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CEOs Behaving Badly

Another cycle of reform is the cost of doing business.

Jun 6, 2005, Vol. 10, No. 36 • By JAY WEISER
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Icarus in the Boardroom

The Fundamental Flaws of Corporate America and Where They Came From

by David Skeel

Oxford University Press, 250 pp., $25

WITH BERNIE EBBERS ABOUT TO appeal his criminal conviction, and Enron's Kenneth Lay awaiting trial, an indictment has become as much of a CEO perk as a company jet.

In his important new book, University of Pennsylvania law professor David Skeel shows that huge corporate failures go far back in American history. Busts follow booms, and waves of populist legislation follow busts, attempting to legislate corporate scandals out of existence. In the wake of our most recent scandals, Skeel proposes a long list of additional regulations, but they aren't likely to prevent the hangover that always follows the party.

He offers a rogues' gallery of Icarus-like CEOs who flew too close to the sun and melted their wings, starting with financier Jay Cooke, who pioneered the sale of small-denomination bonds to the public during the Civil War, but ignored industry overcapacity in backing the Northern Pacific Railroad. Cooke's huge bank failed spectacularly, precipitating the Panic of 1873. Midwestern utility innovator Samuel Insull's impenetrable, overleveraged web of holding companies crashed in the Great Depression. While Franklin Roosevelt denounced the "Ishmael or Insull whose hand is against every man's"--a quote Skeel likes so much that he uses it twice in a few pages--Insull was acquitted of fraud.

More recently, Drexel Burnham Lambert's Michael Milken revolutionized finance with the junk bond, a high-risk product that enabled corporate raiders to sweep out sclerotic old-line corporate managers. But in a replay of Jay Cooke, when good deals began to dry up in the late 1980s, Drexel went up in smoke. And in the last decade, Lay turned a sleepy natural gas pipeline company into a glamorous energy trader named Enron, while Ebbers assembled WorldCom in a rapidly changing, highly competitive telecommunications industry. Both companies imploded through fraud.

Huge failures like these, Skeel argues, are caused by combinations of competition (which reduces returns after an innovator's initial growth spurt), complexity (financial shell games hide the company's true condition as it deteriorates), and risk-taking. But it's not clear whether his five examples are representative of the hundreds of major corporate collapses over the last 150 years. Even if they are, Skeel is not quite sure what he wants to tell us about them. The book alternates between an analysis of the failures, and a more general history of corporations and their regulation, with long digressions on marginally related topics like the history of antitrust, corporate, and campaign finance law.

The real common thread among its poster-boy executives is entrepreneurship. They created or revolutionized markets, grew rich from substantial economic stakes in their enterprises, but stayed at the party too long. Over the long term, the entrepreneurial homeruns outweigh the disasters, and the economy grows. Skeel makes a major contribution in analyzing the politics of the bust part of the cycle when, spurred by public outrage, populists generate enough support to overcome CEO opposition and enact reforms. He observes that backward-looking reforms have often hampered innovation since the days of Jay Cooke. Yet he also seems to hope that, with enough regulation, massive failures can be averted. As the author of Debt's Dominion, the definitive book-length treatment of 200 years of U.S. bankruptcy law, Skeel should be jaded enough to know better.

Virtuous failures (entrepreneurial efforts that don't pay off) and concealment failures (efforts to pull the wool over the public's eyes) pose very different problems. But risk-taking and competition are common to both. Of Skeel's five examples, Cooke, Insull, and Drexel Burnham were virtuous failures (notwithstanding Milken's jail time for securities law violations), while Enron and WorldCom collapsed in fraud.

In virtuous failures, investors, lenders, customers, and suppliers rue their losses and vow to monitor things more closely next time. Government regulation--whether banning companies' ability to hold pariah asset classes in the name of reducing risk, or (as under the New Deal's National Recovery Act) cartelizing the entire economy to stop competition--often succeeds only in constricting the economy.

Complexity, unlike risk-taking and competition, does have different effects in concealment failures. It can add value as corporate scale grows, but also encourages managers to gussy up the corporation's true financial status. General Electric's Jack Welch got a $125 million annual pay package for doing both during the salad days of the 1990s. (The polite term, in those pre-scandal days, was "earnings management.") The more opaque the corporation, the greater its ability to conceal its risk-taking, and the less the market can monitor it. Reforms requiring transparency, which shine the light on complexity and risk-taking, and encourage the market to price for them, have combated this.

The disclosure requirements of the Securities Act of 1933 laid the foundations for the long postwar stock market boom. The Sarbanes-Oxley Act has forced accounting integrity and corporate controls on CEOs, but may not be worth the cost. Some European companies are avoiding U.S. listings because of it.

Skeel advocates even more aggressive disclosure requirements for stock options, special purpose entities, and derivatives, and this is a good idea. But no matter how much disclosure there is, many investors won't care, rushing into the hot asset class without adequately discounting for complexity and risk. Even though the prosecutions of late-1990s book-cookers are still underway, investors have poured nearly $1 trillion into the ultimate black box, hedge funds, which are leveraged and make virtually no disclosures. The New York Times reports that the number of hedge funds jumped 209 percent from 1999 to 2004, making them a good candidate for the next wave of scandals.

The best way to cut through the complexity and monitor true risk is by giving professionals incentives to police it, but, as Skeel notes, they often have mixed loyalties. The New Deal reforms required auditor certification of corporate books, but by the '90s auditors had become corrupted by consulting work from their clients. As far back as the go-go 1960s, securities analysts' primary loyalty has been to their broker-employers, who need good news to get underwriting business and sell stock.

As Skeel notes, other laws actually undermined private incentives to control corporate excess: When the New Deal's Glass-Steagall Act separated commercial banking and investment banking, it broke up players who, with their need to maintain credibility with the investing public, had historically acted as a brake on corporate euphoria.

Yet there are signs that private monitoring is improving. The recent wave of celebrity CEO firings at companies like Disney and Hewlett Packard suggests that directors are becoming more aggressive in addressing management problems. And the great expansion of mutual funds and pension funds over the last quarter-century has reconcentrated ownership in institutional shareholders with deep analytical benches. While Skeel thinks that institutional investors have too many incentives not to rock the boat, their fiduciary duty to their investors creates a powerful incentive to intervene.

And existing law has shown resilience in creating incentives for honesty. Federalism (in the form of activist attorneys general such as New York's Eliot Spitzer) generates regulatory competition that makes it harder for crooked CEOs to neutralize their potential opponents. The evolving liability for high-tech financial products that help corporations conceal their risks--seen in multibillion-dollar WorldCom settlements by Citigroup and J.P. Morgan Chase, and in the fall of AIG's Maurice Greenberg--may make corporations more cautious about treading too close to the line. These flexible rules are more effective than command-and-control regulations that lawyers, bankers, and accountants can maneuver around in what Skeel calls a "cat and mouse" game.

Book-cooking would also be reduced by a resurgence of ethical values in business, even though Skeel mocks George W. Bush's post-WorldCom speech urging just that. But ethical standards are difficult to maintain in unstable, competitive markets: Consider Martha Stewart landing a reality show as soon as she left prison. America's celebrity culture rewards flashy posturing more than the long-term work of building a business, with its false starts and reverses. As Skeel observes, this turns executives into stars worthy of fawning media profiles. CFO Magazine gave awards like "CFO of the Year" to WorldCom's Scott Sullivan, Enron's Andrew Fastow, and Tyco's Mark Swartz. The first two pleaded guilty to felonies, while the third is awaiting retrial. Executives in the spotlight fear falling back in the pack, and juice the numbers to stay on top and get huge pay packages. A recent study by Kees Cools of the Boston Consulting Group quantifies this: Companies with large frauds had profit growth targets of 15-20 percent per year, and compensation packages to match, while nonfraud companies had mere 6 percent targets.

Things weren't perfect in the good old days, either. The golden age of corporate ethics was the clubby, oligopolistic world of 1900-1965, where executives and professionals from a common ethnic background (no Jews or minorities need apply) interacted repeatedly, so reputation mattered. Perhaps wall-to-wall media coverage can compensate for today's lower social cohesion: Stung by loss of reputation because of their misdeeds, many corporations are rediscovering ethics, with Citibank requiring mandatory online ethics training for all 300,000 employees.

Whatever the private incentives, the consequences of Icarus-effect business failures have diminished in economic significance, even though Skeel claims that "the risks have radically increased" at the company level. Jay Cooke's failure helped provoke a worldwide depression, but the later crashes of Milken, Enron, and WorldCom only contributed to mild recessions. The amount lost to fraud in the current cycle pales before the amount lost the old-fashioned way, through greed, in the dot-com failures. Of course, individual investors can get wiped out in business failures: They routinely underestimate the risks of an inadequately diversified portfolio, and severely underestimate the risk of having their pension invested in the same company that's providing their paycheck. Skeel correctly suggests limits on the amount of company stock that employees are allowed to own in their pension plans.

He goes beyond this, however, by proposing that government insure investors against stock declines or fraud, which would be catastrophic. When government covers losses, it almost always underprices risk, since interest groups advocating the "reform" want to expand their activities while pushing the tab onto taxpayers. This has led to flood insurance-induced overdevelopment in hurricane alleys, $350 billion in underfunding covered by the Pension Benefit Guaranty Corporation, and the monstrous growth of Fannie Mae and Freddie Mac. By encouraging investors to take even more risks with their money, Skeel's insurance would trigger an inevitable bailout that would make the S&L cleanup look as cheap as a Big Mac.

Icarus-effect failures are the price of an entrepreneurial economy, but the innovations live on. Insull's dream of low-cost universal electricity is today's reality; junk bonds remain a major financial tool; telecommunications consolidation has accelerated since Ebbers; and former Enron energy traders are now finding a place at investment banks, creating the markets that Ken Lay predicted. While auditors, directors, and investors have to watch CEOs like hawks during a boom, the rest of us have to resist populist overreactions during the bust that always follows.

Jay Weiser teaches law at Baruch College's Zicklin School of Business.