The Importance of Ethics in Business

Ethics and Social Responsibility in Business Will Improve Your Profitability

Ethics and social responsibility will increase your profitability.

Ethics, in business, is the often-unspoken principles of conduct governing business practices.  It can also be defined as a guiding philosophy in business. If your business engages in ethical financial practices, it will be more profitable in the long run than a business that does not. Unethical businesses may profit in the short-run, but not in the long-run.

A recent example is Coca-Cola (NYSE:KO). A recent study by Oxfam reports that the company fails to ensure the well-being of their workers. Coca-Cola is not doing as well in the market as Pepsi Company (NAS:PEP), its direct competitor, and this is one reason.

Some History of Ethics in Business

Lack of ethics in finance is one of the primary factors that led to the fall of Wall Street and the near-collapse of the U.S. economy in September and October of 2008. Lack of ethics combined with the deregulation of the U.S. financial system precipitated the worst recession since the Great Depression in the 1920s and 1930s. Large banking and insurance firms failed. Many businesses failed because they could not get financing for their operations. Large and small banks alike had made risky loans and businesses could not repay them.

Deregulation started with the interstate banking movement in 1980. In 1999, the Glass-Steagall Act was repealed, taking away many of our safeguards regarding the banking system. Banks operated in the U.S. financial system rather freely and without much to control factors like corporate greed and fraud. They began to make risky loans, particularly risky mortgage loans. Banks, including those classified as a small bank, participated as well.

Later, after the Great Recession, the Dodd-Frank Act was passed to try to put some of those guard rails back into place.

The result of deregulation was inevitable with corruption in the financial system.

When company's serve themselves for short-term profit rather than their stakeholders for long-term profit, they are doomed to fail.

This is true whether they are a large business or a small business. This happened before the Great Depression of 1929 and the Great Recession of 2008-2009.

Regulation and Capitalism

Capitalism is an economic system that emphasizes private ownership of the means of production. It is a privately controlled economy. In a capitalist society, you have a free market and companies live by the profit motive. They exist to make money.

Since companies in a capitalist society exist to make money, what is the best way to do that? We've seen, through the fall of Wall Street in both 1929 and 2008, that corporate greed and fraud don't do it, at least not in the long run. Greed and fraud may make short-term profits for both large and small businesses.  But, if companies are to stay alive, short-term profit isn't very important. Long-term viability is the issue. Regulatory requirements help keep companies that are living and dying by the profit motive honest. The Enron scandal and the resulting Sarbanes-Oxley Act that occurred between 2000-2002 taught us this.

The near-collapse of our economic system really began with the financial failure of firms like Enron. The Enron Corporation was a huge energy company that went bankrupt in 2001. It employed 22,000 people and had innumerable shareholders. It collapsed due to an accounting scandal, or "cooking the books," perpetuated by its own auditing firm, Arthur Andersen, one of the premier accounting firms in the U.S. at that time, which also collapsed. Tens of thousands of employees were left without a job and more shareholders were left with a retirement portfolio full of worthless Enron stock.

Enron was the country's largest bankruptcy until 2008 and Lehman Brothers, a huge Wall Street financial services firm. Lehman went under primarily due to the subprime mortgages it made during the 1990s and the early 21st century. The bankruptcy of Lehman Brothers began a domino effect on Wall Street. In order to prevent massive financial firm failures, the Bush Administration put together a huge financial bailout, called TARP, to save most of the other large Wall Street banks.

Since the fall of 2008, we have had many financial firm failures and failures in other business sectors. Failures have not been confined to large businesses. Small businesses have had their share of failures, primarily due to the economic recession that resulted from the collapse of Wall Street and the credit crisis that resulted.

Perhaps in response to increased regulation, more businesses are staying private and are not becoming publicly traded as you can see in the chart below:

Decline of Public Companies in the U.S.
The Decline of Publicly-Traded Companies in the U.S. World Bank 

This raises the question of how does a business, whether a large or small business, stay viable and strong in the long-term? The answer is through satisfying its stakeholders. Just who are these stakeholders? They are the groups that are invested in the future of the company, whether a large or small business.

Stockholders or Investors

Stockholders make an investment in your business. They want a return on that investment. You, as a business owner, have an obligation to try to provide them with a return on their investment. During the 2008 crash on Wall Street, we saw stockholders earning large returns through management employing fraudulent means in operating their businesses. Many stockholders eventually lost their entire investment in some of these firms because the firms failed. Obviously, this is not the goal of the stockholders.

In a capitalist society, small businesses and large businesses alike should have the goal of maximizing the wealth of their stockholders. That means that the management of the business should take action to increase the stock price of the business if it is publicly traded. These actions must be geared toward the long term, not the short term.

Here's an example. Let's say that your business is a small manufacturing facility. You produce a product that can cause water pollution during the production process. If you don't control that pollution, it's much cheaper for you to produce your product and you can promise your shareholders larger returns in the short-term. However, if you do control the pollution and promise cleaner water, it might cost more in the short-term and short-term returns may suffer, but, in the long-term, your small business will be more respected, will attract more business and investors, and your stockholders will profit for a long period of time. This is called social responsibility.

Employees as Stakeholders

Another group of stakeholders is your employees. A business has a responsibility to its employees. They deserve to be treated with dignity, respect, and fairness.

Your business should provide jobs that improve your workers' living conditions, respect their health, and avoid any discriminatory practices.

Employees are hurt if the management of a small business does not act in good faith or does not maintain the highest standards with regard to financial ethics. When Wall Street crashed in September/October of 2008, tens of thousands of financial employees were immediately out of a job. This was a direct result of the fraudulent activities of their employers. This trickled down through the economy until we reached an unemployment rate close to 10%.

Many of those financial employees on Wall Street were highly paid. That may have been good in the short run. In the long run, they don't have a job and many of them may never be able to find a job in their field again.

Customers as Stakeholders

A business should consider its customer base as a stakeholder. Customers, like employees, must be treated with respect and dignity. Live by the principles of business ethics. Without employees and customers, your small business would not be operating. Treat your customers fairly and maintain a high level of customer service. In a recessionary economy, customer service is one factor that will help maintain your customer base.

Respect your customers in all aspects of your business, including product pricing, advertising, and marketing. Keep the culture of your customers in mind. After the collapse of Wall Street, customers seeking financial services are going to be suspicious and afraid to trust financial institutions. If your small business is a small credit union or bank, you will have to make every effort to instill trust back into your customer base.

Society as a Stakeholder

Since, in a capitalist society, the means of production are privately held by business firms, society itself is a stakeholder for the large and small business alike.

Businesses must promote harmonious relationships between themselves and the government and between themselves and other segments of society. It is the responsibility of all businesses to have a commitment to raise the standard of living and promote sustainable development.

Small businesses must strive to contribute to their community and be good corporate citizens. Somewhere along the way, the financial firms on Wall Street forgot this very important lesson of capitalism.