in fact financial corporations are almost invisible to outside oversight or scrutiny?

The problem with socially responsible and ethical investing "research" is that it is ideologically selective and methodologically sloppy – except in the case of companies that are compelled to be transparent, which ironically means natural resource, energy and other such environmentally messy corporations that follow strict voluntary and mandatory disclosure practices. That’s a prescription for trouble. Financial practices are often Byzantine in structure and almost never fully disclosed. Yet a check of the Domini Social Index Fund finds that more than 25 percent of its holdings are in this sector. It’s even worse in Canada. More than 47 percent of the companies in the Jantzi Social Index are in the financial service sector, with Canadian Imperial representing 5.5 percent.

What does that mean in practice? As in the case of Morgan, it means that SRI research is biased in favour of the kind of social perceptions and PR gestures touted by Domini but against a company’s actual day-today stakeholder relations, particularly its corporate governance practices. It is easy for social research firms to find out about Morgan’s gestures toward women but impossible to find out about the make-up of its loan portfolios or even determine whom its customers are (which almost certainly include businesses in such taboo industries as defence hardware, tobacco products, nuclear energy and – horror of all horrors – agricultural biotechnology).

What does Morgan or Canadian Imperial have to do to get dropped from the ethical star list? Fire a female board member?

So how has KLD, Domini and the rest of the US social investment comcommunity responded to the cascade of fraud settlements against its favorite companies? I can’t speak personally, because executives at these firms won’t respond to my emails or calls. But based on the current structure of their funds, it’s business as usual. That’s not a good sign for those of us who believe that doing the right thing is not a minimum legal requirement but the very beginnings of corporate responsibility.


Jon Entine is scholar-in-residence at Miami University (Ohio) and adjunct fellow with the American Enterprise Institute in Washington, DC. Jon is also an award-winning freelance journalist.

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