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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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.