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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.