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The Obligation to Demonstrate Honesty and Fidelity

Feb 1, 2016


Situation

After years operating as partners of a small environmental consulting firm, three engineers seek the advice of a management consultant for strategies to expand their business. Among the consultant's recommendations is a suggestion that the partners incorporate their firm, and the three partners act upon that recommendation.

The engineers establish the new business as an S corporation, a tax status that offers a blend of the characteristics of corporations and partnerships. While the owners benefit from the limited liability features of corporate status, they still report the company's finances on their individual tax returns, as would be the case with a partnership. One of the owners becomes the company's president and receives 40 percent of its shares, while the other two serve as vice presidents and hold 30 percent each. 

The three shareholders decide that, despite the firm's incorporation, they will treat the business as much like a partnership as possible. This includes an informal agreement by the "partners" that, if anything should happen to one of them, the others would be entitled to buy back that person's shares at a discounted price. Although they discuss setting the price at 80 percent of book value, no agreement is ever committed to writing. 

The new corporation does see a rapid growth in business, but it also quickly encounters a problem with cash flow. The company typically incurs expenses well before its clients can be billed, and the increase in work creates a substantial drain on the firm's assets. The shareholders agree to address this shortfall by making personal loans to the corporation, each in proportion to his ownership interest. The president's share is roughly $750,000, and the corporation commits itself to paying back this sum over a 10-year period.

Soon after making this loan, however, the president's health takes a significant downturn. He is unable to participate in the business during the last two years of his life, and upon his death his wife and a longtime family friend are left to administer his estate as coexecutors.

The two surviving owners meet with the coexecutors to discuss buying back the president's shares, and the picture they paint of the company's finances is a bleak one. They describe the company as suffering from "extreme" cash flow problems, and they produce a financial report revealing a cash loss in the previous year of $1.3 million. While claiming that they project growth of 10 percent in the coming year, the owners also state that they have no choice but to seek a bank loan simply to pay their existing bills.

What the owners do not explain is that the current cash shortfall is an indicator of an increase in business. The financial reports shared with the coexecutors use the cash method of accounting, which reports only payments that have actually been received. While this method is beneficial for the owners' personal tax reporting in that it allows them to offset their individual income against the firm's losses, it fails to account for the firm's earned revenue from services performed. Unknown to the coexecutors, the company has also prepared financial statements using the more accurate accrual method of accounting, and these statements show a net income for the year of some $2 million.

Even more significantly, the owners fail to disclose that two other companies have expressed interest in acquiring the firm and that one of them has already proposed a purchase price of nearly $8 million.

On the basis of their assessment of the firm's "book value" and the outstanding balance of the president's loan, the owners offer to buy out the estate for a sum of $530,000. Believing the firm to be in dire financial straits, the coexecutors accept the offer, a transaction that in effect transfers the estate's 40 percent ownership interest for the sum of $5,000.

Upon learning that the firm has been acquired by another company, the president's family files suit against the firm and its former owners, alleging violation of Securities and Exchange Commission rule 10b-5, a federal regulation dealing with fraud in the sale of a public or private security. The federal court sides with the plaintiffs, and the estate is awarded some $3 million in damages. 

One of the two accused owners is an ASCE member, and the plaintiffs' counsel forwards an ethics complaint to the Society's Committee on Professional Conduct (CPC). 


Question

Did the member's conduct violate any of the provisions of ASCE's Code of Ethics? 

Decision

From time to time, a case is reported to the CPC that clearly raises a question of professional ethics but does not precisely correspond to any particular canon of the Code of Ethics. For example, while the member's actions in this case may be seen as a failure to serve as a "faithful agent or trustee," the parties misled by the untrue statements made are not the engineering employers and clients mentioned in canon 4. Furthermore, while the member undoubtedly was not "objective and truthful" in his statements to the coexecutors, a narrow reading of canon 3 and its guidelines could support the view that the honesty enjoined applies only to engineering opinions and judgments. 

Perhaps in recognition of the possibility that no simple code of ethics could hope to cover all types of professional misconduct, one of the earliest revisions to ASCE's code was the addition of what might be described as a catchall provision. Originally introduced as article 10 and now expressed in canon 6, this provision at the time of this case read as follows: "Engineers shall act in such a manner as to uphold and enhance the honor, integrity, and dignity of the engineering profession." 

When contacted by the CPC, the member offered the same defense he had offered in the civil suit. He claimed that the book value had been calculated in accordance with the partners' informal agreement and that the coexecutors had been informed that the report represented cash losses only and did not give a complete picture of the firm's finances. He further stated that he and his fellow owner had notified the coexecutors when the accrual report was completed, but the latter had shown no interest in reviewing the firm's finances or assessing the firm's market value. 

The member's argument was no more successful with the CPC than it had been at trial. Noting the parties' relative business sophistication and that the coexecutors had trusted the owners' judgment on the basis of their long business relationship with the late president, the members of the CPC felt that the coexecutors' failure to perform due diligence did not excuse the member's deceptive conduct. 

The CPC held that the member had violated canon 6's obligation of "honor, integrity, and dignity" and voted to recommend his expulsion from the Society. However, before any further action could be taken, the member announced his intention to resign from the Society. The Board of Direction accepted the member's resignation, and notice of the action was published in a Society publication. 

In 2006 canon 6 was amended to formally express the engineer's obligation to have "zero tolerance for bribery, fraud, and corruption." Category (a) in the guidelines for practice for this canon has this to say: "Engineers shall not knowingly engage in business or professional practices of a fraudulent, dishonest or unethical nature." To leave no doubt as to an engineer's obligations, category (b) adds the following: "Engineers shall be scrupulously honest in their control and spending of monies, and promote effective use of resources through open, honest and impartial service with fidelity to the public, employers, associates and clients." These revisions make it abundantly clear that the obligation to demonstrate honesty and fidelity are by no means limited to engineering matters and that it applies to all business, financial, and professional dealings.  



Members who have an ethics question or would like to file a complaint with the Committee on Professional Conduct may call ASCE's hotline at (703) 295-6151 or (800) 548-ASCE (2723), extension 6151. The attorneys staffing this line can provide advice on how to handle an ethics issue or file a complaint. Please note that individual facts and circumstances vary from case to case, that some details may have been altered for purposes of illustration or confidentiality, and that the general summary information contained in these case studies is not to be construed as a precedent binding upon the Society. 

© ASCE,  Civil Engineering , February 2016