Today’s Financial Scandals Have Roots in Management Incentives of the High-Flying 1980sPublished: October 23, 2002 in Knowledge@Wharton
The financial scandals at Enron, Tyco, WorldCom and other companies victimized shareholders in the past year, but their roots lie in changes in incentives for management that date back to the 1980s, Columbia University Law professor John C. Coffee, Jr. told a recent Wharton conference on “New American Rules for Business? Post-Scandal Directions for Policy and Governance.” In addition, the financial watchdogs set up to oversee corporations failed, in many cases, to prevent fraudulent practices.
The incentive and compensation changes were designed to benefit shareholders, but to some extent they backfired, Coffee noted in a speech titled “What Caused Enron? A Short Legal and Economic History of the 1990s.” Linking corporate control and executive compensation to stock market price created both an obsession with the market and pressure to inflate earnings. Meanwhile, auditors and other gatekeepers had their own incentives to look the other way.
“Last year’s explosion in financial irregularities was the natural and logical consequence of trends and forces that have been developing for some time,” said Coffee. “Ironically, some of the developments were themselves well-intentioned reforms.”
The current debate over the nature of the scandals, and reform measures to prevent similar problems from surfacing again, have been marked by three major oversimplifications, he suggested. The first is that the rash of scandals was due to a decline in business morality. But according to Coffee, this notion reasons backward – “There has been an increase in scandals; there must be a decline in morality” – and it ignores the critical question: “What are the incentives?”
The second oversimplification is to contend that the scandals represent a failure on the part of boards of directors, said Coffee, even though recent corporate scandals grew out of different idiosyncratic finance and governance failures. There has to be a deeper common denominator than “the board was asleep at the switch.”
The third misconception is that scandal is inevitable following any market bubble. “This more cynical response says waves of recriminations, soul-searching and scapegoating necessarily follow any market bubble,” Coffee told the audience. “Obviously a frothy bubble burst between 2000 and 2001. But what led to the bubble? Bubbles are not entirely random. Bubbles may be caused by the failure of incentives and internal controls that made earnings ascend.”
Reform, he suggested, should focus on the financial system’s gatekeepers – the accountants, auditors, analysts, bankers and lawyers who constantly weigh incentives and risks when performing their jobs.
Obsessed with Stock Price
Coffee traced the changes in incentives back to the 1980s when academics were critical of corporate America, arguing that businesses had become bloated bureaucracies more concerned with firm size and executive power than profits or shareholders. But that changed radically with the rise of hostile takeovers made possible by junk bond financing, said Coffee. Conglomerates built in the 1960s and 1970s were worth more torn apart than whole. “The conglomerate was like the brontosaurus – off to the graveyard of antique creatures. This forced managers to focus, for the first time, on the day-to-day stock price and be obsessed with it.”
Simultaneously, he noted, executive compensation was undergoing a major transformation. The leveraged buyout firms taking over companies entered into alliances with existing management, or new managers, and promised the executives large equity stakes. Institutional investors applauded this link between compensation and ownership. The trend accelerated dramatically in the 1990s, but its roots go back a decade earlier.
“The two principle forces that changed American corporate governance in the 1990s were the takeover pressures that forced managers to focus on stock price day in and day out, and equity compensation that incentivized management to maximize shareholder value,” said Coffee. In addition, institutional investors had become increasingly active and were pushing governance issues. Deregulation was loosening up financial rules, and media fascination with the stock market also reinforced an obsession with share price.
In 1990 equity-based compensation for chief executive officers was 5% of total compensation, Coffee said. By 1999 it was 60%. Stock options rose from 5% of outstanding shares in U.S. companies in 1991 to 15% in 2001. The value of stock options at the nation’s 2000 largest companies rose from $50 billion in 1997 to $162 billion in 2000.
Quiet legal changes were also underway. Prior to 1991 a senior executive who exercised a stock option had to hold the underlying stock for six months. In 1991, the Securities and Exchange Commission allowed executives to exercise the option and sell the stock in the same day. “That became the prevailing pattern very rapidly,” Coffee pointed out. It presents for some managers a “perverse incentive to create a short-term price spike in the securities’ value … This is a scenario that does not align management interests with the shareholders’ interest but instead creates conflict.”
The nature of earnings management also changed in the 1990s, Coffee noted. Prior to that it was an accepted practice limited to innocuous income smoothing. Companies routinely stored away profits to ride out bad periods. But in the 1990s, earnings management began to involve premature recognition of future revenue, not the use of money already in hand.
A Proxy for Fraud
At the same time, life was changing for the financial system’s gatekeepers. For years courts and investors accepted the theory that gatekeepers would not risk their reputations for a single client, said Coffee. But he pointed out that last year Arthur Andersen had 2,300 audit clients and revenue of $9 billion. Enron paid it only $100 million. “Somehow something went wrong.”
According to Coffee, by the late 1990s, earnings restatements, long considered a proxy for fraud, were rising dramatically. From 1990 to 1997 there was an average of 49 restatements a year. In 2000 there were 156. This indicates auditors had looked the other way for several years – particularly in the area of premature revenue recognition – before the level of earnings management could no longer be sustained.
Auditors were not the only gatekeepers who failed, Coffee pointed out. As late as October 2001, 16 of 17 sell-side analysts covering Enron maintained a buy or strong buy on the firm. He also cited a study by Thomson Financial that found the ratio of buy to sell recommendations increased from 6 to 1 in 1991 to 100 to 1 by 2000. “Why did the watchdogs not bark in the night?” Coffee asked.
He gave two explanations. First he described what he calls the “general deterrence story.” This thesis argues that the potential liabilities faced by auditors declined while the benefits of using aggressive accounting practices increased.
Judicial rulings and legislation passed in the 1990s limited the exposure of auditors to class action suits and other liabilities, he said. For example, the U.S. Supreme Court’s 1991 Lampf, Pleva decision shortened the statute of limitations applicable to securities fraud. In 1994 the court eliminated liability for “aiding and abetting” in securities litigation, which had been the chief assertion against auditors.
On the legislative side, The Private Securities Litigation Reform Act of 1995, designed to protect firms from frivolous and costly litigation, also made it harder to bring class action suits alleging securities fraud by auditors and others. The Securities Litigation Uniform Standards Act of 1998 abolished state court securities class action suits.
Finally, Coffee said, the Securities and Exchange Commission shifted its focus away from cases involving potential fraud by large accounting firms because they were extremely costly and defendants resisted vigorously.
Audit Work: A ‘Loss Leader’
While liabilities were diminishing, the benefits to auditors of acquiescing to management were going up. Audit work became a “loss leader” for accounting firms, which used it as a way to cross-sell more expensive consulting services, Coffee said. By 2000 a typical large public corporation was paying its auditor three times as much for consulting work as for auditing services.
“The idea that gatekeeper services could be derogated to a loss leader is again not limited to the accounting profession,” Coffee added, noting that investment banking firms subsidized their research departments as a means to draw in more lucrative business, such as underwriting initial public offerings.
An alternative theory to the “general deterrence story” is what Coffee called “the irrational market story.” In this version of events, gatekeepers became less relevant to investors in a market bubble. “In a time of market euphoria, management can regard gatekeepers as a formality, a nuisance, a formal necessity, but not a market or economic necessity.” As a result, the auditors’ reputations matter less and auditors begin to sell themselves cheap. The same notion applies to research analysts, Coffee said.
These two theories, he added, apply in varying degrees to the range of corporate scandals. The bubble theory applies better to the analysts because they were not sued as frequently as the auditors. The deterrence story generally applies more often to auditors.
Coffee raised one last question that he said needs to be factored into an analysis of what led to Enron’s collapse: “What causes a market bubble?” With managers focused on equity prices, earnings were manipulated by recording future earnings into current results, he said. But that led to a larger change: “Gatekeepers and investors began to accept this as the status quo. When you assume status quo, there is less reliance on gatekeepers.”
Meanwhile, the Public Company Accounting Reform and Investor Protection Act of 2002, known popularly as the Sarbanes-Oxley Act, is a well-intentioned, but incomplete, response to the scandals, Coffee suggested, adding that the provisions addressing conflict of interest by auditors are adequate, but there remains limited legal liability for executives and gatekeepers who dupe investors.
Congress, he predicted, is likely to review the legislation in the coming year. However, the true search for reform would be to weigh remedies that include litigation against those that do not. For example, he pointed to the new requirement that calls for the rotation of auditors, although he said even this falls short of ideal because it only requires rotation of the lead partner, not the audit firm itself.
Firms will object to such change, he said, but will likely go along if it means they can fend off efforts to return to the level of liability they faced in 1990. Those levels, he added, were too high to be good for the economy or to be sustainable.
“We should be looking at all this,” he concluded. “We can’t believe that the only answer to Enron is a decline in business morality. That may be the symptom, but the underlying cause may be the change in the incentives.”