Madison Corporation (Madison) along with Sarah, Madison’s chief executive officer (CEO), and James, Madison’s chief financial officer (CFO), engaged in a practice known as using

“dummy assets” to inflate credit ratings associated with an upcoming offering. Madison arranged to offer a collateralized debt obligation (CDO) to investors. The CDO promised to pay investors cash returns based on the amount of cash generated by the pool of investment assets included in the CDO. The price of the offering was based on the CDO receiving a certain rating from a national credit rating agency. Shortly before the agency was due to rate the CDO, employees at Madison realized that the CDO would not satisfy two of the criteria used by the agency, which would result in the CDO receiving a lower than expected credit rating. To address this problem, Sarah and James inflated the assets of the CDO by including in the statements they sent to the rating agency $10 million of fictitious assets, so-called “dummy assets.” With the dummy assets included in the portfolio of the CDO, the agency provided the credit rating expected by Madison and the company proceeded to sell the notes associated with the CDO to shareholders. At the time of the sale, Sarah and James knew the investors were buying the notes based on false and misleading information, which led to the artificially higher credit rating. About six months after the sale of the notes, the economy took an unexpected downturn and the assets included in the CDO failed to produce the cash flow necessary to pay the investors. Ultimately, the notes became worthless.
Discussion Questions

a. Based on the actions of Sarah, James, and Madison Corporation to deceive investors by artificially inflating the value of the CDO’s pooled assets, what federal securities laws may have been breached? Explain.

b. Madison Corporation along with its CEO (Sarah) and CFO (James) undermined the integrity of the financial markets in the United States and damaged the financial interests of the investors in the CDO notes. Discuss the ethical issues raised by the facts in this question. Do you believe Sarah and James acted ethically or unethically? Why? Is it possible for an artificial entity, such as Madison Corporation, to act ethically or unethically?
Explain.