Case Studies

Case Study 9 – Challenges in implementing a Code of Conduct in South East Asia

Industry: Telecommunications (Mobile) - South East Asia

Client: Dominant mobile services provider listed on NYSE and local Stock Exchange.

Objective: To strengthen integrity and ethics in this major, partly state owned enterprise, in order to improve operations and comply with Sarbanes Oxley Act requirements.

Results:

Background: Sarbanes Oxley Act requirements increase pressure to implement Codes of Conduct at listed companies

A conflict of interest is defined as a situation where the officer or employee of a company has a relationship with another person or entity so that a decision made to commit the company is unlikely to be independent and unbiased. An example is where the employee owns a part of a third party company or is an officer contractually engaged to the third company and signs a contract for services or goods between this third party company and the company where he employed as the officer. Another example is where an officer of the company accepts financial incentives to agree to a purchase contract.

During the course of developing internal controls and systems to prevent conflicts of interest in the client company, the new Vice President Internal Audit (VP IA) noted numerous examples of potential conflicts of interest which were detrimental to the client. As a result of stringent requirements arising from the Sarbanes Oxley Act provisions, the VP IA was given the task of drafting and implementing a Code of Conduct at the client company, for distribution throughout its 60 national branches.

Some of the actual cases relating to deficiencies in "Tone at the Top" and breaches of ethics and integrity are described in the following sections and provided input during the drafting of the Code of Conduct.

Use of Inducements and bribes to affect and neutralize professional judgment and independence

In October 2004, shortly after starting the assignment, the Vice President Internal Audit had an informal meeting with the CFO of the client company who was also interim HR Director. The CFO had had been appointed as a senior mentor to the VP IA. During this meeting the VP IA was asked by the CFO to invest in two separate businesses owned or managed by him. Both businesses were located in the east of the country, in different industry branches. The VP IA refused to accept such a proposal. Owning a share of two businesses with the CFO would create a conflict of interest and could be construed to impair his judgment, as the VP IA was expected to independently audit the finances and financial reporting of the company under the authority of the CFO. Having an economic stake in a business together with the CFO would affect this independence.

It was unusual that the CFO was put in place as a "mentor" to the VP IA, creating a complicated relationship of senior to junior executive and affecting independence. It is generally unusual for senior officers of a large company such as the one where the VP IA was engaged to run their own businesses on the side as it detracts from their professional focus and commitment.

During this conversation, the CFO, who was at that time also the Director HR, mentioned
that he was also engaged in several discussions with a prominent Asian businessman, a former Finance Minister, on the topic of a major bank purchase in Indonesia. There was a conflict of interest if the CFO was in fact a paid advisor to the investing team led by the Asian businessman, not least because of the focus on other external businesses.

Inappropriate and fraudulent contracting relationships with related third parties

A cashier in one of the regional offices had taken funds from the client company customers for her/his own account and there were differences between the cash that should have been received and that was in fact banked in the company accounts. From the initial investigation it became clear that the cashier was a sub contractor working for an organization owned by the employees of the client company.

The organization was an employee owned and operated company with had close links to the union of the client company. Virtually all employees of the company were part owners of this organization and were being paid annual dividends. The VP IA was advised by one employee that he received the equivalent of USD $ 500 per year as a dividend from the organization. If about 3,000 employees belonged to this employee organization out of the total 3,300 employees employed, this would mean the equivalent of USD $ 1.5 million net profit would be earned by the organization per annum from contracts with the company. The organization would sign a contract with the client company for services and supplies, and then sub contract the services to other suppliers, in effect being a middleman, in many cases not providing any value for the commissions received. The local General Manager Internal Audit, reporting to the VP IA, was on the Board of Directors of this organization and attended Board meetings regularly.

When it became clear that the cashier in the regional office was an employee subcontracted by this organization to the client company, the VP IA asked to see the contract under which this cashier had been employed, and for all contracts concluded between the employee organization and the client company, to determine any action possible under these contracts.

On reviewing the contract between the employee organization and the client company the VP IA noted that it had been signed by a VP of the client company in one of the relevant provinces. The contract had been signed in absence of any authorization or Power of Attorney from the Board of Directors. On review of the contract it was found that the contract did not contain specifications for service or standards on contract breach provisions. It became clear that the contract was not a proper legal document, having been signed by a VP without authority and not containing key clauses required for the enforcement of the contract and the benefits to be received by the client company.

The VP IA requested formally but never received all contracts between the employee organization and the client company. This is not surprising as it would not have been in the interest of any employee of the client company to assist with this research, as presumably all employees were beneficiaries and recipients of dividends, including the members of the Internal Audit department. This was confirmed during a regional audit the VP Internal Audit attended, where he was advised by the Internal Audit Team Leader of the client company that that as the audit program did not include any testing of the subcontracted employees from the employee organization, the audit team had only audited and tested the cashier responsibilities executed by client company personnel. He also added that in his opinion, the auditors should not test and audit the activities of the sub contracted cashier services.

The VP IA sent a memorandum on this issue to the CEO and management explaining that any fraud investigations related to the contracts between the employee organization and the client company would have to be conducted by outside professionals to avoid any conflict of interest. The investigation was not continued.

Challenges in establishing a Code of Conduct

During the first quarter of the assignment the VP IA was actively engaged in an attempt to
draft the Code of Conduct, reflecting the requirements of Sarbanes Oxley, together with the GM Financial Accounting. The Code of Conduct includes a section on Conflict of Interest. An initial draft had been approved by the CFO and signed by all office holders of the company, but after a further review by a major public accounting firm based in Jakarta there were numerous areas requiring clarification.

One of the key areas was the policy on accepting gifts from third party suppliers. No limit was ever set, and no procedure was provided for reporting any gifts to senior management for decision making. In one case, a General Manager from a regional office was referred to the VP IA to obtain a decision on a number of gifts to his wedding party, some of which substantial (roughly equivalent to USD $ 2,000) and from dealers. Dealer contracts were to be renewed in June 2005 after evaluation, so clearly a gift of this size was designed to influence the contract renewal decision.

When the financial limit of gifts was discussed at director level, directors wanted to keep the limit at an equivalent sum of USD $ 600 for any gift to any officer, without specifying whether this would apply to any one supplier for one year, or for each case from one supplier in year, or as a limit for any one officer of the company. It was clear that , without clarifying this matter, officers would be entitled to take as many US$ 600 equivalent gifts as they would like to obtain from third party suppliers in any one year, affecting the decisions of these officers in selecting specific suppliers, and resulting in purchasing decisions which might not be in the interest of the company.

This issue was emphasized after discussions with senior representatives of a US based multinational providing Base Transmitter Stations to the client company, who had been required to give money to the VP Procurement in order to win the contract. The issue came to light when they had been terminated as client company suppliers in favour of a new vendor, who had been signed up after an organizational change resulted in a new VP Procurement.

When the VP IA proposed a nil limit on any gifts, in accordance with national policies for government departments, and also attempted to introduce an annual statement to be signed by each officer of the company to confirm whether they had any beneficial ownership in any related parties, the draft policy development was effectively stopped by the CEO and directors.

Even though the policy was distributed and circulated to all directors in March 2005, no feedback was ever obtained. The reasons for this lack of progress were to be made clear during the course of March - June 2005, and should also have been clear from earlier discussions with directors and senior managers of the company as well as the several cases investigated by the VP IA.

In the course of this period the VP IA was advised that the Deputy VP IA is also the Chairman of an Insurance company registered in South East Asia, and that one of the other officers of this insurance company was the Chairman of the Board of Commissioners. In addition, the VP IA was advised that other senior officers of the company own sideline business similar to the CFO as previously mentioned including accounting, consulting companies, car showrooms, immigration businesses, modelling agencies and so forth.

Lessons Learnt

The process of establishing a Code of Conduct in compliance with international standards is a major challenge in many emerging markets. In the absence of a written, detailed and explicit Code of Conduct the company and its shareholders may suffer financial losses due to:

1. Purchasing contracts not being awarded to correct and competent suppliers.

2. Company employees including directors and commissioners being engaged in sideline businesses which divert their energy and time away from their real responsibilities.

3. Fraud and theft not being investigated independently and those responsible not being held accountable.

4. Company funds being diverted inefficiently to related party/ employee businesses, which reduces net profits to shareholders without any clear benefits.

5. Professional officers being corrupted or neutralized to the point of being ineffective in discharging their responsibilities.

In hindsight, the willingness of the CFO of the client company to freely offer a stake in his personally held companies to the VP IA should have been a sufficiently clear indicator of the endemic corruption existing within the client company.

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