Scenario 3 Ethical Leadership Challenges at Diamond Foods Diamond Foods, a nut and snack company, was founded in 1912 by a group of cooperative walnut growers, known as “Diamond of California.” Over the years, Diamond Foods grew mostly by acquiring other brands, including Pop Secret, Kettle Foods, and Harmony Foods. It also introduced another line of snack nut products under its Emerald Brand. Today the company is owned by Snyder’ s-Lance, Inc. and is headquartered in Charlotte, North Carolina. Snyder’ s-Lance, Inc. purchased the company for $1.91 billion in a cash- and-stock deal after an SEC investigation. In addition to Diamond, the Snyder’ s-Lance, Inc. product line includes the brands Cape Cod, Lance, Tom’s, Eat-Smart, Stella D’ora, Kruncherst, Late July, Archway, Oke-Doke, Pretzel Chips, and Jay’s. There are currently 6,400 full-time employees and numerous notable competitors such as Kellogg. U.SA., Frito-Lay, USA Inc., and Mondeleze International, Inc. Brian Driscoll was named President and CEO of Snyder’ s-Lance, Inc. in June 2017. He had previously been President and CEO of Diamond Foods, a position he assumed after its former President and CFO were let go due to the scandal at Diamond in which financial reports were falsified. The scandal originated in 2005 under the management of the preceding President and CEO, Michael Mendes. His business philosophy was â€œBigger is Better,” which ultimately led to a corporate culture of poor judgment and fraud. As part of his growth strategy, he secured millions in loans to finance the acquisition of Pop Secret. He later attempted to purchase Pringles from Proctor and Gamble. Had the merger been successful, Diamond Foods would have been the second largest distributor of snack foods in the United States following PepsiCo. In 2011, Mark Roberts, an analyst with the Off-Wall Street Consulting Group, raised questions about Diamond’ s accounting practices. He accused Diamond of incorrectly reporting its payment to suppliers. Diamond would pay growers in September for walnuts that were delivered in Diamond’ s fiscal year 2011 which had already ended in July. This significantly impacted Diamond’ s financial statements, which, if done intentionally, would be illegal. Initially Diamond denied any wrongdoing, arguing that the payments were an advance on the future 2012 crop and had nothing to do with the previous year’s crops. Growers refuted this claim, arguing that they were told that the payments were, in fact, for the previous year. Investigations revealed that these payments were made to inflate the fiscal 2011 results by shifting costs into the upcoming year. An internal investigation found that CEO Michael Mendes and CFO Steven Neil had systematically improperly accounted for growers’ payments in 2010, 2011, and 2012. They skewed Diamond’ s financial results and reported an EPS of $2.61 when the correct number was $1.14. As a result, they took home millions of dollars in additional compensation. The “improved” EPS resulting from the accounting fraud was, in part, an attempt to follow Mendes’ aggressive philosophy and acquire Pringles from P&G. Diamond needed to improve financial performance at any cost in order to meet conditions laid down in the loan covenants and seal the deal. One of those conditions required higher performance standards for factors that affected management compensation. Higher reported earnings would allow for greater compensation. The improper accounting of earnings was an attempt by management to deceive the lenders about Diamond’ s true earnings. Another ethical concern raised at this time was the fact that Diamond’ s CFO had a seat on the company’s Board of Directors, which created an overlooked conflict of interest that could have easily lead to a lack of oversight by the Board. Subsequently, the company was investigated for criminal fraud, and a new audit was undertaken. This also disrupted the Pringle acquisition process. In addition, Diamond had difficulty meeting the financial report filing deadlines. Their fraud resulted from lack of quality controls and from the inability or unwillingness of top management to set proper ethical standards, thus encouraging more unethical behavior by employees. For example, after payment irregularities were discovered, Diamond’ s management denied the claims, and insisted that the system worked to optimize cash flow for the growers.” Stock prices dropped to a six-year low of $12.50. The lower stock price was the result of restated historical financial results as well as of the current year’s performance. The restated financial results removed a previously reported $56.5 million in profits due to the accounting fraud. The price decline was also impacted on rumors that billionaire investor and activist, David Einhorn, was shorting the stock. The combination increased investor uncertainty about Diamond’s future profitability, and the Pringle deal with Procter & Gamble was lost. Following the SEC investigation, Mendes and Neil were placed on administrative leave. Mendes subsequently resigned, and Neil was let go. Mendes did not receive promised insurance benefits as his resignation was considered a violation of his duty as CEO. He was required to pay back the 6,665 shares of Diamond common stock that he received from fiscal year 2010 and also reimburse the company for his 2010 and 2011 bonuses, which totaled $2.743,400. This amount was taken from his Retirement Restoration Plan, but he still received a payment of $2,696,000. After restating its profits, the company still faced risks of litigation, regulatory proceedings, government enforcement and insurance claims. The SEC levied a $5 million fine as settlement of the fraud allegations. The SEC charged Neil for falsifying walnut costs and Mendes for his role in the misleading financial statements. Mendes forfeited $4 million in bonuses and benefits and also paid a penalty of $125,000. Though it was not proven Mendes participated in the scheme, regulatory authorities believed he should have known about Diamond’ s incorrect financial statements. Neil initially fought the SEC charges but settled by paying $125,000 civil penalty. Investors filed lawsuits against Diamond because of the misrepresentation of its financial standing; a $100 million settlement was made by Diamond Foods. When Brian Driscoll took over Diamond, he outlined his strategic plan to advance the company past its ethical mistakes. It began with improved internal controls of financial statements. Six new directors were appointed to strengthen the board. A forward-looking statement of risks was issued, which identified problems that may arise in the future. It included the Company’s Code of Conduct and Ethics Policy, and a statement about top management’s responsibility in setting the proper tone for the organization. He replaced the CFO and installed new company financial reporting processes in which managerial approval was needed for material and non- routine transactions. Ethics training, led by the CFO, reinforced proper accounting procedures and training for employees. It led to a better understanding of financial reporting integrity and ethical expectations. He modified the walnut cost estimation policy and added inputs each quarter which had to be reviewed and signed off by cross-functional management. His efforts fostered better documentation and oversight of accounting procedures and better supplier communication. A Grower Advisory Board was introduced to receive input from the growers and enhance communication between growers and the company. Diamond followed the Sarbanes-Oxley internal control policies involved with grower accounting procedures. The controls on accounts payable and invoice processing were revised. A third-party report known as “Internal Control – Integrated Framework” evaluated the effectiveness of its internal controls. The reporting controls were implemented and improved communication, which allowed better transparency. These new controls enabled the company to escape bankruptcy and restore shareholder confidence which ultimately led to the Snyder’ s-Lance, Inc. merger. Under Brian Driscoll’s leadership Snyder’s-Lance, Inc. has an Ethical Code of Conduct with questions and answers on the webpage.
What were the organizational culture factors that caused misconduct and accounting fraud?