Fraud: what starts small can snowball: most episodes of financial fraud start as "tweaks" or "adjustments." Experts say that most often, its the culture that is to blame, and as the schemes deepen, individual reservations are simply overwhelmed.

The situation is vexing. You are a mid-level financial manager at a company, and you're attending a meeting with Wall Street analysts. Your boss--who just happens to be the company's chief financial officer--brilliantly reels off an array of statistics projecting a rosy picture of growth in revenues and net earnings. Too bad that the numbers are inflated and untrue.

Suddenly and without warning, the CFO looks over at you and demands corroboration. "Isn't that correct?" he demands.

Welcome to the hot seat. What do you do? Agree with him? After all, he is your boss. Do you mumble something unintelligible and excuse yourself from the room? Or do you make it known that the numbers are wrong?

That scenario is among the numerous ethical dilemmas that employees at MCI--the reconstituted telecommunications company rising from the ashes of scandal-ridden WorldCom Inc.--are asked to confront in training sessions these days. So far, more than 3,000 persons at the 55,000 employee company have either undergone the training or are registered for it, reports Richard Breeden, former chairman of the Securities and Exchange Commission and president of a his own consulting firm in Greenwich, Conn. Breeden, who was appointed corporate monitor by the bankruptcy court, is overseeing MCI's return to respectability.

"If people just remembered what their mothers taught them, it would carry them a long way," Breeden says. "But one of the things about ethical decisions is that they can come up quickly. In a business environment, you don't have time talk to your mother or your minister."

Training programs like the one at MCI today teach employees what they should have learned at home or in Sunday school. In addition, they emphasize what many ethicists and corporate reformers increasingly recognize: that most of the scandals that have beset Corporate America have deep roots in dysfunctional organizations, the dictates of which too frequently overwhelm an employee's better angels.

It should come as no surprise. The social critic and religious philosopher Reinhold Niebuhr anticipated the fundamental causes of recent business skullduggery in the 1930s, when he wrote Moral Man and Immoral Society. In the book, Niebuhr argues that insidious institutions and peer pressures can compel otherwise honorable individuals to engage in sinister acts and perpetuate injustice.

As the past couple of years have shown, the outsized financial frauds that have landed top executives in jail, driven companies into bankruptcy, deprived investors of their life savings and thrown the financial markets into turmoil were aided and abetted by intelligent and law-abiding citizens.

Indeed, experts in the fields of law, accounting and business ethics say that one crucial lesson to be learned from the fraud at Enron Corp., WorldCom, HealthSouth Corp., Global Crossing Inc., Adelphia Communications, Tyco International and Xerox Corp., among other egregious examples, is how easy it is for otherwise honest people to be swept up in a climate of corruption.

"We have learned the same thing again and again: financial fraud does not start with dishonesty," says Michael Young, a partner at the New York law firm of Willkie, Farr & Gallagher. "Your boss doesn't come to you and say, 'Let's do some financial fraud.' Fraud occurs because the culture has become infected. It spreads like an unstoppable virus."

Brian Brinig, a San Diego attorney, agrees. "Virtually everybody I see gets up and goes to work in the morning trying to do a good job," he says. "But at some point, people lose sight of the forest for the trees. The pressures of achieving short-term goals cause them to become short-sighted in relation to longer-term moral and ethical objectives."

And it is not just the high-profile publicized cases where cooking the books occurs. Accounting and financial fraud, unfortunately, have been far more widespread than just the celebrated scandals. The U.S. General Accounting Office (GAO), the watchdog agency of the U.S. Congress, noted last year that 689 companies restated their earnings between 1997 and 2002. While many of the restatements were done for technical reasons or because of rule changes, the cumulative effect was nonetheless stunning: all told, the restatements resulted in losses of close to $100 billion in market capitalization, the GAO found. "That's a lot of money evaporated," remarks Toby Bishop, president of the Association of Chief Fraud Examiners (ACFE), headquartered in Austin, Texas.

It also helps explain why highly publicized legal action by state attorneys general and the U.S. Justice Department have been on the rise. So, too, are costly class-action lawsuits. The 217 cases of private securities litigation brought during 2002 represented a hike of 17 percent compared with the year before, according to a PriceWaterhouseCoopers study.

Even more dramatic, the study declares, was that the dollar values of settled securities cases surged; that a record number of the securities cases involving restatements and lawsuits were aimed at Fortune 500 companies; and that criminal investigations and indictments related to securities cases rose sharply in 2002. "By almost every measure in the area of securities litigation and regulation," PWC's report states, "2002 was a year to remember."

One common characteristic of fraud arising from accounting irregularities and misstatements is that it usually takes a passel of wrongdoers to keep the unfortunate enterprise afloat. That is a palpable departure from a case of simple embezzlement, which can be carried out by a lone malefactor, notes Harvey Kelly, a partner in the New York-based corporate investigations practice at PricewaterhouseCoopers. While each case of fraud has its own tawdry set of circumstances, he adds, "rarely is one individual able to perpetuate fraud of significant magnitude and materially misreport a company's financial position without being detected."

At a big company, such schemes are elaborate, perhaps involving as many as 30 to 50 people working in concert, ACFE's Bishop says. Quite often, he adds, they toil together diligently for several years. Young, the Willkie Farr attorney, agrees that "financial fraud involves a lot of work. Often, the ringleaders don't know how to work computers, so a junior accountant is brought in. But he's not asked to participate in financial fraud, just to keypunch in some data or change some numbers in a way that he probably doesn't understand. By the time he sees what's going on, he's up to his neck in it."

PwC's Kelly says, "If you have significant fraud, the amount of time spent concealing fraud becomes enormous, and the number of people in the know becomes enormous as well. If inventory was falsified, it can mean that people in warehouses were asked to fabricate bills of lading or inventory movement, for example."

By all accounts, the corporate swamps that serve as a breeding ground for fraud have two common characteristics: overly aggressive targets for financial performance and a can-do culture that does not tolerate failure. It is not uncommon, moreover, for what becomes a massive fraud to start out small.

"There's an expectation that, 'We just need a small amount of additional revenue or earnings--or both--and with a minor adjustment, we can meet Wall Street's estimates,'" observes Paul Regan, president of Hemming Morse in San Francisco and a forensic accountant involved in financial fraud investigations for 30 years. "So people reduce a judgment account, like the allowance for bad debts.

"There's always the expectation that next quarter will be okay," he adds. "People say, "We can patch things up.' But the next quarter comes along, and they've got to do a little bit more. Pretty soon, it gets to be very noticeable. But you can't go back. So that's how they get trapped ."

At the same time that people are striving frantically to meet unrealistic Wall Street earnings projections in order to keep buoying the company's stock price--that holy grail of the corporate world--the culture demands and rewards success. Numerous investigations into financial fraud, notes Breeden, have identified the "tone at the top" as a root cause. Adds Regan: "In a lot of these scandals, the CEO is a very charismatic guy. Sometimes it's a 'celebrity CEO,' like Ken Lay at Enron."

And then there is the CEO whom Regan describes "a dominant, over-powering bully who won't take 'no' for an answer." ACFE's Bishop asserts that this take-no-prisoners leader bears all the earmarks of a psychopath: among other qualities, he--it will usually be a man--is megalomaniacal, glib and superficial. This personality shows no remorse, is by nature deceitful and manipulative, impulsive and has a need for excitement. "These are people who are focused more on the ends than the means, and do whatever it takes to accomplish their objectives," Bishop says.

Consider WorldCom. There, says Breeden, former CEO Bernie Ebbers "scoffed at ethics and controls. He communicated the message that 'real men only worry about revenue growth.' People who didn't were pansies. The people who got promotions were not the ones who told the truth, but people who claimed credit for things they didn't do, twisted reality and promised things without worrying about whether they could deliver."

Experts applaud the panoply of newly enacted controls, such as Sarbanes-Oxley and corporate governance reforms, designed to put an end to such practices--and put more white-collar criminals behind bars. Particularly welcome are such avenues for whistleblowers as toll-free telephone numbers, Web sites and an ombudsman to field reports of fraud, scares and assorted ethical violations.

But Bishop, for one, would like to have seen better training and education programs insisted upon in the law. "If a CFO instructs a corporate comptroller to book a certain entry which is misstating results," Bishop says, "the comptroller needs to know it's a crime--not just aggressive accounting--and that he should not be aiding and abetting in a felony."

The abiding belief that better training and education are essential to snuffing out a climate of corruption has taken hold at MCI. The CEO and top management have signed an ethics pledge and can be fired for violating their oath of duty. The company's newly minted code of ethics, "The Way We Work," is etched on the reverse side of everyone's identification badge; similarly, signage proclaiming the code are on display throughout the company (see box).

Employees by the hundreds are taking classroom and online training courses, learning the basic responsibilities required by laws like Sarbanes-Oxley and the Securities Act of 1934. MCI staffers are learning the fundamentals of accounting rules, as well, and are being admonished to take them seriously and to spot the most common methods by which they can be circumvented. In addition, there are now classes using case studies and role-playing to reinforce ethical behavior.

Which brings us to that moral dilemma--the exercise where the CFO is asking you confirm his fabricated figures. It would be tempting, and not entirely dishonest, to say that you feel sick and excuse yourself from the room. But at MCI, you will now tell your boss that his numbers are incorrect. FEI members, who sign a code of ethics before they join, know full well that this is the right thing to do.

'Irregularities Never Occur in a Vacuum'

Mark A. Zorko, CFO Partner at Tatum Partners, recalls the ethical issues be confronted when he was brought in during the mid-1990s as the CFO of a $240 million publicly held electronic manufacturing firm. A revived board had ousted the previous management following the discovery of significant fraud. So Zorko and his finance team had the support of the new leadership in deciding how to resolve the situation.

But, as Zorko found, "You can get rid of the top guys, but there's still likely to be lingering bad behavior." People thought they were doing the right things, he says, when they were given incentives to make their numbers. Pricing problems, inventory mis-management and shipping discrepancies continued. After a couple of years of having such behavior condoned, these practices had become ingrained.

"As we brought a new finance team in and began draining the pond, we found deeper problems, caused by a lack of good financial management and misguided incentives," Zorko remembers. "We had situations, for example, where we disagreed about inventory valuation. Is that bad judgment or fraud? When I see [a lot] of dust on boxes of electronic parts for instance, I have a tough time accepting a plant manager's view on their full value." Zorko says the business was worse than had been initially envisioned. Eventually, it was liquidated.

"Accounting irregularities never occur in a vacuum--these things start with business operations failing to meet expectations," he says. "Some companies have resorted to trying to fix their problems with magic pencils.

"You can have management that legally might not fit the context of what fraud encompasses, but is tantamount to it," he adds. Cleaning it up "still means changing the habits and behavior of an organization--to go from bad to good or good to better can take a lot of coaching. It's easy to underestimate how much time it can take."

--Jeffrey Marshall

Paul Sweeney is a freelance business writer in Brooklyn, N.Y., and a frequent contributor to Financial Executive. He can be reached at 718.636.2036.