Corporate Reform Proposals: On the Money or Off-base?Published: July 17, 2002 in Knowledge@Wharton
Republicans and Democrats are stumbling over each other to show who can be toughest with corporate wrongdoers. The House and Senate have passed competing legislation calling for everything from longer jail terms and statutes of limitations to new accounting rules and oversight boards.
Are they going overboard? Or are they not going far enough? Left alone, will the marketplace provide its own remedies to scandals like Enron, Tyco and WorldCom? Or are the corporate scandals of 2002 a prime example of the need for government intervention? What remedy would have the best chance of success? Knowledge@Wharton put the question to five Wharton faculty members.
“I think the problem is we’re going at this piecemeal. You want to look at it holistically,” says Wharton accounting professor David F. Larcker. It is far from certain, for example, that proposals to force top executives to take personal responsibility for financial statements will really prove an effective deterrent to misstatement, he notes. While the idea sounds good in principle, a final rule would have to be flexible enough to provide for errors a CEO might not be able to prevent, thus opening loopholes that could benefit deliberate wrongdoers.
“It’s inconceivable that the CEO of a company could have super-detailed knowledge of every accounting practice,” Larcker says. “It’s good political rhetoric, but how it would actually be applied is anyone’s guess.”
Ultimately, the marketplace may help correct many problems without new regulation, Larcker adds. Executives with tainted histories should have more difficulty becoming CEOs, accountants will be careful not to follow Arthur Andersen’s path to destruction. Investors may reward companies with super-clean, transparent statements by bidding up stock prices. “It’s got to be the case that, but for the grace of God, it could be me,” he says.
Finance professor Andrew Metrick concurs that the marketplace, rather than new regulation, will do the most to correct corporate problems. While he thinks some regulations can be improved, he agrees that rules that are too specific can sometimes inadvertently provide loopholes. “You want CEOs, accountants and lawyers to look at what a company is doing and to really be nervous about misleading investors in any material way,” he says. “You want them to throw up their hands and say, ‘Why bother misleading people? They are going to find out anyway.’”
In a series of interviews in mid-July, three other Wharton professors spoke at length about the corporate scandals and possible remedies. Following are their thoughts.
Gerald R. Faulhaber, professor of management and public policy, considers the current crisis in confidence aimed at corporate America to be “much more serious than I think a lot of people do. The fact of the matter is that all investments in all capital markets rely on trust … If you don’t have trust, then investing in the capital markets becomes a mug’s game … We all know that if you invest in Third World countries where there are no safeguards, you’re going to get taken to the cleaners.”
Two factors have aggravated the situation in the past decade or so, Faulhaber adds: The compensation for CEOs “has gotten obscene” and the tenure of the average CEO had plummeted. The result is an impulse to “take the money and run.” At the same time, he says, accounting firms have come to rely more and more on income from consulting. Many accountants argue that the two roles complement one another.
But Faulhaber says that auditors and consultants actually have little to do with one another, that neither group’s work is improved by the involvement of the other. In fact, he suggests, the only way the accounting firm benefits from the dual role is by exploiting the conflict of interest – pulling punches in audits to ensure a continuation of consulting business. “The auditing system in this country has failed,” he says. “It’s systemic failure. It’s one that I think threatens American capitalism.”
He supports the idea of banning accounting firms from providing both services to the same clients. “It should have been done years ago. We’re not giving up anything, and we’re potentially gaining a lot.”
While he has not worked out the details, Faulhaber also argues that the nature of accounting must change to put less emphasis on following a checklist of rules and more on whether the audit, in its entirety, accurately depicts what is going on within the company. Auditors should be required to be detectives, and should be liable for the accuracy of their reports, he suggests. In addition, companies should be required to change auditors every five years or so. “You get too cozy there. It’s not a good idea.”
Faulhaber does not believe that making directors more accountable will prevent failures of corporate governance, as some have suggested. Part-time directors have no choice but to rely on managers for information about the company, and it is easy for managers to conceal or misdirect.
Finally, he says, it is less important to establish longer prison sentences for corporate criminals than it is to make sure they are caught and incarcerated for some period, even if short. Powerful executives tend to think they are bulletproof, he notes, and nothing will deter crime better than the real threat of having to don an orange jumpsuit.
Marshall Blume, professor of financial management and finance, is a member of the shadow regulatory committee of the American Enterprise Institute. In that role he participated in a recent study of the Enron debacle.
“What we concluded was that if the auditors for Enron had done their job, Enron would not have happened as it did,” he says. “This means that the general accounting procedures – GAAP – are strong enough. We then concluded that methods have to be found to cause auditors to do their job properly.”
Yet it is difficult, he notes, to find remedies that don’t create new problems or undercut current safeguards. The recently passed Senate bill, for example, would ban accounting firms from doing consulting work for companies they audit. But, says Blume, some experts argue that consulting actually gives accounting firms better insight into the firms they audit.
Similarly, President Bush wants corporate executives to sign off on their companies’ financial statements so they can be held liable for incorrect reports. But some legal experts believe executives are accountable under current rules. Using new rules to establish accountability could imply that executives accused of wrongdoing in the current cases were not legally accountable. Hence, new rules could undermine legal cases growing out of the current scandals.
Blume notes that the two cases getting the most attention are quite different. It appears that Enron executives attempted to follow the letter of the rules in a way designed to deceive – using accounting loopholes to hide enormous debt. But at WorldCom, executives simply violated the rules to inflate profits.
Whether to treat the two cases as equally egregious is a tricky regulatory question, Blume says. Inevitably, the decision will affect cases down the road. In some respects, he adds, these are like pornography cases: It may be hard to define corporate misconduct, but most people will know it when they see it.
Among the issues getting much attention in Washington is whether executive and employee stock options should be counted as a business expense, as are other forms of compensation. Doing so, advocates say, will make the cost clearer to shareholders. That should discourage the excessive use of options, cutting back executives’ incentive to doctor the books to achieve quick stock price gains for their personal benefit.
This is not a gray-area issue, says Blume. “I think they should be expensed, definitely,” he notes, arguing that options are a liability that will cost shareholders money one way or another. The books should reflect that.
Blume expects continuing revelations over the coming months. “The auditors are going to be cleaner than ever in the next few rounds of auditing, and we’re going to find a lot of surprises.”
According to management professor Michael Useem, director of Wharton’s Center for Leadership and Change Management, “First of all, we need to remember that we have come a long way from where governance and accounting and disclosure were 20 years ago… All are better. At this moment, we need to further strengthen the way that boards and their policies operate.”
The Securities and Exchange Commission, the New York Stock Exchange and the Business Roundtable have come up with ways to ensure that boards are more independent of the managers they oversee, he says. In general, these proposals require that a majority of a company’s directors be outsiders rather than managers. The new rules and proposals impose stricter definitions, requiring, for example, that an outside board member have no family or business ties to the company.
As many as a quarter of the companies listed on the NYSE will have to alter their boards to comply with the exchange’s new rules by this fall, he says. “That’s a regulation which I think will significantly improve the independence of boards in two months.”
Historically, Useem points out, the chief executive serves as the chief recruiter for board vacancies. In theory, this produces a board that works well with management. But the system is obviously open to abuse by CEOs who want to bring on cronies. It is important, therefore, that nominating committees be composed entirely of outsiders, Useem suggests.
Currently, director candidates nominated by the board typically get 99% of the vote. Some shareholder activists would like to make it easier for unhappy shareholders to nominate alternate slates. But it is so expensive and difficult to mount a proxy challenge that this is not likely to be much of a remedy, Useem says, noting that each side spent scores of millions on the recent Hewlett-Packard fight.
On the other hand, angry shareholders have become increasingly effective at using public humiliation to press for change, he adds. Groups such as the Council of Institutional Investors, which represents the nation’s largest pension funds, have been able to produce change by publicizing an annual list of the worst performing companies.
Mutual fund companies now own so much stock that they, too, have the clout to demand change, according to Useem.
With members of Congress voting for reform by wide margins, and with regulators and prosecutors on the hunt for malefactors, companies are likely to play straight for some time, he adds. “The pendulum has really swung, for the moment, in favor of investor power.”