Big Business's Bad Behavior

...Just as gamblers won't put their bets down when they know a wheel to be rigged, so investors won't put their money into shares if prices can be manipulated by inflated profit reporting or special treatment of insiders...

...Another claimed that if he treated options as an expense, he would wipe out his entire reported earnings, an argument, I suppose, for refusing to account for almost any expense that constitutes a threat to reported profits—what might be called the WorldCom excuse...

...Again, we have a case of skewed incentives...

...No CEO wants to see his company's stock battered by investors who fear that share values will evaporate as profits are restated to eliminate the imaginative counting of revenues (claim them now, before the customer pays or even considers paying) and of costs (capitalize rather than expense every outlay, regardless of the life of the item purchased...

...So, let's get the incentives right and mandate a separation of the investment banking and stock-picking businesses, another McCain proposal...

...One need not be an apologist for the accounting profession to suggest that such a move would merely continue the failed practice of attempting to control auditors by closely supervising them...

...It would have taken a brave auditor indeed to fly in the face of these clear incentives and tell Enron's management that placing some item off-balance-sheet might be technically legal, but would obscure the company's true financial condition, or to insist on access to documents that might have revealed WorldCom's recording of current expenses as capital investments...

...Andersen's $12 million in consulting fees from WorldCom dwarfed its $4 million audit fee...

...Which brings us to directors...

...Most important, chief executive officers should create a "moral tone" that ensures the company's top managers behave in accordance with the highest ethical standards...

...Enron paid Arthur Andersen as much or more in consulting than in auditing fees...

...All of which makes Bush's silence on this subject rather odd, and the Senate Democrats' insistence on a broader prohibition on consulting than is contained in the House Republicans' bill more likely to get the auditors' incentives lined up with shareholder interests...

...One captain of industry replied that he would not tell his shareholders how much he earns lest he encourage kidnappers (as if they would only become aware of his affluence if he revealed it in his company's annual report...

...All of this in the presence of Chinese walls erected to separate bankers from analysts...

...But they had a right to such a belief, since the commissions they pay their brokers are supposed to be in return for such advice...

...measures that merely restrict auditors from engaging in some specified form of consulting activity, let's get the incentives right by complete, mandated separation of the audit and consulting businesses, as John McCain proposes...

...The quarrel comes not with what the president said, but with what he didn't say...

...The right kind of regulation can be a model of minimal— and effective—government...

...Hence we have a stream of quite sensible reforms proposed by the Business Roundtable and the New York Stock Exchange, some going beyond those being pushed by the president...

...Shareholders should speak up...

...Audit firms are unlikely to compete on price, since the risks associated with the audit business have risen...

...Still, neither self-interested reform nor a new emphasis on business ethics can be relied upon to save capitalism from the capitalists...

...Start with the fact that it is important to distinguish the role of government from that of the private-sector institutions that monitor corporate America...

...But it is of a special, self-liquidating sort...

...To make sure the directors remain friendly, executives often shower them with perks and consulting fees, the continuation of which depend on the goodwill of the CEOs they are supposed to be supervising...

...Enforcement agencies should be given adequate resources...

...Note that the issue is not whether companies, especially start-ups, should be allowed to use options to attract talented staff, but whether they should have to treat this compensation as an expense when reporting profits...

...Forget the double negative: Grubman was conceding that part of his salary, which reached $20 million per year, came from the $140 million in underwriting fees that his firm received from WorldCom over the past five years...

...Plummeting share prices are dangerous to the careers of chief executives...

...In today's world, executives are more likely to ask what they can get away with legally than what's fair and honest...

...Once those incentives are in place, other provisions of the House and Senate bills become unnecessary...

...Nominations for that slate should come from sources other than the company management, to avoid a you-sit-on-my-com-pensation-commit-tee-and-I'll-sit-on-yours selection process...

...True or not, bankers believe that CEOs, being human (yes, most are), are likely to take into account what a firm's analysts are saying about their stock when selecting an investment banker...

...bunch of goodie-two-shoes, but for the more reliable reason that honest markets and accurate profit reporting are in their interest...

...How to create incentives to induce managers to act in the interests of the shareholders who own the business has bedeviled students of corporate governance ever since 1932, when Adolph A. Berle Jr...

...As Greenspan points out, refusing to deduct the cost of options diverts capital and other resources from truly profitable to only apparently profitable firms...

...Jack Grubman, the Salomon Smith Barney (a division of Citigroup) analyst famous for his enthusiastic recommendations of WorldCom stock, last week told the House Financial Services Committee, "No one can sit here on Wall Street and deny to anybody on this committee that banking is not a consideration in the compensation of analysts of a full-service firm...

...Managers placing self-interest above the interests of owners were immune to retaliation by farflung and essentially powerless shareholders...

...Immediately after the president's speech the White House was bombarded with calls from CEOs protesting his demand that they disclose their compensation packages in easily accessible terms...

...As Milton Friedman, no fan of big government, has written, society needs rules and an umpire "to enforce compliance with rules on the part of those few who would otherwise not play the game...

...One way, now preferred on Wall Street, is to write contracts that make analysts' compensation independent of the fees flowing into the investment banking divisions of the large firms...

...Both bills call for still more regulation of auditors, and create still another regulatory body to set and oversee accounting standards...

...Auditors will compete for business on the basis of their ability to provide a product that gives investors confidence in the transparency and accuracy of the company accounts, with the uplifting effect that will have on the prices of their clients' shares...

...If we adopt policies that get the incentives of all the players right, government can then get out of the way so that the various actors can do their thing—audit, advise on investments, monitor management performance in the interests of owners, and manage the company in a world in which managers' interests coincide with those of shareholders...

...The latter can be relied upon to act when the integrity of the system is threatened, not because these private sector players are a Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of regulatory studies at the Hudson Institute, and a columnist for the Sunday Times (London...

...The first step is to understand the limits of criminal sanctions...

...Again, get the incentives right...

...Yes, it makes sense for the Senate to insist, as it did unanimously last week, that the crimes perpetrated by some corporate managers and accountants be defined as precisely as possible...

...There are only four major firms, and rotation of auditors on something like the five-year basis favored by Senate Democrats, although necessary to prevent over-identification between client and auditor, is a classic cartel market-sharing arrangement—all legal, in this case...

...I well recall the reaction when, several years ago, I made a similar suggestion at a think-tank-sponsored meeting of top business and government officials...

...Lead the CPAs not into temptation, and reliance on porous Chinese walls becomes unnecessary...

...This opposition of important segments of the business and accounting communities to reform means that government must take on the burden of revising the institutional framework within which business operates—setting the rules of the game that will allow markets to do their job of allocating human and financial capital to its highest and best uses...

...Rather than rely on such strength of character, some 70 percent of the directors surveyed by McKinsey & Co...

...Instead, policymakers should turn to that trusty guideline, "Get the incentives right...

...The directors should not accept anything within the gift of the CEO...

...the prospect of hefty banking fees was quite enough...

...Many investment bankers—not all, but many—will find ways to persuade their partner-analysts to be team players...

...For the economy as a whole, experts estimate that expensing of options would reduce aggregate corporate profits by about 8 percent...

...Again, I recall a discussion that followed a similar proposal I made several years ago...

...The Senate was pleased with itself for toughening the laws under which executives will operate, but criminalizing bad behavior is no guarantee of future good behavior—behavior that is not merely indictment-avoiding, but is efficiency- and wealth-enhancing...

...Board members should be independent and "ask tough questions...

...Besides, unless analysts suddenly become willing to issue "sell" recommendations just when their investment banking partners are pitching a company for business, this proposed reform is unlikely to be effective, especially after the current heat is off and congressional attention turns to other matters...

...It would be an unusual CEO, indeed, who would cheerfully receive an investment banker after reading in the morning papers that the banker's analyst-partner had just downgraded his company's stock from a "buy" to a "sell...

...Corporate executives should be held responsible for the accuracy of what they tell shareholders, disclose their compensation in annual reports "prominently and in plain English," and explain why their "compensation package is in the best interest of the company...

...their directors' fees should be compensation enough, and high enough to provide an incentive to accu-s mulate a record that s will persuade share-I holders to reelect CL them at reasonably regular periodic intervals—perhaps throwing in term limits to make sure that directors and management don't develop too cozy a relationship...

...Analysts would then have an unambiguous incentive to make the best "buy" and "sell" recommendations they possibly can, so as to build reputations that will attract investors to them...

...Auditors know that success or failure in their profession depends not so much on the accuracy and realism of their audits, as on their ability to conduct themselves so as not to imperil the flow of consulting fees to their firms...

...That situation was partially corrected when Mike Milken and his debt-financed corporate raiders snatched control of many companies from the worst abusers of shareholders' interests, grounded fleets of corporate jets, sold off hunting lodges, and generally sweated the fat out of expenses—a wonderful example of markets working to correct abuses that seemed beyond the reach of regulators...

...Only if there is a conceptual framework within which specific reforms can be created and defended is there any hope that a sensible corporate governance system will emerge from the congressional legislation factory...

...Add in the requirement that options be treated as profit-reducing expenses—another McCain proposal that so horrified senators that it has for now been derailed—and you will have a new parsimony that will keep salaries to levels commensurate with effort and performance...

...Under such a regime, executives would have a clear incentive to spend their time creating efficiencies and new markets, rather than figuring out how to cash in options, and how to persuade their boards to revalue options if poor company performance has driven the stock price below the price at which the options may be exercised, rewarding executives whether or not they have delivered long-term value for shareholders...

...Nor did anything the president said persuade the accountants to call off their lobbyists, who continue to oppose reforms that would make their devotion to the accuracy of their audit statements unambivalent...

...To keep rules to a Friedman-esque minimum, we need a conceptual framework for reform rather than competing laundry lists...

...But, as the president recognized when he called for higher ethical standards, self-interest cannot be relied upon to produce honest business dealings unless that self-interest includes what Adam Smith called a "desire to be both respected and respectable," and such esteem is seen to flow not from "wealth and greatness" but from "wisdom and virtue...

...Truly independent boards, created along the lines described above, would be another advance, since compensation committees not beholden to corporate managements are more likely to relate pay to performance than the supine committees that now exist on some boards...

...Instead of such ongoing regulation, including half Policymakers should turn to that trusty guideline, "get the incentives right...

...President Bush's proposal for publication of compensation arrangements in an accessible format would be a step in the right direction, its effectiveness attested to by the howls of outrage it produced from some CEOs...

...And we have companies scrambling to adopt governance rules and accounting practices that will reassure investors that the game is not rigged against them...

...Investors may have been naive to believe that these students of income statements, balance sheets, and other economic data would provide honest advice about a company's financial condition and prospects...

...But nowadays there aren't many people who want to be like Mike, so it is incumbent on policymakers to get managers' incentives right...

...And investors will get something in return for their commission dollars—honest advice from men and women expert in the analysis of corporate financial data, competing with one another to attract clients by creating a track record of picking winners...

...It took no Joshua-plus-trumpet to bring these walls down...

...Longer sounds better if you're just compiling a laundry list of items aimed at punishing politically unpopular corporate bad guys...

...In the game of matching his laundry list of reforms against the inevitably longer list generated by the Daschle-Leahy-Sarbanes-Gephardt crowd, the president inevitably loses, as last week's unanimous vote of Senate Republicans for the Democrats' bill proves...

...Banking fees are large enough to give them an enormous incentive to do just that...

...It is the rare director who chooses to feast on the hand that feeds him, not merely because he is venal, but because the courtesies lavished upon him genuinely persuade him that the CEO is a decent chap, deserving of every million he is paid To get the incentives right, directors must be selected by vigorously participating shareholders, most especially institutional shareholders, from a slate of demonstrably independent people who, although well compensated, have reputations worth protecting...

...But just how analysts can prosper if the banking division isn't earning enough to pay the rent is unclear...

...Analysts are another group who now face perverse incentives...

...The problems we are facing stem from the fact that we have provided the four guardians of shareholder interests—auditors, analysts, directors, and corporate managers—with the wrong incentives...

...Or convince CEOs of Silicon Valley and other high-tech companies to bow to Alan Greenspan's call for them to report their share options as the expenses they most certainly are...

...Then the other regulations become unnecessary...

...Yes, criminal sanctions can be used to make life miserable for those caught with their fingers in the till and to deter from evildoing those for whom Adam Smith's "desire to be respectable and to be respected" is insufficient inducement to decent behavior...

...Finally, we come to the CEOs and top managers...

...But, as law professors David Skeel and William Stuntz recently pointed out in the New York Times, "Criminal laws lead people to focus on what is legal instead of what is right...

...Directors are hired by managers to protect shareholders from, er, those same managers...

...Along comes New York State Attorney General Eliot Spitzer and revelations that some of these supposed agents of the shareholders' interests are recommending stocks they know to be "shitty" in order to win investment banking business for their partners and increased compensation for themselves...

...This may sound like an awful lot of regulation...

...now say they will in the future oppose the granting of such contracts, a policy that Arthur Levitt, Bill Clinton's SEC chairman, was unable to push through over the massed opposition of the accountants' lobbyists...

...Which may be what Bush had in mind when he said that we need "men and women of character, who know the difference between ambition and destructive greed" to lead our major corporations...

...There is no reason to believe that such supervision will be any more successful in the future than it has been in the past, especially since in the end auditors are required only to say that they followed often complex and arcane rules that necessarily involve the exercise of judgment...

...And it may be what he had in mind when, immediately after delivering his talk, he returned to Washington to award the Presidential Medal of Freedom—America's highest civilian honor—not to the nation's richest (Intel founder Gordon Moore may have been the one exception), but instead to folks who have enriched our national life with their sharp iconoclasm (Irving Kristol), gentle humor (Bill Cosby), and quiet devotion to family and good causes (Nancy Reagan...

...One CEO said that he couldn't place a value on these options for purposes of reporting to shareholders, even though he could value those same options for the purpose of deducting their cost from his profits for tax purposes...

...Crooks should be forced to disgorge their ill-gotten gains, and should go to jail for extended periods...

...and Gardiner C. Means published their classic The Modern Corporation and Private Property, detailing the potential for managerial abuse created by the separation of ownership from control of large corporations...