Ethics at work

By Jonathan Allard
Illustration: Michelle Thompson

Silence used to be golden. No more. Companies want everyone to talk — about fraud. And they're setting up hotlines to do just that

William, an experienced machinist with a large manufacturing company, amazed by his new foreman’s sumptuous lifestyle. He was very curious how the foreman could afford his deluxe cars and sun-filled luxury cruises, which were part and parcel of his way of life.

However, one day William noticed the name of an employee he didn’t know on an envelope topping a pile of pay packets, and became suspicious. He mentioned it to a few people,who encouraged him to report the situation through the company’s ethics hotline. Not without some compunction about meddling in others’ affairs, he did just that. It turned out the foreman was creating fictitious jobs, then pocketing the wages. Thanks to William, the fraud was limited to 10s of thousands of dollars. And he was given a $1,000 reward.

In similar situations many employees are reluctant to talk for fear of losing their job, believing they’ve got more to lose than to gain. So it’s not surprising that organizations find it hard to persuade their employees to communicate critical information that could help prevent or detect misconduct.

However, executives who have studied the risk of remaining ignorant of potential problems understand that changing their organization’s culture to promote disclosure is worth the investment. Despite the complexity of the task, an ethics hotline is an ideal tool for this purpose.

Such hotlines are intended to prevent misconduct in the workplace. Fraud is the most serious violation because of its extent, its impact on an organization and how difficult it is to detect. According to the Association of Certified Fraud Examiners (ACFE) 2004 study, US organizations experienced fraud losses totalling approximately US$660 billion, or about 6% of their annual sales.

How do these reporting systems work? They are usually independent telephone lines where employees, vendors, customers and clients can confidentially report acts they consider to be unethical.

But corporate interest in whistleblowing issues is nothing new. As early as 1863, the False Claim Act in the US legitimized this principle to help reduce fraud against the US government. This act, passed during the Civil War, was intended to prevent and detect fraud committed by military contractors. For example, opportunists sold the army the same horse several times, while others became millionaires by unloading stocks of moth-eaten blankets. The act helped put an end to such abuses.

In the wake of the highly publicized financial scandals at Enron, WorldCom and Nortel, regulatory authorities put increasing pressure on corporate executives and directors. This pressure was reflected by tougher legislation and regulations such as the Sarbanes-Oxley Act, which requires any US publicly traded company — which includes Canadian companies that trade on US exchanges — to implement fraud and abuse prevention methods. In Canada, the implementation of these systems has been limited because legislators and the corporate world have been slower to react. How-ever, although they are not as restrictive as the US legislation, Bill 198, the Ontario equivalent of SOX, and regulation 52-110, adopted by the provincial securities authorities, encourage the setting up of controls and reporting mechanisms to combat fraud.

More recently, in response to the sponsorship scandal, the Canadian government tabled the Federal Accountability Act (Bill C-2), amending the The Public Servants Disclosure Protection Act (Bill C-11) to en-sure protection not just for public servants but for all Canadians who report wrongdoing to the Public Sector Integrity Commissioner. This measure supplements a recent amendment to the Criminal Code to protect whistleblowers from being penalized and is a key factor in encouraging witnesses to come forward.

In reality, despite the protection measures in place, many who do speak up are subject to reprisals. Some US reports suggest that up to 85% of whistleblowers suffer repercussions. One employee of a Canadian manufacturer who reported on a manager taking hidden commissions, which led to more than $100,000 in losses for the company, eventually decided to quit her job. The manager had made an agreement with a supplier to approve artificially inflated invoices in exchange for cash. When coworkers heard she had turned the manager in, they were less inclined to trust her and stress levels in the workplace escalated, affecting their work as a team. To escape this depressing and unhealthy atmosphere, the whistleblower left her job.

However, some whistleblowers are hailed as heros in the workplace. That’s what happened with Michael, an employee with a firm of professionals. He reported a coworker who was doctoring his time-sheets to improve his productivity statistics. Because his misconduct was an open secret for years and caused resentment over performance evaluations, his coworkers were delighted when it was finally reported. Such incidents illustrate just how important it is for employees to know that there are effective mechanisms in place to protect them, mechanisms that go beyond the theory enshrined in legislation or in corporate policies. For whistleblowers, immunity and confidentiality are a must.

If reporting systems are managed efficiently, they are ideal for preventing fraud and unethical behaviour. They are generally cost effective, even in organizations that are not impacted by the new regulations. The ACFE report notes that organizations without reporting mechanisms suffered fraud-related losses that were more than twice as high as those where such mechanisms had been established, i.e. US$135,500 versus US$56,500.For example, the City of Toronto, one of the country’s leaders in implementing ethics hot-lines, estimates that its system has saved or recovered more than $500,000The municipalities of Ottawa and Windsor, Ont., also now operate reporting systems.

The principle behind a hotline is simple. It is a channel that concerned parties can use to report, in the strictest confidence, any wrongdoing they have witnessed. Because the ACFE study showed that nearly 60% of tips leading to the detection of misconduct came from employees, a toll-free number should be made available not just to employees, but to customers, vendors and shareholders, anyone who wants to participate in the reporting system.

Given that almost 50% of calls are made outside regular business hours, it should be accessible around the clock, 365 days a year. Because it is also intended to prevent management fraud, the system must remain independent and free of any influence from corporate executives, since losses from fraud committed by executives are 14 times higher than from schemes involving employees. The number should be displayed in various locations, such as offices and production areas; employee manuals; pay slips; invoices; cheque stubs; and corporate websites, where it can be readily noticed.

The City of Toronto reports that use of its ethics hotline increased by more than 100% (from 89 to 184 calls) between 2004 and 2005 because more people were aware the line was available.

How are calls received? The people answering the calls are specially trained to deal with all sorts of reporting situations and are active listeners. They adapt questions and their approach to each caller, reassuring callers who may be reluctant to reveal critical information that could be useful in subsequent investigations. They stress that the call is confidential and show empathy to encourage full disclosure.

The information gleaned from a call is logged into a book, which is regularly sent to the audit committee or board of directors to keep them updated on disclosures. However, if a case is considered urgent, the log book is forwarded immediately.

Employees manning the phones are trained on the urgency criteria specific to each organization, and understand how to exercise professional judgment. This ensures a balance between the organization’s risk tolerance and the time available to the audit committee, given the committee’s understandably limited resources.

Because confidentiality is vital when gathering follow-up information after an initial call is an issue, hotlines include a callback system where the caller is asked to call back after a period of time, usually two weeks to a month. This allows the organization to obtain more details and analyze the information. If a whistleblower agrees to come forward and reveal his or her identity, he or she can collaborate more closely on the investigations and keep current with developments.

Lastly, if the audit committee feels the case calls for more in-depth inquiry, it has a wealth of information available to plan and launch such an investigation. The committee may then decide to conduct the investigation in-house or entrust the mandate to independent experts.

Why is an ethics hotline necessary?

Given that fraudulent activities cost US organizations about US$2,500 per employee in 2004, it seems logical to seek an effective means of reducing these costs. On the other hand, some 40% of frauds are initially detected thanks to a tip provided through a reporting mechanism. According to the ACFE, tips are in fact the No. 1 method of detection, outranking internal audits (24%), accident (21%), internal controls (18%) and external audits (11%). They are particularly effective (51%) in discovering fraud committed by owners and/or executives making ethics hotlines a key detection tool.

According to Toronto’s auditor general, the city’s hotline has had many positive repercussions. More specifically, measures implemented following the analysis of complaints reduced losses attributed to fraud, waste or other irregularities by terminating substantiated incidences, and strengthening controls to reduce the risk of future incidents. Another advantage of reporting structures is their dissuasive effect on potential perpetrators. After all, wouldn’t you be deterred from dipping into the cash register if you knew coworkers could easily and confidentially report you?

But there is a downside: these systems can create a climate of fear and suspicion, which is obviously negative for any organization. According to a forensic and investigative accountant — who prefers to remain unnamed — with a major Quebec company that set up an ethics hotline several years ago, whistleblowers fear repercussions on the job and reprisals from the persons targeted. Their concerns translate into repeated demands for confidentiality. These employees usually make their calls outside office hours because they are afraid of being overheard by their coworkers. So it’s vital to implement measures to reassure them in order to maintain the system’s effectiveness.

A survey among City of Edmonton employees suggests the availability of an ethics hotline would make them more willing to report misconduct and at the same time enhanced their peace of mind. In fact, 62% of respondents who said they were unlikely to report misconduct through their superiors said they would use the hotline.

What’s more, in addition to fraud, reporting systems help detect such unethical behaviour as theft; statutory/regulatory infractions; discrimination; harassment; and health and occupational safety risks.

This means that ethics hotlines not only effectively reduce fraud, but also curb behaviour that could be detrimental to organizational efficiency. Their effectiveness in preventing fraud is widely documented and validated by various studies, including the ACFE’s. Thanks to its hotline, the City of Toronto was able to recover some 75% of losses arising from complaints for which a survey was completed in 2005, or about $380,000 for that year alone. For many organizations, the advantages of such a system significantly outweigh its operating costs, which are generally estimated at less than $10 per employee per year. In a March 2006 report entitled “Hotline Evaluation — Leading Practice Review,” the City of Edmonton also reports that despite additional costs and a certain number of nuisance complaints owing to the anonymous nature of the system, its benefits exceed the costs and the risks incurred.

Setting up reporting mechanisms

Is there anyone who hasn’t heard about the waste of public funds in recent years? There’s no shortage of examples, ranging from the idleness of municipal workers, to firearms registry and the Gomery Commission, the commission of inquiry into the sponsorship program and advertising activities. Incidents such as these have raised frustration levels among the public. If the witnesses of these abuses had been able to talk, their testimony would certainly have been extremely valuable.

While some media have been critical of ethics hotlines, linking whistleblowers to informers, criticism underscores the importance of having an effective communication strategy when setting up such systems because they can be perceived as eroding confidence or invading privacy. Preconceived ideas have to be overcome in order to focus on the primary goal of reporting structures, i.e. to prevent or detect unethical behaviour. This communication is generally in the form of training on ethical issues for employees. If WorldCom or Enron had implemented reporting mechanisms, the board might have known what was going on and their employees would probably still have a job today.

Once a company decides to set up a reporting program, it has to decide whether to offer the service in-house or use external resources. This decision should be based on several factors, the most important being expertise, cost and independence.

Expertise is needed to plan, organize, manage and control the system. While large organizations with substantial internal audit resources usually have the expertise they need, it can be advantageous for smaller companies to use specialist firms.Cost comparisons can generally be made in the same way for all outsourcing decisions. It should be taken into account that managing the system internally will incur more fixed costs than outsourcing it, which, however, reduces the system’s flexibility.

Lastly, the independence of an ethics hotline is a crucial element in detecting management fraud. Obviously, outsourcing provides greater independence since employees and executives are not involved in managing the hotline.

In the current environment, where more and more frauds are coming to light, reporting systems are an effective and under-used tool. (Only 37% of US organizations the ACFE surveyed have such a hotline, and this could be even lower in Canada.) They enable organizations to take prompt action to prevent and detect fraud and limit the scope of the damages. Will they be able to check the increase of fraudulent activities? Let’s hope so. In the meantime, let’s blow the whistle. After all, is there really any difference between exposing a fraud and calling the police when you witness a bank robbery?

A TRADITION OF SILENCE?

Jonathan Allard, CA, MBA, is a forensic accounting adviser with Leclerc Juricomptables Inc. in Montreal