“If people behaved the way nations do, they would all be put in straightjackets.”
If people behaved the way corporations do, they would all be serving time.
An impartial observer who conducted a thorough review of the business media during the first half of 2002 could be forgiven for concluding that the whole corporate system is hopelessly corrupt. From the time Enron’s troubles began to make headlines in the fourth quarter of 2001, a trickle of stories about dubious accounting practices turned into a flood of stories about fraud and now threatens to create a tidal wave of negative media coverage that could sweep away the confidence and credibility that are the very foundation of the capitalist system.
At first, it seemed the story might be limited to a handful of new economy companies. Enron, despite its lofty position at the pinnacle of the Fortune 500, was still a teenager, founded as it was in 1985. Telecommunications pioneer Global Crossing was founded in 1997, but has accumulated an impressive $12 billion in debt in its short life. But it soon became clear that more established companies were just as much a part of the problem: Andersen, of course, dragged down by the undertow from the Enron scandal, and Xerox, almost 100 years old, and until relatively recently—it was one of the companies featured in In Search of Excellence—among America’s most respected corporations.
Some CEOs and business commentators continue to insist that these are isolated problems, that the overwhelming majority of corporations are honest and upfront with their investors, but the numbers suggest otherwise. Until the mid 1980s, it was unusual for companies to restate their earnings: restatements rarely exceeded 12 a year. In the early 90s, about 50 companies a year issued restatements. In 1999 it was 204. If this year continues at its current pace, we could see 240 or more. The fact that very few companies restate their earnings upwards suggests that these are not simply bookkeeping errors.
The restatements are getting larger, too. WorldCom’s restatement was the largest ever—a $3.8 billion reduction in previously reported pretax income. Add in Xerox, which overstated its earnings by $1.4 billion, and you have two companies that between them almost equal the $5.8 billion from all restatements from 1998 to 2000.
The accounting problems are clearly profound, but there are other issues too, issues that hint at an even deeper malaise. Wal-Mart is under fire for business practices that would put a Third World sweatshop to shame—behavior more morally repugnant than anything at Enron or WorldCom—and this week’s Forbes magazine cover story suggests some companies are prepared to ignore fraud convictions and even allegations of rape in order to keep their star performers in place.
These are specific problems, but the majority of Americans don’t see them as anomalies. After all, these are the same CEOs who—in the eyes of the public—use their shareholders’ wealth to twist and distort the political process to impose their narrow agenda on the rest of us, who deny global warming and risk the planet’s future rather than invest in environmental safeguards, who would rather lay off tens of thousands of workers than take a 5 percent pay cut themselves.
When Gallup asks Americans how much confidence they have in big business, only 7 percent say they have a great deal and only 13 percent quite a lot. That means big business ranks lower than television news, newspapers, Congress, the criminal justice system and labor unions and ahead of only Wall Street and health maintenance organizations—both corporate structures themselves. Almost a third (32 percent) of respondents say they have either very little confidence in big business or none at all.
Viewed in this context, it should be apparent that many Americans view accounting fraud charges are mere lesions, a symptom of a much deeper and uglier cancer on the soul of American business. A quick scan of recent business headlines reveals many other symptoms.
Consider the charges against Wal-Mart, which forces even its most junior employees to take a written test designed to measure their honesty and integrity. According to a lawsuit, store managers often force employees to work up to an hour after they have clocked out, and in some cases to lock the doors and refuse to allow people to leave until additional work is completed. Other former employees say managers deducted hours from their timecards—a practice that amounts to stealing from employees to pay extra to shareholders.
Or consider the stories about companies like Stanley Works, which announced in February that it would reincorporate in Bermuda to avoid paying U.S. taxes, a decision that came less than six months after the attacks on the World Trade Center and made it clear to everyone that the wave of patriotism that swept through corporate America in the immediate aftermath of the attack was nothing more than a marketing ploy, an attempt to fool an anguished populace into believing that CEOs felt the same way about the attack on their country as the rest of us.
Or consider the front page of last week’s Forbes magazine, which explained how companies are prepared to overlook almost any sin—from fraud to alleged rape—if it’s profitable to do so. The story quotes the chief executive of Hypercom (a company that makes card-swipe machines for supermarket checkout counters), defending a top-performing executive who has been accused of rape four times. “He was bringing in $70 million a year. Do you fire your top rock star because he’s difficult?”
The Holy Grail of Higher Earnings
This points to one root cause of the current crisis, the Holy Grail of higher earnings. The prevailing ethos of corporate America has always been inclined to excuse all kinds of unpleasant behavior in the name of increased shareholder value, but somehow, during the 90s, the system was perverted to the point that companies were rewarded for hitting their earnings targets—no matter how they did it—and severely punished for falling short.
Hollman Jenkins, writing in The Wall Street Journal, understands this (though I suspect he draws very different conclusions), when he writes, “This isn't about free-standing cases of criminal behavior…. This touches the entire system of corporate performance begun in the 1970s, when corporate America was rationalized to align the interests of managers with shareholders…. Surely something deeper was at work here than mere fraud.
“Consider WorldCom and its CFO Scott Sullivan. Sullivan may be a criminal, a cowboy or a jerk, but it’s hard to see how what he did was intended for any other purpose than to protect what was left of WorldCom’s share price. Indeed with a few exceptions, this whole scandal seems to be about desperate men trying to prevent the one unforgivable act in our system now—a falling share price.”
So when Fortune listed 10 reasons why corporations fail, it included among them being “a slave to Wall Street.” On a list of 14 companies in crisis, nine—including Enron, Global Crossing, Lucent, Tyco, and Xerox—fell into this category. The magazine quoted Lucent chief executive Henry Schact, somewhat chastened after the company’s stock lost 80 percent of its value: “Stock price is a byproduct; stock price isn’t a driver. And every time I’ve seen us lose sight of that, it has always been a painful experience.”
Writing in Fast Company, three prominent academics—Robert Simons of Harvard Business School, Henry Mintzberg of McGill University, and Kunal Basu of Oxford University—describe the notion that corporations exist to maximize shareholder value one of “the five half-truths of business.”
“Shareholder interests are significant,” the authors say. “The capital markets do need to work, and for that, shareholders need a fair return on their investment. But there is a larger truth to this half-truth: Maximizing shareholder value at the expense of all the other stakeholders is bad for business and bad for capitalism. It drives a wedge between those who create the economic value—the employees—and those who harvest its benefits.”
The wedge becomes even more profound when one factors in executive compensation, and stock options in particular.
Two decades ago, CEOs of American corporations made 50 times as much as the average worker. Today, they make more than 500 times more. Fifteen years ago, the highest paid CEO in America was Lee Iacocca, who made $20 million. Last year, it was Larry Ellison, who made $706 million, an increase of 3500 percent.
Management guru Peter Drucker, who last week received the Presidential Medal of Freedom, has been a voice in the wilderness lamenting the “unconscionable greed” of American CEOs, who appear to have rigged the system so that they are rewarded for failure as well as for success—Gary Winnick sold 30 percent of his shares in the never-even-remotely-profitable Global Crossing for $600 million and now resides on a four-acre, $60 million estate in Beverly Hills while the company he created languishes in bankruptcy protection.
Enron’s Jeff Skilling made $112 million off his stock options before the company collapsed, while Tyco’s Denniis Kozlowski cashed in $240 million over three years before his dismissal, and Joe Nacchio, chief executive at Qwest, made $232 billion off options in three years while losing billions for investors. That why reducing CEO pay is number four on Fortune’s list of seven ways to fix the system.
Says the magazine, “If you’re looking for reasons corporate America is in such ill repute, this over-the-top CEO piggishness is a big one. Investors and in some cases employees lost everything, while the architects of their pain laughed all the way to the bank.”
Professional athletes, movie stars and musicians have all succumbed to the same syndrome: they earn so much, and they surround themselves with so many people who tell them only what they want to hear, that they begin to believe they are no longer bound by the rules that govern mere mortals. As CEOs became superstars, and their salaries spiraled upwards, they too came to believe they could write their own rules. The crimes they committed were different—they cooked the books rather than breaking into hotel rooms brandishing pistols—but only, one suspects, because those were the crimes for which they were best suited by skill and circumstance.
The Regulatory Response
Being lectured on business ethics by George W. Bush is like being lectured on sexual mores by William Jefferson Clinton.
The president profited from the kind of loans he now wants to ban. The vice president was the chief executive of a company, Halliburton, which is now being investigated by the Securities & Exchange Commission for counting unapproved billings as revenue. The Secretary of the Army Thomas White is a former Enron executive who cashed out with $31 million just before the company collapsed. Under the circumstances, the most remarkable thing about President Bush’s speech on corporate ethics was that he kept a straight face while delivering it.
To be fair, the president did a good job identifying the problem.
“The American economy—our economy—is built on confidence, the conviction that our free enterprise system will continue to be the most powerful and most promising in the world,” he told his audience. “That confidence is well-placed. The American economy is the most creative and enterprising and productive system ever devised….
“Yet our economy and our country need one more kind of confidence—confidence in the character and conduct of all of our business leaders. The American economy today is rising, while faith in the fundamental integrity of American business leaders is being undermined. Nearly every week brings better economic news, and a discovery of fraud and scandal—problems long in the making, but now coming to light.
“We’ve learned of some business leaders obstructing justice, and misleading clients, falsifying records, business executives breaching the trust and abusing power. We’ve learned of CEOs earning tens of millions of dollars in bonuses just before their companies go bankrupt, leaving employees and retirees and investors to suffer. The business pages of American newspapers should not read like a scandal sheet.”
But he made it clear that he would not back his rhetoric with any action that might displease his friends and supporters in the corporate world. While calling for tougher criminal penalties against execs who fudge the numbers, and an increase in the SEC’s budget, the president essentially called for “tougher enforcement of existing laws, rather than sweeping changes,” as USA Today summarized the proposals. The market, perhaps expecting real reform, plummeted.
In public relations terms, the speech was an unmitigated disaster. First, it allowed critics of the president to take a new look at his financial dealings while a director of Harken Corporation, and to hold him to the same standards he had proposed for corporate wrongdoers. And second, it allowed Democrats to seize the high ground in a debate that will surely be a key factor in the midterm elections.
Said William Saletan, writing in Slate, “There are standards and assumptions under which the explanations [of his own behavior while a director of Harken] Bush gave Monday can be defended, and there are company directors whose conduct can be defended under the standards and assumptions Bush outlined Tuesday. But there’s no way to square the rules Bush applied to himself on Monday with the rules he applied to others on Tuesday.”
On Tuesday, Bush advocated personal responsibility, particularly for directors. “Those who sit on corporate boards have responsibilities,” he said. “I urge board members to check the quality of their company’s financial statements; to ask tough questions about accounting methods.” But a day earlier he was explaining that he was not responsible for knowing about errors in the way his stock sale at Harken was reported, even though he was a member of the company’s audit committee.
He also called for companies to forbid “all company loans to corporate officers,” despite the fact that he had borrowed money from Harken while a director. When challenged on these loans, spokesman Dan Bartlett suggested the loans were appropriate because Bush didn’t profit on them. The reason he didn’t profit was because he used the loans to buy Harken stock, which turned out to be a poor investment.
Says Daniel Gross, author of Bull Run: Wall Street, the Democrats and the New Politics of Personal Finance, “Bush still received substantial benefits from his Harken loans. The loans—and the way they were unwound—allowed Bush to take financial positions without risk that ordinary investors have to pay for. And the loans were offered on terms that are unavailable to even the best credit risks… Bush may not have turned a direct profit on his Harken loan. But he got an awful lot of valuable—and potentially valuable—stuff for free.
“Bush essentially borrowed $180,000 in stockholders’ cash to bet on Harken stock. When the bet soured, the debt was forgiven and he was given new chips to play with.”
Questions about the administration’s own standards are likely to intensify with the selection of Larry Thompson to lead the president’s white-collar crime task force. Thompson, served on the board of directors of Providian Financial—and as chairman of the audit and compliance committee—at a time when regulators found the company had systematically charged excessive fees and used deceptive sales tactics to bolster its bottom line.
The resume of Securities & Exchange Commission chief Harvey Pitt is equally disturbing. In a 1994 “crisis management primer, Pitt advised that “each company should have a system of determining the retention and destruction of documents. Ask executives and employees to imagine all of their documents in the hands of a zealous regulator or on the front page of the New York Times.
“Obviously, once a subpoena has been issued or is about to be issued, any existing destruction policy should be brought to an immediate halt.”
In other words, until shredding is actually illegal, only an idiot would be concerned about the ethics of it.
Meanwhile, the reaction to the speech from critics made it clear that Bush’s mealy-mouthed response would not satisfy his critics.
The response from corporate accountability organization Infact was swift and scathing. “With public outrage building over unethical corporate behavior and its impact on ordinary people, we are faced with a unique opportunity for major change. President Bush’s proposals barely skim the surface,” said Infact executive director Kathryn Mulvey.
At the same time, a group called American Family Values, which was critical of Bush during the election, began running ads suggesting that “the foxes [are] guarding the henhouse” when it comes to corporate crime. Says Mike Lux, the group’s president, “Bush is not a credible messenger, because the Bush administration from day one has coddled big business interests at every turn. The hypocrisy factor comes into play pretty heavily.”
Democrats in Congress, meanwhile, have clearly woken up to the fact that corporate malfeasance could be a wedge issue in the November elections, perhaps sufficiently resonant to counterbalance the president’s “war on terror.” William Saletan, writing in Slate, explains how corporate corruption could become the key campaign issue: “Beginning with the election of Richard Nixon in 1968, Republicans called Democrats the party of ‘acid, amnesty, and abortion,’ while claiming God, patriotism, and law-and-order for themselves…. Democrats were the party of weakness; Republicans were the party of strength.
“George H.W. Bush beat the ‘wimp factor’ by making Michael Dukakis look soft on crime and defense…. Now, suddenly, the villains of the hour are the ones Democrats have consistently warned us about. The populist rhetoric that seemed so out of place in the 2000 election, when Al Gore railed against ‘powerful forces’ that threatened ‘the people,’ has found its logical context.”
At the end of last month, Senate majority leader Tom Daschle made the Democratic strategy clear when he suggested that the root of the current scandals was “a deregulatory, permissive atmosphere that has relied too much on corporate America to police itself. It is as if the line between right and wrong, legal and illegal, acceptable and unacceptable was so little enforced that it became blurred…. Self-policing is no replacement for a vigilant cop on the beat.”
The key word in that outburst was “permissive,” a word that has found itself into almost every Democratic pronouncement since, a word designed to make people think about the shady business dealings of Bush and Cheney, the close personal ties between senior administration officials and companies such as Enron, Global Crossing, and Halliburton, and the Republican Party’s recent history of supporting almost any excess as long as it was committed in the name of freer markets.
Last week, Daschle was on Face the Nation, blaming the business scandals on a “permissive” climate of deregulation four times in three minutes. Twice, he called for “more cops on the beat” and five times he urged the government to “go after the bad actors.” Suddenly, law and order is a Democratic issue, because suddenly the image of the criminal out to rip off America’s life savings resembles Dick Cheney or Martha Stewart more closely than it resembles Willie Horton.
A Broader View of Governance
But some observers have serious questions about whether more laws will provide a solution to the problem. David Skeel, who teaches business law at the University of Pennsylvania, and William Stuntz, who teaches criminal law at Harvard, suggest that while the push for tougher criminal statutes is understandable, it is not even clear whether the actions of executives at Enron and WorldCom violated the proposed laws.
In any case, “if experience is any guide, new criminal laws are as likely to make things worse as to make them better. The reason is both simple and all too easily ignored: criminal laws lead people to focus on what is legal instead of what’s right…. We’ve turned what used to be moral questions into legal technicalities. In today’s world, executives are more likely to ask what they can get away with than what’s fair and honest.”
Evidence for that contention can be found in the fact that most of the chief ethics officers in American corporations have a legal background. This qualifies them to help companies comply with legal requirements, but cynics might say it disqualifies them from answering complex ethical questions.
One thing should be clear, however, which is that companies are unlikely to act ethically as long as they elevate their obligation to a single group—shareholders—above their obligations to society. The way our system has evolved, corporations are answerable exclusively to their shareholders, and it’s hard to escape the conclusion that an over-emphasis on keeping Wall Street happy is one of the root causes of the current crisis.
Hollman Jenkins, quoted above, understands the root of the problem but he is either disingenuous or experiencing tunnel vision when he attempts to find a solution. The best he can come up with is to “go back to the era we abandoned, say the 1950s, when there was virtually no reason to worry about systemic accounting fraud, when instead of telecom’s risk and reward, America had one ‘reliable’ phone company, when corporate executives drove company cars and held corporate country-club memberships. That was the golden age of financial insiders, and most big-time pols were in the club.”
But rather than going back, perhaps there a way forward, a way to refine and improve the current system, to make businesses more perfectly accountable. “The challenge,” says Jernkins, “is to again align managers with rational incentives.” Should those incentives focus exclusively on share price and the interests of those who provide the financial capital for an organization, or should they also include those who provide labor and social capital?
Our notion of democracy has advanced through the ages. There was a time when relatively few were enfranchised, when only those who owned land were considered worthy of inclusion in the electoral process. Over time, however, the right to vote was extended to those who toiled the land, and ultimately to society as a whole. Most would agree that political governance was improved as a result.
There is no reason why our notion of capitalism should not advance in a similar direction. Today’s system empowers shareholders to the detriment of all other stakeholder groups. But there is no reason why employees and the wider community should not enjoy a role in governance, and good reason to believe that corporate governance would improve as a result.
The irony is that the emphasis on shareholders to the exclusion of all others is a relatively recent phenomenon. As Harvard’s Robert Simons and his colleagues point out, “We used to recognize corporations as both economic and social institutions—as organizations that were designed to serve a balanced set of stakeholders, bit just the narrow economic interests of the shareholders.”
In fact, the Business Roundtable once argued: “Balancing the shareholder’s expectations of maximum return against other priorities is one of the fundamental problems confronting corporate management. The shareholder must receive a good return but the legitimate concerns of other constituencies (customers, employees, communities, suppliers, and society at large) also must have appropriate attention.”
The Roundtable abandoned that view in 1997. In a new report on corporate governance, it assigned a new priority to CEOs: maximizing shareholder value. “The notion that the board must somehow balance the interest of stockholders against the interests of other stakeholders fundamentally misconstrues the role of directors,” said the Roundtable’s report. “It is, moreover, an unworkable notion because it would leave the board with no criterion for resolving conflicts between the interests of stockholders and of other stakeholders, or among different groups of stockholders.”
That last argument sounds particularly spurious. First of all, acknowledging that directors must balance occasionally conflicting interests does not imply that it cannot establish criteria for resolving those conflicts. Secondly, the board must even now resolve conflicts between long-term and short-term investors, balancing the need for strong quarter-by-quarter performance with the need for long-term security. And thirdly, nowhere is it written that boards of directors should not have to make difficult decisions. Anyone who doesn’t want to be faced with such dilemmas should steer clear of directorships.
Of course the case will be made that the current system—the system that elevates shareholder needs above the needs of society as a whole—has served the western world, and America in particular, well. After all, a couple of years ago we were lecturing the rest of the world on how superior our brand of capitalism was, compared to the almost socialistic business practices of western Europe and the strange, clubby networking that exists in Asia.
But that’s a spurious argument. Capitalism is the most powerful engine for economic prosperity man has yet devised, but 500 years ago the same could have been said of feudalism. The fact that something is better than what went before is not an argument for abandoning efforts to devise something better still. If we have, as Francis Fukuyama argued in his 1989 magazine article and subsequent book, reached “The End of History,” that’s merely a testament to a collective failure of imagination. Can we really not conceive of anything better than the current political and economic system, with all its flaws and injustices?
The Challenge to Public Relations
In theory, at least, the current crisis ought to present a golden opportunity for public relations professionals. If this profession is really about all the things it claims to be about—building trust, protecting reputations, helping companies establish mutually beneficial relationships with key stakeholder groups—then corporate public relations people should be front and center, helping align the goals of their companies with the expectations of the society in which they operate.
But there are few indications that the public relations profession is taking any kind of leadership role in this crisis.
One reason is that most chief executives appear more concerned with defending their outlandish compensation packages that with regaining the public trust. The Business Roundtable has been actively campaigning against two of the few reform proposals that might actually make a difference—the New York Stock Exchange’s suggestion that stock options be subject to shareholder votes, and the proposal that the cost of options should show up on the company’s balance sheet.
Says Fortune’s Joseph Nocera, “It’s probably safe to say that Oracle would never have paid Larry Ellison $706 million in cash or any other form that would have to show up on the company’s earnings statement. But all that money (Ellison didn’t get a salary last year) came from exercising stock options that the company had given him in earlier years. And because of the current screwed-up accounting for stock options, Oracle’s earnings statement says that Ellison’s bonanza didn’t cost the company a cent.”
Since 1985, in fact, the Financial Accounting Standards Board has sought to improve the way companies report option grants. In 1993, it proposed that companies deduct the value of the options on their income statements, just as they would with any other compensation. The Business Roundtable lobbied ferociously against that proposal, and in the end the board backed off and required only that companies disclose the value of option grants in a footnote to the accounts.
For that reason, it seems a little disingenuous when the Roundtable claims to be “appalled, angered and, finally, alarmed” about the current crop of scandals. If you can hear an echo of Claude Rains’ Captain Renault, who was “shocked, shocked,” to find gambling at Rick’s Place, you’re not alone. When you hear these guys say, “We must and will be at the forefront of supporting these reforms,” it’s probably time to take the last of your savings out of stocks and stuff it under your mattress.
NYSE chairman Richard Grasso is one who clearly believes CEOs just don’t understand how angry investors really are. After being on the receiving end of the lobbying effort to de-claw the exchange’s reform efforts, he told Business Week: “They are going to have to balance how the public feels right now with their position, and frankly this market shows that people aren’t feeling very good.”
And that was long before the Bush speech sent the markets into yet another steep decline.
Carl McCall, the New York state comptroller and co-chairman of the NYSE committee that suggested the changes in corporate governance, is more blunt. “I can’t understand the opposition,” he says. “This is good for corporations. This is an opportunity for corporate leaders to stand up and say, ‘We are going to do everything possible to restore confidence and safeguard your investment.’”
If business leaders don’t take the loss of confidence seriously, they should consider the following:
Only 4 percent of investors responding to a Business Week poll said they were “very confident” that corporations accurately report how much money they make.
Another problem with business leadership in America today is that it wants to stand up and say those things, but it doesn’t want to have to sacrifice anything. Its priority appears to be finding a cheap cosmetic solution that will obviate the need for expensive, substantive action. In this regard, most observers appear to view public relations as part of the problem, rather than part of the solution. And in some ways, it’s hard to argue with them.
The public relations industry certainly played its part in creating the bubble economy, which burst so spectacularly last year. PR people—on the corporate side and in agencies—were all too willing to churn out hype and promises for dot-com companies with deep pockets and shallow ideas. They have also been complicit in too many superficial attempts to position companies as socially responsible.
Enron, for example, was a member of socially responsible organizations such as the Pew Center on Global Climate Change, the Business Council for Sustainable Energy and the World Business Council for Sustainable Development. The company lobbied heavily for the U.S. to accept the Kyoto protocols on global warming, which the company regarded as potentially profitable.
Francis Fukuyama, professor of international political economy at Johns Hopkins University’s Nitze School in Washington, believes the patina of social responsibility helped shield Enron from criticism. “They were a really politically attuned company. They were spreading their money everywhere just to buy favorable publicity for themselves, and I th