College of Business Administration

Article Reprints:

Irwin M Stelzer

The corporate scandals and American capitalism. Public Interest, Winter 2004., Iss. 154; pg. 19

The trading excesses of the 1920s and the Great Depression also led to legislation that helped to preserve capitalism. This time, new laws, established under the New Deal, created rules of the road for the myriad institutions that would be known famously to future generations as Wall Street. Under the new rules, those seeking to raise money from the public were required to reveal details of their business plans and practices truthfully; those trading securities would have to treat all buyers and sellers alike; and the stock exchanges would thenceforth be required to monitor members to prevent abuses.

Operating properly, of course, free markets would in the long run make it difficult and costly for businesses and entrepreneurs in search of capital to transgress. But even those who abhor government regulation must concede that the key policy goal of these regulations-to reduce the information asymmetry that gives the seeker of capital an advantage over the investor-is legitimate. And the conduct of corporate America and of the financiers who make it possible have more or less conformed to the strictures imposed by the New Deal reformers.

The problem

Recently, though, a spate of what have come to be called corporate scandals has attracted the attention of the media and of government. The scandals-which included the collapse of Enron and other major corporations, revelations that securities analysts hyped stocks to help their investment-banking colleagues get lucrative assignments (small investor be damned), and revelations that CEO-friendly corporate compensation committees often awarded executives pay packages that were inscrutable and not necessarily related to any measure of performance-revealed several old and some new flaws in the American system of market capitalism. "There oughta be a law" was once again heard in our land. The result was the Sarbanes-Oxley Act of 2002, "the most important securities legislation since the original federal securities laws of the 1930s," according to Securities and Exchange Commission (SEC) chairman William Donaldson. The act aims to improve the accuracy and reliability of corporate disclosures by, among other things, requiring corporate chief executives to certify, personally, the accuracy of their companies' financial statements. Have this statute, the accompanying actions by enforcement authorities, and the wave of self-created corporate governance reforms proven to be as effective as their twentieth-century forebears were?

The arguments against the latest changes can be put simply. The first is that new laws are not needed; existing statutes are adequate to clean up any excesses. The second is that new governance requirements are simply too costly: More audits are expensive, as are the increasing presence of lawyers in board rooms and the higher fees required to induce competent people to serve on boards. Third, it is argued, increased fears of transgressing vague new rules heighten risk-aversion among managers and corporate boards, threatening the pace of innovation, discouraging efficiency-inducing corporate mergers (if such there be), and causing a general wariness to act. Finally, literally hundreds of empirical studies dating to the 1960s have found little direct relationship between board composition and day-to-day financial performance. Only the size of boards seems to affect performance, with smaller boards turning in the best results for shareholders. Board independence seems to matter only infrequently, as in cases where a takeover is threatened. One might reasonably conclude on the basis of these studies that legislation or regulation dictating the composition of boards is useless at best and costly at worst.

But even if true, these arguments miss the larger point. The most important issue facing the architects of public-policy responses to troubling corporate behavior has little to do with the specific practices uncovered. What's ultimately at stake is the healthy functioning of capital markets on the one hand, and the battle of ideas over the acceptability of capitalism on the other.

Principals and agents

Seventy years ago, Columbia professor Adolf Berle and his co-author Gardiner Means identified the problem that lies behind our recent corporate scandals: Managers of large corporations are in a position to act in their own interests, regardless of whether those interests conflict with the interests of shareholders. As they wrote in their classic work The Modern Corporation and Private Property (1932):

Where the bulk of the profits of enterprise are scheduled to go to owners who are individuals other than those in control, the interests of the latter are as likely as not to be at variance with those of ownership and . . . the controlling group [will be] in a position to serve its own interests.

This has become known as the principal-agent problem: A situation in which the shareholders who own the company cannot adequately control the agents who manage their property. So it should come as no surprise that recent studies have found that managers end up encouraging dispersion of ownership in order to gain autonomy.

Anyone who has studied the history of large mergers knows that Berle and Means were onto something. Acquisitions often reduce the value of the shares of the acquiring company while enhancing the prestige and compensation of the managers who engineered them-at least in the medium term and frequently in the long run.

Many defenders of the capitalist system were and still are unperturbed by the principal-agent problem. Their solution is straight-forward. Principals who are unhappy with the way their managers are performing can sell their shares-the financial equivalent of the dissatisfied citizen who votes with his feet. Unfortunately, the presence of substantial market imperfections makes life in the corporate and financial worlds more complex. In order to know whether to exit from an investment, shareholders must have immediate, accurate, and comprehensible information about the financial performance of the firm in question. Such information typically comes from three sources: management, securities analysts, and auditors.

Managers, especially those not performing well or engaged in dishonest self-enrichment, are not likely to bombard shareholders with timely and relevant information. Securities analysts, who operate from within financial institutions where investment-banking fees loom large, found that their career paths improved and their incomes increased if they became de facto sales adjuncts for the bankers. They often touted stocks of companies they knew to be underperforming in order to enable their investment-banking partners to ingratiate themselves with potential clients. No corporate executive can be expected to give lucrative investment-banking business to a financial institution after its stock analyst has rubbished his company's shares and prospects. So some analysts became touts for investment bankers, ignoring the interests of the investors they claimed to protect by withholding accurate information. This led even those economists suspicious of regulation to call for the elimination of institutionalized conflicts of interest that inhibit the flow of information.

The corruption of many securities analysts left the auditors as the shareholders' last defense. The dangers were many: managers who sought to conceal information, boards that were lax in discharging their responsibilities, analysts who succumbed to a desire for the massive rewards that mere solid research could not generate, and the principal-agent problem identified by Berle and Means. But more than a few auditors also found themselves faced with temptations too great to resist. The chief executives of their audit clients also turned out to be a potential source of lucrative consulting contracts, whose revenues were many times more profitable than the audit business. Raise a question about the accounting treatment of future income streams, or of investment in some affiliate, and one risked losing not only the audit account but, more important, the consulting contracts that had become a prime source of revenue. This institutionalized conflict of interest challenged even the bravest auditor to fulfill his responsibilities adequately while keeping clients sufficiently satisfied for his partners in the consulting division of the firm.

The resulting poor flow of information to investors might have been less serious if, as some contend, relatively well-informed pension-fund managers and other large institutional shareholders that now own about half of all the shares in American companies-and account for the bulk of trading in equities-had disposed of shares in ill-managed companies. These investors, they contend, are perfectly capable of protecting themselves from slovenly and conflict-ridden analysts and auditors. Unfortunately, life on the trading floor is not so simple. As Andrew and Nada Kakabadase, both of Britain's Cranfield School of Management, have noted, the share-holdings of even medium-sized pension funds are often so large that a program of disposing of stock in companies with subpar managements might well depress the price of those shares. Such an alternative is often simply too expensive to be realistic.

The worst of all worlds?

Whether recent legislation will eliminate these abuses is yet to be demonstrated, although there have been some changes in the composition and behavior of boards since Sarbanes-Oxley was passed. A shareholder research group reports that 376 first-time directors were appointed to large U.S. companies in 2002, nearly five times as many new-comers as in the previous year. Outside directors now meet regularly without representatives of management present, and headhunters are increasingly relied upon to find board members not beholden to the CEO. The chairmen of audit committees are today more likely to have some expertise in accounting; top executives must accept personal responsibility for the accuracy of their company's financial statements; and investment banks are required to fund some independent research.

The new vigor of corporate boards is perhaps best reflected in the record turnover in the executive suites of corporate America. A tabulation in the business press shows that 39 of the largest 200 corporations replaced their CEOs in 2000, and that two-thirds of all major companies replaced their chief executives at least once in the last five years. Perhaps most important, shareholders have more power over compensation packages, nomination of directors, and other aspects of how their money is managed. And as a study of 1,500 stocks by the National Bureau of Economic Research shows: "Weaker shareholder rights are associated with lower profits, lower sales growth, higher capital expenditures, and a higher amount of corporate acquisitions."

In addition to new rules, reformers have chosen fines, imprisonment, and exhortation in order to discipline directors like those at the now-defunct WorldCom. With only two hours' notice of a telephonically organized meeting, and no written materials distributed in advance, WorldCom's board approved a reckless $6 billion-plusdebt bid for Intermedia Communications. Such blatant inattention by a board to its fiduciary obligations is less likely under the new rules and in the current political climate. But the structural features of the investment-banking industry that created powerful incentives for misbehavior have been disturbed very little, creating perhaps the worst of all possible worlds-a costly regulatory regime, higher costs of doing business (higher pay for directors, more consultants, more meetings), and increased risk-aversion by corporate boards, without eliminating what New York University professor Baruch Lev calls "heightened concerns of investors with the credibility of financial reports [that] has probably led to increases in firms' cost of capital" and therefore to a slower rate of economic growth.

Policy makers are, it seems, faced with a rather unpleasant situation. Many of the traditional guardians of investors' interests, the analysts and auditors, have conflicts of interest that make it unwise to entrust them with the task. Large institutional shareholders find themselves the prisoners of their own size, often unable to sell shares lest they harm those for whom they are responsible by driving down share prices. And still another solution to the principal-agent problem-the stock option-proved inadequate to the task of protecting investors' interests.

Failed options

Options were invented to tie the interests of managers to those of shareholders, to turn agents into principals, in Berle and Means' terms. Managers' self-interest would be served when the value of the owners' stock increased, since the value of the managers' options would increase correspondingly. This explains in part the results of a study by Brian Hall and Kevin Murphy, professors of business administration at Harvard and the University of Southern California, respectively. In 1992, firms in Standard & Poor's group of 500 large companies granted their employees options worth $11 billion at the time of the grants; by 2000, that figure had risen to $119 billion. Shareholders quite reasonably assumed that they had laid to rest the problem raised by Berle and Means.

Unfortunately, the link between principals and agents that these options were supposed to create proved to be surprisingly weak. For one thing, auditors obligingly allowed firms issuing these options to treat them as costless, making it difficult for shareholders to know just how much of their wealth had been transferred to managers, and what level of performance would be required of managers in return. For another, the more complex a compensation package, the less likely the compensation committee is to realize what it has wrought. (Witness the unedifying spectacle of the compensation committee of the New York Stock Exchange expressing surprise and shock at the magnitude of the compensation package it had bestowed upon its chief executive Richard A. Grasso.) In the end, the practice of repricing worthless options made a mockery of the notion that options would align managers' and shareholders' interests by linking executive compensation to share price performance.

Worse still, the increasing gap between compensation paid in the board rooms and wages on the shop floor gave critics of the market system a new arrow in their quiver. Estimates vary, but CEO pay probably now exceeds the average manufacturing wage by some 400 times, perhaps 10 times the gap prevalent in 1980. This makes it more difficult to argue that pay differentials between executives and workers merely represent the difference in their contribution to the value of the enterprise. Granted, for believers in capitalism, multi-million or even multi-billion dollar compensation is not necessarily an evil, and indeed can reflect the massive contribution the recipient has made to the profitability of the enterprise he manages. In the case of executive-entrepreneurs like Bill Gates, the jobs, investment, economic growth, and material well-being generated are tremendous. But the flawed process of pay-setting guarantees that not every massively compensated executive earns his keep.

Getting compensation right

In any case, we are not dealing with the type of free-market compensation negotiation envisioned in elementary economic texts. In such scenarios, the employee faces an employer compelled to pay him no more than his marginal contribution to the firm's value. In addition to the fact that the executive selling his talents has often hand-picked the board members who are supposed to represent the shareholder-buyers of that labor, the procedure by which executive compensation is set is clearly flawed.

Compensation committees hire consultants to recommend appropriate compensation for their leading executives. These consultants claim to see no conflict in accepting consulting assignments from the chief executive, the level and composition of whose compensation they have just recommended to the board. And compensation committees are loath to set the remuneration of their executives below the average their consultants say prevails in other companies. Indeed, it is the rare board that does not feel it demeaning to the company's chief executive-and to its own standing in the financial community-to offer a package that is not in the top quartile of all such packages. The inflationary impact on compensation due to this combination of conflicts of interest and the felt need by the boards to be associated with a high-flying chief executive, is obvious.

The sec hopes to solve the problem of excessive executive compensation by requiring that pay packages be put to shareholder vote. That certainly can't do much harm, and might help by making the nature of such packages more widely known. But whether such a rule can exert much restraining effect, given shareholders' lack of expertise in the complicated task of linking pay to performance, is doubtful.

Market forces

A better solution to the problem created by this highly imperfect market is to attempt to eliminate the imperfections. Benjamin Hermalin and Michael Weisbach, professors at the University of California and the University of Illinois, respectively, note that "CEOs with interlocking boards get paid more than otherwise similar CEOs" and conclude that "interlocking directorships provide the CEO a degree of control over his board" that harms performance. The elimination of the you-scratch-my-back-and-I'll-scratch-yours arrangements by which a chief executive serves on the board of a company whose counterpart serves on his board would be a healthy development.

So, too, would a move to bar compensation consultants from accepting additional assignments from the executives whose incomes they are determining. Whether this is accomplished by voluntary adoption of such a rule by CEOs, by the various stock exchanges, or by government regulation matters little.

But these changes in governance procedures are unlikely, alone, to bring the financial rewards of America's top executives more closely into line with their performance, nor to restore popular support for the system of rewards inherent in market capitalism. Fortunately, market forces are at work to ameliorate the problem. First among them is competition in product markets. Such competition tends to reward efficiently managed firms and penalize those that are badly run. Even the most supine board cannot forever ignore truly woeful performance by the firm-loss of market share, falling profitability or mounting losses, post-merger collapse of share values, or liability on account of a poor public image. The policy lesson is clear: The maintenance of competitive product markets helps to separate corporate sheep from corporate goats, and provides shareholders with protection (unfortunately often belated) against the worst managers.

The second market force that operates to shorten the careers of incompetent managers is the hostile takeover. Excessive compensation and poor performance create an opportunity for entrepreneurs to wrest control of companies controlled by boards of directors that tolerate-indeed, often benefit from-such performance. There are costs to be saved by eliminating excess pay, fleets of corporate jets, and ski lodges. And there are certainly profits to be made by the "takeover artists," "predators," and "sharks"-to name just a few of the epithets used by threatened managers to describe those who are willing to take on large amounts of debt to finance a takeover.

The threat of takeover has the dual effect of encouraging managers to retain the support of shareholders by delivering superior performance, and of sharpening attention to performance by board members who know they, like the CEO, will be replaced if control passes to a new group of owners. All of which explains why the corporate establishment found Michael Milken's discovery of a method of financing these takeovers so threatening, and why lawyers earn enormous fees for devising so-called "poison pills" and other impediments to the operation of a vigorous market in companies.

The moral economy

In the end, structural reforms of corporate boards, even combined with competitive product markets and the threat of hostile takeovers and prison terms, provide only a partial solution to the problem of corporate misbehavior. Some argue that still more regulation, more government intervention in corporate governance, and more jail time is needed.

Perhaps. But no amount of government intervention can alone adequately substitute for what Adam Smith called "temperance, decency, modesty and moderation." The behavior of corporate executives in a number of instances suggests that we are faced with a collapse of a sense of "enoughness," of the constraints on behavior that were once imposed by conventional morality. What has been lost is the fact that the very preservation of the system requires that executives behave with moderation.

An interesting research paper by Lynn Stout, a professor at UCLA's School of Law, shows why the link between conventional morality and modern economics needs to be taken more seriously. In recent decades, she writes,

Economic analysis had little use for such concepts as honor, trustworthiness, or duty.... [But] the evidence demonstrates that people behave altruistically-as if they care about others, and not only about themselves.... To understand the proper role and conduct of corporate directors, we must accordingly abandon the homo economicus approach in favor of a model of human behavior that takes account of the empirical phenomenon of other-regarding behavior.

Like Adam Smith, Stout would rely on "other-regarding behavior" and "character." She would choose as directors men and women with a history of other-regarding and altruistic behavior, especially since the usual legal sanctions in most cases are not effective deterrents to all save the most blatant corruption.

It is simply not true that economics has little use for moral character. Some 125 years ago Alfred and Mary Paley Marshall, in their classic The Economics of Industry, observed, "Uprightness and mutual confidence are necessary conditions for the growth of wealth." But we live in an age in which members of the business community-as well as others throughout society-place less value on these virtues than in times past. As a consequence, we now see more self-interested behavior than might have existed before the goal of becoming rich succumbed, in succession, to the goal of becoming very rich and then to the goal of becoming fabulously rich-and quickly.

Corrective policy might usefully be aimed at reinforcing moral, altruistic behavior. One way of doing this is to make executive compensation transparent to shareholders and the broader society on which the executive's reputation depends. Such transparency requires more than merely publishing the details of compensation. It requires that compensation packages be sufficiently simple to be understandable. Far too many compensation packages are overly complex. Some of this complexity results from quite sensible and useful tax-avoidance strategies. But other complexities are designed to conceal the true aggregate value of compensation packages that include money, elaborate pension schemes, stock options, jet airplanes, yachts, apartments, memberships in country clubs, and a host of other valuable "perks" that often continue long after the executive retires and after he has ceased to contribute anything of value to the company.

That complex arrangements are often intended to conceal damaging information is obvious from the speed with which executives often surrender many of these forms of payment when they become known. Shame works-at least in enough cases to make the transparency that might produce such embarrassment a useful supplement to the reforms of corporate governance.

Saving capitalism from itself

This messy combination of legislation, regulation, competition in the markets for products and companies, and reinforcement of less self-interested behavior through enhanced transparency will satisfy very few in this debate. The many executives and investment bankers who think that the corporate scandals of recent years were too exceptional to warrant any change in the way corporations are governed will cry foul. And liberal reformers will see the changes as merely cosmetic, designed to cover the inherent blemishes of capitalism with a pleasing bit of meaningless gloss.

But this pragmatic mixture should have a certain appeal. The corporate scandals and the felt need for an adequate response ultimately concern the continued broad acceptability of the capitalist system. The belief that capitalism somehow, even if imperfectly, rewards the meritorious and gives even the smallest investor a fair chance to multiply his funds by entrusting them to the boards and managers of the corporations is at stake. If the activities of those Theodore Roosevelt once called "malefactors of great wealth" are allowed to go unchecked, the moral acceptability of corporate capitalism will be put in question. Only a pragmatic response incorporating the larger moral questions will work in the long run.

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