The Magazine

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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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.