Chapter 18 Corporate Governance McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. What is Corporate Governance? o Corporate governance: The exercise of authority over the members of a corporate community based on formal structures, rules, and processes o The authority is based on a body of rules defining the rights and duties of shareholders, boards of directors, and managers 18-2 Figure 18.2 - The Power Triangle 18-3 The Corporate Charter o Corporate charter: A document issued by a state government to create a corporation o Corporate charters specify the purpose of the corporation and basic rights and duties of stockholders, directors, and officers o Fiduciary responsibility: The legal duty of a representative to manage property in the interest of the owner 18-4 The Corporate Charter o Charters include provisions about numbers of shares and classes of stock authorized, dividends, annual shareholder meetings, the size of boards, and procedures for removing directors o Bylaws: Rules of corporate governance adopted by corporations 18-5 The Corporate Charter o States compete to attract the incorporation fees and tax revenues of corporations o For more than a century tiny Delaware has been the victor in this competition 18-6 Figure 18.3 - Flow of Authority in Corporate Governance 18-7 Federal Regulation of Governance o Corporate governance laws have been primarily the province of states, however, the Supreme Court has said that the Constitution empowers Congress to regulate corporations if it chooses o Federal intervention generally comes in reaction to conspicuous failures of governance and imposes mandatory rules and restrictions 18-8 Enron Corp. Example o Enron enjoyed admiration and respect among investors, managers of other companies, and the public o Government regulators uncovered multiple instances of : o Juggling accounting records to inflate sales and profits o Hiding debt, concealing excessive CEO perks and compensation in vague footnotes 18-9 Enron Corp. Example o Ignoring standard accounting and financial practices o Shredding documents to destroy incriminating records 18-10 Enron Corp. Example o The board’s Special Investigative Committee did not place sole blame for Enron’s failure on its directors, but it accused the board of failing to exercise it oversight responsibility o A fundamental cause of the catastrophe was the culture of the company o In 2006 a federal jury found Chairman of the Board Lay and CEO Skilling guilty of conspiracy and fraud 18-11 The Sarbanes-Oxley Act o It holds management responsible for accurate financial reports and strengthens the power and responsibility of board audit committees o A few of the act’s provisions are: o Creates a five-member oversight board that has authority over practices of accounting firms o Prescribes rules to improve auditing 18-12 The Sarbanes-Oxley Act o Requires the CEO and CFO to sign and certify the accuracy of annual and quarterly financial statements o Establishes heavy criminal penalties for violating its provisions 18-13 Lehman Brothers Example o Lehman Brothers Holdings began in 1850 as a cotton broker and grew into the nation’s fourth-largest investment bank o Since 1994 it had been run by a CEO named Richard S. Fuld, Jr. Intense, intimidating, and impatient o In 2006, Fuld decided that the way to keep share prices rising was to make Lehman grow faster 18-14 Lehman Brothers Example o To fund its operations, Lehman depended on borrowing tens of billions of dollars each day in financial markets o Lehman’s bankruptcy caused panic in the markets o During the year preceding bankruptcy the board met eight times and its members earned between $325,038 and $397,538 o Lehman’s management made serious errors of judgment 18-15 The Dodd-Frank Act o A statute to reform financial regulation and prevent a recurrence of the 2007–2008 financial crisis o Portions repealed in 2018 – what is the effect on financial organizations? o Any unintended consequences? 18-16 Boards of Directors o Directors in large corporations are chosen after being nominated by the board and approved by a majority vote of shareholders o Directors who are employees of the company are called inside directors; those who are not employed by the company are outside directors o Boards are divided into committees 18-17 Duties of Directors o Laws impose two lofty duties on directors: o Represent the interests of stockholders o Exercise due diligence in supervising management o Directors do not make day-to-day decisions o Boards exercise a very broad oversight o Compensation varies substantially among industries 18-18 Duties of Directors o Some specific board functions: o Approve the issuance of securities and the voting rights of their holders o Review and approve the corporation’s goals and strategies o Select the CEO, evaluate his or her performance, and remove that person if necessary o Give advice and counsel to management 18-19 Duties of Directors o Create governance policies for the firm, including compensation policies o Evaluate the performance of individual directors, board committees, and the board as a whole o Nominate candidates for election as directors o Exercise oversight of ethics and compliance programs 18-20 Board Composition o The average board has 11 members and this has not changed for many years o Most state incorporation laws require a minimum of three, but companies typically have between 7 and 15 o Directors are elected by shareholders, usually for terms of one year o Inside directors o Outside directors o Independent directors 18-21 Board Dynamics o The average board meets eight times a year, although many meet monthly o Agendas include committee reports, mandatory governance matters, and presentations by company executives o The chairman of the board presides over meetings 18-22 Board Dynamics o Advocates of greater board independence believe that a better solution for strengthening the board is to split the roles of chairman and CEO o Management opposes separation o One fear is compromising clarity in the chain of command 18-23 Executive Compensation o A compensation committee of the board of directors sets the pay and benefits of top executives o Elements of compensation include a combination of the following o Base salary o Annual cash incentives 18-24 Executive Compensation o Long-term stock-based incentives o Stock options o Performance shares o Restricted stock o Retirement plans o Perquisites 18-25 Problems with CEO Compensation o The size of extraordinary payouts o The compensation packages given to some newly hired CEOs o The golden handshakes received by some CEOs when they leave under fire o An alleged bias in favor of boosting CEO compensation due to the composition of the compensation committees 18-26 Problems with CEO Compensation o Nonconformance with the interests of shareholders o The number and misuse of stock option grants o The spread between executive pay and that of the average worker 18-27 Concluding Observations o Despite well-defined legal bonds between share owners, boards of directors, and management, there are many tensions between them o Scandals revealed lax oversight of financial strategies and reporting by many boards 18-28 Concluding Observations o Many shareholders believe that boards have allowed management compensation to exceed reason o The outlook is for more pressures and regulations that tighten board oversight 18-29 Mercy MBAA 605 – SUMMER 2019 Business, Government, and Society BUSINESS CASE PAPERS:  It is expected students thoroughly read the case study, textbook chapters, and supplement materials to understand the topic and identify the issues so as to qualitatively and substantively critically evaluate how the issues affect and are affected by the inter-relationship of business, government and society.  As you are Master’s students, write accordingly paying attention to grammar, spelling, syntax, and tone. Thoroughly proofreading your paper prior to submission is strongly encouraged. Business Case Papers WILL:  Be a critical evaluation of the issues and NOT personal opinion.  Include citations and references of at least 3 trusted sources other than the case study to support assertions being made as part of the critical evaluation process.  Answer the multi-pronged Assignment Question specified in the syllabus.  Comport with all current APA formatting guidelines including, but not limited to references; in-text citations; cover page; pagination; double-spacing; 1-inch margins; Times New Roman 12-point font.  Be independently authored and submitted as a Word document via Blackboard.  Be a Minimum of 3 full pages, Maximum of 4 pages of content. *this does NOT include the cover page, an abstract if written, or the reference section **Failure to submit 3 FULL pages of content will adversely impact your grade as follows: (1 page=33%, 2 pages=66%, 3 pages=100% of content). Grading Rubric for Business Case Papers Concise Introduction Summary of Case Critical Evaluation of issues from the perspective of Business Critical Evaluation of issues from the perspective of Government Critical Evaluation of issues from the perspective of Society Critical Evaluation of how issues relate with each other Concise Conclusion Grammar, Spelling, Syntax, Tone and Writing Style APA Referencing and Citations Total points per Business Case Paper POINTS 10 20 10 10 10 10 10 10 10 100 Business Case Papers will comprise a maximum of 30% of the final grade. Cases can be purchased at Harvard Business Publishing accessed by clicking this link: https://hbsp.harvard.edu/import/629182 9 For the exclusive use of S. Campbell, 2019. NA0180 The Midnight Journal Entry Anne T. Lawrence, San José State University O n an overcast afternoon in Portland, Oregon, on Friday, March 28, 2003, Richard Okumoto intently studied a set of hard-copy accounting documents called “adjusting journal entries” spread out on his desk. He had been appointed chief financial officer (CFO) of Electro Scientific Industries, Inc. (ESI), a multi-million-dollar equipment manufacturer, just a few weeks earlier. Okumoto was in the midst of closing the company’s books for the third quarter of fiscal year 2003, which ended February 28. An experienced executive who had served as CFO for several other technology firms, Okumoto was familiar with the task, which normally would be routine. But this time, he felt that something was seriously amiss. When reviewing the company’s recent results, he had noticed a sharp dip in accrued liabilities between the two quarters ending May 31 (the last quarter of the 2002 fiscal year) and August 31 (the first quarter of the current fiscal year). Now, looking at the detailed journal entries his staff had provided, he noticed that several significant accounting entries had been made around midnight on September 12, 2002. The entries made that September evening had significantly changed the company’s results for the quarter ending August 31, 2002, a few days before they were reported to the Securities and Exchange Commission. He later recalled: The fact that the time stamps [on the journal entries] were midnight through one o’clock in the morning made me believe they were having difficulties closing the quarter. Not just because of accounting difficulties, but because they were having difficulties finding the right answers. My initial reaction was, even given a difficult quarterly close, if the team was working that late at night, that wasn’t typical. From the pass codes required by the accounting software, Okumoto could see who had made the entries. They included James Dooley, then the company’s acting chief operating officer and now the CEO, the corporate controller, and several senior members of the finance team. One midnight journal entry in particular drew the new CFO’s attention. The late-night team had wiped out an accrued liability of $977,000 associated with the anticipated cost of retirement and severance benefits to company employees in Japan, Korea, and Taiwan. That entry, and several smaller ones, all of which were favorable to Copyright © 2012 by the Case Research Journal and Anne T. Lawrence. The author developed this case to provide a basis for class discussion rather than to illustrate either the effective or ineffective handling of a managerial situation. An earlier version of this case was presented at NACRA’s annual meeting in San Antonio, Texas, October 2011. The author gratefully acknowledges the assistance of Richard Okumoto and the thoughtful comments of the editor, Deborah Ettington, and three anonymous reviewers. The Midnight Journal Entry 137 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. net income, had the cumulative effect of permitting the company to report earnings of $0.01 per share for the quarter ending August 31, 2002, rather than a loss. When he realized that, Okumoto recalled, he felt “a sinking feeling in my gut.” He asked himself, “What happened here? At that time of night? All of the changes in a single direction? What’s going on?” He was sure something was not right. Richard Okumoto Born in 1952, Richard Okumoto was raised with his four siblings in a JapaneseAmerican family in a low-income, African-American neighborhood that bordered the Pepper Street Projects of Pasadena, California. He explained how his parents’ experiences had shaped their outlook: My parents grew up during the depression years. Dad farmed with relatives, and Mom grew up tending 3,000 chickens on a three-acre ranch in Gardena, California. Shortly after the Pearl Harbor attack by the Japanese, my parents were relocated under Executive Order 9066 [under which persons of Japanese ancestry on the West Coast were sent to relocation camps during World War II]. They met and married in a relocation camp. During their incarceration, their families could not make their payments. Dad and his relatives lost their land, and Mom’s parents lost their chicken ranch. After those experiences, my father was committed to having no debt. He built our family home in 1955, with the idea of paying off the loan in eight years. In 1962, Okumoto’s father, who worked as a gardener, landscaper, and salesman of Japanese mutual funds, was disabled in a serious auto accident. Fortunately, by then, he had almost paid off the loan on their home, so the family was able to survive financially. After the accident, Okumoto’s mother took a job cleaning homes to help support her five children. Okumoto described his relationship with his mother: She and I had an especially close bond. Shortly before my dad’s accident, both her parents had died. I was the one who supported her through a very difficult year. As a result, she always treated me differently from the other kids—almost like an adult. The Okumoto family’s financial situation after the accident was difficult. Okumoto had vivid memories of how they coped: Money was very short. We had to account for every penny. Every week, my mother wrote down in a leather-bound journal everything she earned and everything we spent in the household, down to the penny. Every week, from the time I was ten years old, she went through that with me. We lived on a cash basis. There was no credit card, no second mortgage. In that situation, budgeting became extremely important. Her comment to me was, “You can’t complain [about what you don’t have] unless you understand what’s happening.” Those were her ground rules. He added this comment about his mother’s values: The ethics of doing the right thing become very important, because that’s really all you have. [My mother] instilled in me at an early age, regardless of what else you do, always take the high road, always do the right thing. That has influenced me throughout my career. After high school, Okumoto attended San José State University, where he completed an undergraduate degree in accounting in 1974 and attended the MBA program from 1975 to 1978. He soon embarked on a highly successful career in finance. Over the next two-and-a-half decades, he held increasingly responsible roles at a number of high-technology companies in the Silicon Valley, including Fairchild Semiconductor, 138 Case Research Journal • Volume 32 • Issue 2 • Spring 2012 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. Novellus Systems, Measurex, Credence Systems, and Photon Dynamics. Okumoto admired a number of managers he had worked for, who had set high professional and ethical standards for him and his co-workers. He felt fortunate to have had three exceptional mentors: Woody Spedden, the CEO of Credence Systems; Jim Hefferman, his boss at Fairchild and later at Measurex; and Don Waite, the CFO at Measurex who later took over that position at Seagate Technologies. “All three individuals upheld the highest integrity,” Okumoto recalled. “Aside from the technical training I received from them, I got a strong ethical grounding. They would always tell me to ask myself—what are your obligations to others?” Electro Scientific Industries, Inc. Electro Scientific Industries, Inc., the company that Okumoto joined as CFO in early 2003, was the second-largest technology company in Oregon, trailing only Tektronix in size. Based in Portland, the company was founded in 1944 as Brown Engineering to make test and measurement equipment. As technology evolved, so did the company’s products. In the 1960s, the firm—by then called ESI—moved into lasers, and later developed applications of laser technology for the emerging semiconductor industry. ESI went public on the NASDAQ exchange in 1983. In 2003, ESI’s core business was providing precision production equipment to electronics firms. The company manufactured equipment that was used in the production of a wide range of electronics products, such as computers, cellular phones, home entertainment systems, automotive electronics, electronic games, and personal digital devices. Its products included advanced laser systems, test equipment, and packaging systems, among others. The company’s customers included many leading electronics firms, including AMD, Ericsson, IBM, Samsung, Hitachi, Flextronics, Honeywell, and Lucent. Seventy percent of ESI’s sales were outside the United States, mainly in Asia and Europe. The company owned and operated manufacturing facilities in Portland and Klamath Falls, Oregon, and in Escondido, California, and operated sales offices in many countries. In 2002, it employed 875 people and reported sales revenue of $167 million (down from $472 million the prior year). Like many firms in the electronics industry, ESI was badly battered by the economic downturn that began in 2001. After achieving record sales and income in the fiscal year ending May 31, 2001, the company’s financial results declined precipitously in FY 2002, as shown in Exhibit A. Sales and profits had continued to decline in the first half of FY 2003. Exhibit A: Electro Scientific Industries, Selected Sales and Income Data*, 1998–2002 1998 1999 2000 2001 2002 Net sales 252,134 197,118 299,419 471,853 166,545 Net income (loss) 22,347 7,528 40,860 99,933 (15,961) Net income (loss) per share 0.89 0.29 1.55 3.71 (0.58) *Data refer to fiscal years ending May 31. All data are given in thousands of dollars, except per share data. Source: ESI 2002 Annual Report. The Midnight Journal Entry 139 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. The company noted in its 2002 annual report: In fiscal year 2002, ESI weathered the worst downturn in the electronics industry in over 30 years . . . We are conducting a thorough review of our overall market strategy as well as product line strategies to assure that they will generate significant shareholder returns over the inevitable cycles in our industry. To cut costs, the company initiated a shutdown of its Escondido facility, consolidating its operations in Portland. It divested several underperforming lines of business and sought to invest in areas it saw as promising through partnerships and, potentially, acquisitions. It also informally explored a merger with another firm in southern California. In early 2002, Don VanLuvanee, the company’s long-time CEO, suffered a stroke and was no longer able to serve. The board appointed David Bolender, the former CEO of Protocol Systems and a director since 1988, to step in as acting CEO until it could find a permanent replacement. At that time, the board also elevated James Dooley, who had been serving as the firm’s chief financial officer, to the role of acting chief operating officer to run the company’s day-to-day affairs. In December 2002, the board promoted Dooley to the position of chief executive officer, and Bolender became chairman of the board. (Executives and directors of ESI named in the case, and their positions, are summarized in Exhibit B.) Exhibit B: Executives and Directors of Electro Scientific Industries, Inc. (Listed in Order of Mention) Richard Okumoto Chief Financial Officer (CFO) James T. “Jim” Dooley Acting Chief Operating Officer (COO), early 2002–December 2002 Don VanLuvanee Former CEO David F. Bolender Acting CEO, early 2002–December 2002 John “Jack” Isselmann, Jr. General Counsel Mike Tetsui Manager, Japanese Office Barry L. Harmon Former Chief Financial Officer (CFO) Gerald F. “Jerry” Taylor Director and Member of the Audit Committee Jon D. Tompkins Director Chief Executive Officer (CEO), December 2002– Chairman of the Board, December 2002– Director and Member of the Audit Committee Closing the Quarter Shortly after Dooley became CEO, Okumoto was recruited as chief financial officer. He started work on February 17, 2003. I was excited about the job. I thought it might be my last one in the industry. The company, management, and employees—all had a long history of stability. To me, it was another walk down the path of hard work, a fresh chance to apply my skills in strategic planning and execution as well as to implement the new Sarbanes-Oxley compliance rules. 140 Case Research Journal • Volume 32 • Issue 2 • Spring 2012 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. His first task was to prepare for the FY 2003 third quarter close. In reviewing the company’s books for the past several quarters, he soon noticed a sharp downward spike in the balance of accrued liabilities. He noted that fact for further investigation. In addition to closing the quarter, several other items required Okumoto’s attention. Just one week into his new job, on February 24, he got an email from John (“Jack”) Isselmann, Jr., the general counsel, asking him to forward to the manager of the Japanese office, Mike Tetsui, a set of revised work rules (terms of employment) for ESI’s Japanese employees. As a newcomer, Okumoto knew little of the background or why he had been asked to do this, but complied with the general counsel’s request, sending on to the Japanese office manager the revised work rules. Okumoto received the following reply from Tetsui on March 2: I have read the proposed work rule and found no section of [sic] retirement fund. I do not know what is the intention of removing that section, but it is a huge impact on each employee we have…I do not think I can get concents [sic] from [ESI’s Japanese] employees without reasonable change in retirement benefit. Please let me know how you would like me to proceed. Okumoto recalled: My first response was, “uh-oh.” There was a big disconnect between what I had been told and Mike’s reply. I had assumed that the Japanese had already been informed of the cancellation of their retirement benefits and agreed to the changes. It was clear they had not. In a prior job at Novellus Systems, Okumoto had set up that company’s Japanese operations, and he was aware that Japanese work rules were normally filed with the government. Regulators were very strict about altering any documented benefits. Accordingly, Okumoto believed that ESI was obligated to pay benefits that had been promised to employees, and he told Isselmann this. Okumoto also expressed the opinion that employees, if dissatisfied with the revised rules, could take the matter before the Japanese labor board, and that this would be a “quantifiable event” that would have to be recorded on the books as a liability. Isselmann responded that he was unfamiliar with Japanese law. On March 4, Okumoto spoke with CEO James Dooley about his concerns that the reversal of benefits for Japanese, Korean, and Taiwanese employees might expose ESI to litigation, and this could affect the accounting treatment of the event. Dooley strongly disagreed. Okumoto recalled: He told me that everything had been cleared with everyone. He said there was full information. There was full disclosure. He emphasized that KPMG [ESI’s external auditor], the company’s own legal staff, and the board had all signed off on it. He said I should “just get past it.” Okumoto was concerned about this conversation, particularly because the CEO seemed so defensive. On March 11, Okumoto met again with Dooley, this time to discuss Okumoto’s upcoming presentation to the audit committee. The new CFO recommended that the company delay announcing its third quarter earnings and restate its first and second quarter earnings to report correctly the $977,000 in liabilities associated with the anticipated cost of retirement benefits for its Asian employees. Okumoto explained his view that not reporting these liabilities had violated Generally Accepted Accounting Principles. At that point, Okumoto recalled, Dooley became visibly upset. The Midnight Journal Entry 141 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. The CEO—all six feet-six inches and 280 pounds of him—turned an angry red and told me again to just get past this. That’s when I knew that this was going to be swept under the rug. It was clear I was not part of the club. Then Jim said, “If I’ve got to reverse this entry, I’ll quit.” The “MoFo” Memorandum On March 13, Okumoto attended a meeting of the board of directors’ audit committee. Also present at that meeting, in addition to the audit committee members, were Dooley, Isselmann, and several senior managers. At the meeting, Okumoto recommended that the company’s financial statements for the previous two quarters be restated, and that it hire an independent accounting firm to conduct an audit of the Asian benefits issue. Dooley countered that everyone had been fully informed of the reversal and had “bought off” on it. The audit committee declined Okumoto’s suggestion that an independent accounting firm be brought in, but it did direct Barry Harmon (formerly ESI’s CFO and a member of the audit committee), Okumoto, and Isselmann to lead an internal investigation into the matter. After the audit committee meeting, Isselmann came into the CFO’s office. Okumoto recalled: He closed the door and just broke down. He told me that after the benefits reversal in September he had asked MoFo [Morrison Foerster, an outside law firm on retainer to ESI] to review its legality. MoFo had advised it was illegal to cancel the retirement benefits without employee consent. He said he had immediately shown the memo to Dooley, who had brow-beat him, intimidated him, and essentially boxed him into a corner. I believed this, because in one meeting I actually saw Jim stand up and tower over Jack, who was only 5 feet 6. I watched Jim almost physically overtake him. Jack was a young guy, pretty inexperienced, and his job at ESI was his first in the industry. On his way out, Isselmann handed Okumoto some documents. From the documents, Okumoto learned that on October 3, 2002, Isselmann had written MoFo, asking for an opinion on whether or not it would be legal for the company to terminate the Asian employees’ retirement benefits unilaterally. In his letter, Isselmann had pointed out that the rules had been distributed to employees but had not been submitted to the relevant government agency. On October 7, Toshihiro So, a Japanese labor and employment attorney affiliated with Morrison Foerster, responded to Isselmann’s request. The MoFo memo, now in Okumoto’s hands, read in part: Retirement allowances are not a legal requirement [in Japan]. However, once the company agrees to pay retirement allowances in Rules of Employment (even though they have not been submitted to the relevant government agency), the company is obliged to pay them in accordance with the Rules and cannot remove them at the company’s discretion. According to Japanese case laws, as a general rule, …the deprivation of previously acquired rights by newly drawn up or changed work rules are [sic] not permitted…[It] is required that before changing the work rules, the company should hear and consider the opinion of the related employees. Okumoto was shocked. “This is the smoking gun,” he thought. Investigating further, Okumoto learned that although private employers in Japan were not obligated to pay retirement benefits, doing so was considered a good industry practice, and since 1981 ESI had offered such a benefit to its employees there. 142 Case Research Journal • Volume 32 • Issue 2 • Spring 2012 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. Under the rules of employment established for ESI’s employees in Japan, any employee (except executives) who chose to retire after reaching the voluntary retirement age of 60 would be entitled to a “retirement allowance” of one month’s pay per year of service—in effect, a one-time severance payment. Workers who were involuntarily terminated and the estates of any workers who died before reaching the age of 60 were also entitled to this benefit. Similar rules were in effect for the company’s workers in Korea and Taiwan. At the time, ESI had 18 employees in Japan, 13 in Korea, and 23 in Taiwan, mostly in sales and customer support roles.1 On March 14, Okumoto called an “all hands” meeting to disclose his initial findings and discuss a path forward. Present at the meeting were Dooley, Isselmann, Harmon, and several other senior managers. The CFO asked directly if there had been full disclosure and review of all material facts with respect to the accrual reversal. Dooley confirmed that everything had been disclosed. Okumoto did not mention the MoFo memo, thinking that Dooley’s response indicated that he must have already disclosed it to KPMG and the audit committee. On March 20, Okumoto spoke by telephone with Mike Tetsui. The Japanese manager told the CFO that the employees had not yet been told that their retirement benefits had been terminated, and he—Tetsui—would resign before he would tell them that news, which he expected would be devastating. “As head of the group,” Tetsui told Okumoto, “I will fall on my sword.” On March 21, Okumoto met again with Dooley to press him on how the reversal had happened. Dooley was initially “combative.” As the conversation went on, however, he “let his guard down” and began talking about what had happened on the night of September 12. As Okumoto recalled the conversation: Jim told me that he had sent a financial packet to the board of directors prior to their meeting on September 13. After he had distributed the packet, but before the meeting, he was contacted by KPMG, who told him there had been an error in the company’s calculations of its overhead costs, so the financial statements distributed to the board were incorrect. ESI’s reportable earnings were suddenly much less than they thought, by as much as a million dollars. Jim said this was particularly important because the company was in informal merger discussions with a company in southern California. Then he said, “No one was helping me, so I had to help myself.” When Jim made that comment, my first thought was, he was looking for revenue. He was hunting for credits. He was looking to manipulate earnings. That was a definite red flag. Okumoto walked out of Dooley’s office stunned. He called his staff together and asked them to assemble any documentation they had on accounting entries on or around September 12. He also began talking with the members of the finance team who had participated in the late-night meeting with Dooley and learned that a number of people on the finance staff had questioned the benefits reversal, but had not brought it forward. This was consistent with a negative tone at the top. I would almost characterize it as bullying. That’s one reason why no one stepped forward. That tone at the top created an environment where people really couldn’t speak out. It’s important to look at the people. It’s similar to qualitative research. We all do that intuitively. When I looked at the body language of a lot of the people involved—the cost accountants, the financial analysts—it became apparent to me that they were scared. They knew something was wrong, and they wanted to say something, but something held them back. They The Midnight Journal Entry 143 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. reminded me of beaten animals. Growing up in the neighborhood I did, I knew what fear looked like. As part of his further investigation, Okumoto independently approached the audit team from KPMG. They told him Dooley had informed them that the company had received a legal opinion that the reversal was appropriate, and they had deemed that information sufficient. Okumoto observed: KPMG was new on the account, which they picked up after the collapse of Arthur Andersen. They didn’t have deep familiarity with it. They did not have all the information. Some of the partners were new. On March 28, a week after he had requested the relevant accounting entries for September 12, his staff finally produced the complete documentation for that date. Now, drilling down into the details, he saw the full scope of the midnight journal entries—and who had made them. Weighing the Risks Over the weekend, Okumoto considered his next moves. None of the individuals and groups from whom he had sought support—the CEO, the general counsel, or the auditors—seemed to share his concern about the seriousness of the issue. The audit committee had shown some interest, but had turned down his recommendation to bring in independent auditors and seemed to believe the matter could be handled internally. Okumoto was losing sleep, worrying constantly about what—if any—additional steps he should take. He had tried to warn the key players. From all, he had received the same message: We don’t see this as a serious problem. Let it go. Okumoto realized the risks of escalating the issue further. He was earning a base salary of $250,000, with the possibility of a 100 percent performance bonus. He reflected: I certainly realized the risks. I knew that if I brought this forward, there was a strong likelihood that I would either lose my job, or I would be in an environment where it would be difficult to operate, so I would have to leave. The idea also occurred to him that “I can leverage this for more money and stock if I look the other way. Plus, I can become invaluable to the company with this dirt. I can immediately become part of the established inside club.” He had also recently signed a contract to purchase a home in the nearby community of Lake Oswego, and wondered how he would make good on that commitment if he lost his job. However, he felt reasonably secure financially. Following the example of his parents, Okumoto had worked hard to avoid debt and to save for adverse times. He reflected: One of the first things I ask friends who are or would like to be CFOs or general managers, where risks such as this can jeopardize their careers, is: Are you financially secure enough to make good decisions? Because if you aren’t, I can count on the fact that you will make bad decisions when times of adversity hit. We all talk about the value of making good decisions, but as we all know, life creeps in. There are economic commitments, family commitments, and people are sometimes moved to do the wrong thing. As the old adage goes, hire your sales people so they are hungry enough to get the deal done. Hire your finance people so they are not hungry enough to do the wrong thing. 144 Case Research Journal • Volume 32 • Issue 2 • Spring 2012 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. He added: Fortunately, I was financially in a position where I could afford to leave if it came to that. I was single, so I figured the only person I had to protect was myself. He also had a network of friends in the area he felt he could turn to for support. I had a number of friends in the Portland area, having worked there earlier. My prior company had a division of about 1000 employees in the area. Of these, 500 had worked directly for me. It might have been a false sense of security, but I felt I had a pretty good infrastructure of people that I knew. By this time, Okumoto was also becoming concerned about his personal safety. Several times, he received anonymous messages on his home answering machine. At the time, he was living temporarily in corporate housing while he shopped for a home, and he felt he was particularly visible there. But, he added that he was not easily intimidated. I felt that I could take care of myself. I had faced a lot worse threats than this one. As a teenager, I was robbed at gunpoint. I was stabbed in the back and left for dead. I was beaten so badly that my eyes were swollen shut. I grew up around a lot of physical violence. Although Okumoto saw risks in taking action, he also saw risks in inaction. He commented: I was concerned about my own legal liability if I did not take action. From the point of view of the DOJ [Department of Justice] and SEC [Securities and Exchange Commission], if you don’t fix the problem, you become the problem. I had potential legal risk. As Okumoto pondered the risks of both action and inaction, he reflected on the board of directors and what kind of response he might expect if he approached them directly. (See Exhibit C for a list of members of the board.) Dooley was the only insider on the board. There were some old timers on the board— like Barry Harmon, who had earlier been CFO at ESI. But there were also a fair number of independents. Even though I was new at the company, I had a prior relationship with two of the directors. Jerry Taylor, the former CFO at Applied Materials, was a member of the audit committee. Jerry and I had worked together 25 years earlier at Fairchild. So, I had a long-standing relationship with him. Jon Tompkins, the former CEO of KLA-Tencor, was also on the board. I had known Jon from Tencor days, where he had interviewed me for the CFO position. As he contemplated his next move, Okumoto thought back to an experience earlier in his career. As he told the story: I had been in a situation before where I hadn’t spoken up. I had been a CFO for another public company. I was in a situation in which I had questions on some of the accounting. But it was close enough, and I was concerned that I didn’t have enough evidence to support my reservations. I had only been with the company three months. Within four months, we had a major revenue shortfall. At that time, I made the decision not to try to cover up the revenue shortfall. But, because we had not called it to the attention of analysts earlier, we lost the confidence of the Street. At that point, the CEO and I both resigned. I made a decision then that if I ever again saw something that was close, I would act much faster. The Midnight Journal Entry 145 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019. For the exclusive use of S. Campbell, 2019. He also thought about his mother’s admonition always to do the right thing, and the advice of his mentors, who had counseled him always to ask the question—what are your obligations to others? Exhibit C: Members of the Board of Directors, ESI Inc., March 2003 David F. Bolender, Chairman of the Board Chairman of the Board and CEO (retired), Protocol Systems, Inc. President (retired), Pacific Power and Light Co. James T. Dooley, Chief Executive Officer Barry L. Harmon, member of the Audit Committee Senior Vice President (retired), Avocet Corp. Formerly, Senior Vice President and Chief Financial Officer, ESI Keith L. Thomson Vice President (retired), Intel Corp. Chair of the Board of Trustees, University of Oregon Foundation Jon D. Tompkins Chairman of the Board and CEO (retired), KLA-Tencor Corp. President and CEO (retired), Spectra-Physics Vernon B. Ryles, Jr. President and CEO (retired), Poppers Supply Co. Gerald F. Taylor, member of the Audit Committee Chief Financial Officer (retired), Applied Materials W. Arthur Porter, Chairman of the Audit Committee Dean of the College of Engineering, University of Oklahoma Larry L. Hansen Executive Vice President (retired), Tylan General, Inc. Note 1. In 2002, average annual salaries for ESI employees were $68,000 in Japan, $27,000 in Korea, and $38,000 in Taiwan (in U.S. dollars). 146 Case Research Journal • Volume 32 • Issue 2 • Spring 2012 This document is authorized for use only by Sade Campbell in MBAA605 - Summer 2019-1 taught by DANIEL CUTTER, Mercy College from May 2019 to Nov 2019.
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