The Importance of Ethics in Business

How Business Ethics and Social Responsibility Can Improve Profitability

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Ethics in business is the (often unspoken) moral code of conduct a company embraces and applies toward its stakeholders, including employees, customers, investors, and the public regarding its business practices. It can also be defined as a guiding philosophy in business, one that is defined by simply doing "right" by most public and business standards.

Not only is ethics important economically and socially, but it is also important for the business's long-term profitability. Firms that practice business ethics and are socially responsible can become more profitable and maximize their stock price for the long term than those that are unethical.

The History of Ethics in Business

"The Forgotten Man" is a comprehensive analysis of the Great Depression, written by Amity Shlaes. In this book, According to the article written about the book, Ms. Shlaes notes that low morals among the population and false growth seen in the economy occurred in the 1920s, before the years of the Great Depression. Shlaes went on to say that dangerous inflation caused by speculating margin traders in the stock market had a great part in causing the Great Depression. Money was lost as banks failed and the American people suffered during the 1930s. Then came World War II and the Great Depression gradually eased.

A lack of financial and business ethics is evident in the factors Shlaes contended caused the Great Depression. False growth in the economy and questionable activity in the stock market point to possible ethical issues. In response to the Great Depression and to restore confidence in the banking system, the Banking Act of 1933 (also known as the Glass-Steagall Act) was passed. It was repealed in 1999 prior to the Great Recession.

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. The Glass-Steagall Act had been repealed, which took away some of the safeguards inherent in the U.S. financial system.

Large banking and insurance firms failed due to the rise of subprime lending, faulty mortgage securitization, and the housing bubble. Financial institutions, meanwhile, had made risky loans to unqualified individuals and they could not repay them.

Financial institutions were seeking short-term profit instead of fulfilling a long-term goal which, ethically speaking, is to maximize stakeholder wealth, or increase the stock price, After the Great Recession, the Dodd-Frank Act was passed to try to put some of those safeguards back into place.

When companies serve themselves for short-term profit rather than their stakeholders for long-term maximization of the firm's stock price, it can lead to failure. This is true whether they are a large business or a small business.

Regulation and Capitalism

Capitalism is an economic system that emphasizes private ownership of the means of production. It is an economic system in which private individuals own the business as opposed to government ownership. In a capitalist society, you have a free market and companies live by the profit motive.

The Goal of the Business

Companies in a capitalist economy exist to maximize their stock prices for the benefit of their investors. Through the fall of Wall Street in both 1929 and 2008, we've seen that corporate greed and fraud are not the ideal pathways to maximization of shareholder wealth. Greed and fraud may lead to short-term profits, but it takes corporate social responsibility and effective corporate governance to truly achieve the ethical and financial goals of the firm.

Repeal of the Glass-Steagall Act

The core purpose of the Glass-Steagall Act of 1933 was to separate the investment banking function from the deposit, or retail, banking function. The reason that regulatory authorities felt this was important is that the Act kept banks from using the money of investors to make risky investments in search of short-term profit.

The repeal of the Glass-Steagall Act was met with unintended consequences. Banks, once again, began to engage in risky investments and the same type of aggressive financial risk-taking that may have caused the Great Depression. Some economists think that the repeal of Glass-Steagall was responsible for the financial failures of firms like Enron, the 2008 Great Recession, and decreased and ineffective corporate governance.

Enron: An Example of Greed

The near-collapse of our economic system really began with the financial failure of firms like The Enron Corporation between 2000-2002. The Enron Corporation was a massive energy company that went bankrupt in 2001. Before it filed for bankruptcy, Enron 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.

Regulatory requirements help ensure that companies adhere to the firm goal of maximization of shareholder wealth. Effective corporate governance also helps ensure that corporations will practice social responsibility.

Enron was the country's largest bankruptcy until 2008. After the Enron scandal, steps were taken to increase the public's confidence in business and improve corporate governance.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 was passed after the Enron failure and other corporate failures between 2000-2002 to strengthen the regulation of publicly traded business firms. This act gave the board of directors of business firms more power regarding the financial dealings of businesses. It cracked down on corporate financial fraud by protecting the whistleblowers in such actions. It also set new financial reporting standards for publicly-held corporations.

Dodd-Frank Act of 2010

The Dodd-Frank Act of 2010 was enacted in response to the Great Recession of 2008-2009. Between the Enron scandal and 2008, banks had continued to mix their investment and deposit functions by making risky investments. One such investment class was subprime mortgages.

Lehman Brothers, a large Wall Street financial services firm, went under in 2008 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.

Tens of thousands of financial employees were immediately out of a job, while investors were left holding worthless stock. This was a direct result of the fraudulent activities of their employers. This trickled down through the economy in which the unemployment rate reached nearly 10%. The purpose of Dodd-Frank was to increase regulations on banks and other financial institutions and try to protect consumers against poor corporate governance.

Perhaps in response to increased regulation, more businesses are staying private and are not becoming publicly traded. The firms that are becoming publicly traded, however, are larger than in the past.

Investors as Stakeholders

Investors buy shares of ownership, or shares of stock, in business firms expecting to earn a return on their investment. They also become owners of the firm. In a capitalist society, small businesses and large businesses alike should have the goal of maximizing the wealth of their shareholders or increasing the price of the firm's stock. These actions must be geared toward the long term and must be socially responsible.

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.

Example of Shareholder Wealth Maximization and Social Responsibility

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 shareholder larger returns in the short term. If you do control the pollution and promise cleaner water, it might cost more in the short term causing short-term returns to suffer. In the long-term, however, your small business will be more respected, will attract more business and investors, and your stockholders will profit. This is called social responsibility and is brought about by good corporate governance.

Employees as Stakeholders

Another group of stakeholders is your employees. A business has a responsibility to its employees. who deserve to be treated with dignity, respect, and fairness. Businesses that are well-run treat their employees fairly and take their concerns and opinions into account.

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. Respect your customers in all aspects of your business, including product pricing, advertising, and marketing. and keep the cultures of your customers in mind.

Society as a Stakeholder

In a capitalist society, since the means of production are privately held by businesses, 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.

The seminal research on the theory of maximization of shareholder wealth was written by Milton Friedman as an essay in The New York Times in 1970. Since then, the principle of maximization of stockholder wealth as the appropriate goal of a business in a capitalist society has been widely accepted.