A Long (Range) Look at the Markets, Executive Stock Ownership and the Public TrustPublished: October 23, 2002 in Knowledge@Wharton
In addition to the reforms that have been proposed or enacted in response to recent corporate scandals, deeper changes in corporate governance – many of them focusing on a longer time horizon – are necessary to avoid the missteps of the recent past. This was the consensus of experts on regulation, executive compensation and ethics who participated in a panel titled “What Governance, Who Leads? Perspectives on Routines and Norms of Corporate Governance in the U.S.”
Cynthia A. Glassman, who became a member of the Securities and Exchange Commission in January, quickly dispensed with finger-pointing to focus on the future. “All of the institutions that provide protection against fraud by sell-side analysts, lawyers, auditors, rating agencies, officers and directors failed to varying degrees.”
The Public Company Accounting Reform and Investor Protection Act of 2002, also known as the Sarbanes-Oxley Act, is a start, Glassman said, adding that reform must go deeper than technical compliance. “In my view reform embodies the idea of good governance and an objective of restoring the public trust.”
In addition to Congress’ legislative response, Glassman noted that the SEC has also initiated regulatory reforms, many of them before passage of Sarbanes-Oxley in July. Those reforms include new rule-making provisions that seek to accelerate financial reporting and to certify analysts. The agency has also stepped up reviews of corporate filings and is offering more investor education programs.
Glassman addressed the role of markets in correcting the abuses of corporate America in the past year, and the possibility that Sarbanes-Oxley and other attempts at reform may create unintended consequences that will generate new problems in the future. “The long history of financial scandals shows markets have a way of disciplining those who violate the public trust,” said Glassman. She pointed to the rating agencies’ decision to include stock options as expenses even though it was not required by U.S. accounting rules. She also said auditors appear to be issuing increasingly aggressive opinions.
However, she noted that as a commissioner she must constantly weigh the benefits of proposed reform against the possibility of creating unintended, and harmful, consequences. “Though we may all be furious,” she said, “you must acknowledge that most of our corporations are doing the right things and are not pillaging and looting their companies and investors.”
In her mind, she added, the most important elements of regulatory reform will be to create incentives that align management and shareholder interests for the long-term. The steps toward reform taken so far are heading in that direction. “But whether there is more that should be done, only time will tell.”
Re-examining Stock Ownership
Ira T. Kay, global practice director for compensation consulting at Watson Wyatt Worldwide, described stock options as an imperfect solution to concerns that executives were running corporations without regard to shareholders. Kay said companies are already paring back stock options dramatically and he predicted they will be required to record options as expenses by 2004.
However, he warned of overreacting to the excesses that have come to light through the recent corporate scandals. “Executive compensation is a critical force in economic success. It is not the only thing that drove the U.S. economic miracle, but it was an important part.” Kay also said that despite the well-publicized failures, most companies played by the rules.
Executive stock ownership is essential to good management, Kay pointed out, but it does not have to come through options. “Why don’t we just make them buy the stock?” he asked. Companies with a high percentage of ownership by chief executive officers, excluding options, substantially outperform other companies with higher chief executive officer pay, he noted. “We have been worried about stock options for many years. Stock option usage has been too high and the market has been voting against it this year.”
Companies should encourage executives to own shares by raising ownership targets and requiring a certain percent be held after exercising an option. But Kay would not go so far as to suggest that executives hold their shares until the end of their career. He said that could hurt the company because the executives would become too risk averse.
He presented a proposal to take insider-selling disclosure to another level – requiring executives to announce they are going to sell stock before they actually do so. According to Kay, if executives were required to say they were going to sell stock in a few days or a week, that would eliminate short-term earnings manipulations.
“Unreasonable Pressures from the Top”
Legal studies professor Thomas Donaldson, who teaches ethics at Wharton, discussed the role of ethics in the current debate on the future of corporate governance. He suggested that while societies can rely heavily on market forces, or regulatory structures such as the SEC, to police behavior, these structural measures are usually a step behind the times. Ethical standards are necessary to limit damage from problems that arise before legal or other mechanisms are created to deal with them.
For example, people working in the asbestos industry were aware of asbestos’ health hazards long before the asbestos litigation and legal settlements, he said. “The law inevitably lags behind.”
Ethics are also necessary for efficient markets, Donaldson noted. The World Bank and the International Monetary Fund have frequently pointed out that corruption leads to misallocated resources and hampers economic growth. Research indicates, he said, that ethical practices translate into good business. “The results are encouraging. The vast majority of the studies show positive correlation between ethics and traditional performance measured.” However, he cautioned that many of the authors of the studies have an interest in ethics and that may skew the findings.
Donaldson then discussed how society can foster ethical practices in business. In a typical corporation, he said, the people at the top of the organization have a much more positive view of the firm and its ethics than the people lower down. The people at the top and their lawyers draft ethics codes and statements, then believe they have addressed the issues. But “most companies get it dead wrong,” Donaldson noted. “Codes or statements about written beliefs … are at best a start.”
A better approach would be to address what Donaldson called “risky currents” that can sweep up executives who believe they have good business ethics. “The tendency is to look for creeps, dirtballs and the kind of person who never calls his mother and his mother is happy about it.” But that won’t uncover the real problem, Donaldson said, noting that while individuals like Enron’s Jeffrey Skilling and Kenneth Lay stand out, there are hundreds of others at scandal-ridden companies who were also swept up into currents generated by “unreasonable pressures pushed from the top.” He said people with sound ethics can lose those values if they work for long periods of time in an environment where unethical behavior builds slowly until a precedent is set and accepted.
One powerful way to reward good ethical behavior on the corporate level is for firms to work together, Donaldson suggested, adding that companies have done this in conjunction with nonprofit organizations to combat corruption in other parts of the world. If all companies in an industry stand together, they can eliminate bribery and other costs of corruption without having one firm face a competitive disadvantage for embracing ethical behavior.
Donaldson also called for a reexamination of executive compensation levels. He said the current system presumes there is a rational means of finding an optimal point where incentives generate economic return. But at the recent stratospheric levels of compensation that seems impossible. “There are times I’m embarrassed to be an American with compensation levels where they are.” Kay, the compensation consultant, defended current levels of compensation, arguing they are the product of an efficient labor market.
Counting the Roosting Chickens
Sidney G. Winter, co-director of the Reginald H. Jones Center, wrapped up the conference with a talk entitled “Looking Ahead” in which he suggested governance issues should be approached with a view two to 20 years out. “Proposing that the past is a good indication of the future is suspect. Great fortunes have been made by doubting this proposition.”
Winter said he and other academics used to lecture that accounting was only a view of the past and that the stock prices established by keen investors and analysts offered a true picture of the market. The scandals and market declines of the recent past, however, have changed the story. “It was a great shtick in its time. It seems like a tale whose charm lies in its innocence.”
Going forward, Winter has formulated guideposts for dealing with accounting and governance issues. The first is to accept that the difficulty of looking ahead is at the heart of all asset valuation. Second, financial accounting is about the past and should not attempt to incorporate the future. Indeed, many of the scandals resulted from accountants applying future revenues to past periods. “If reform is needed here, it is in restraining the tendency to smuggle in future revenue.” Reforms aimed at financial accounting, he said, will not resolve the central problem for investors attempting to arrive at valuations: knowing the future. “All of those reforms will leave a big and central problem untouched.”
Winter said the relevant time period for valuations is two to 20 years ahead. Beyond that, there is too much uncertainty. The period up to two years ahead is already largely determined. “We do live with great uncertainties, but our collective underachievement is with this mid-range. Our stock market needs help in thinking about that mid-range future.”
According to Winter, a better image of an impending bull market would temper a harsh bear market. Likewise, remaining mindful of recession can dampen over-expansion during good times. He said many believe the boom-and-bust cycle is simply the nature of capitalism. But he argued there are ways to make the process less painful. “A lot of constructive institutional change has happened in the past, and a lot more can be done.”
If CEOs are to look ahead to the mid-range period, they need new incentives, Winter said. Currently they have enormous incentives to focus on near-term results, and performance measures are easily manipulated, even in accordance with the rules. “I would argue it is the legitimate manipulations that pose the most consequences,” Winter added. He pointed to the example of cost-cutting, which is not a form of financial fraud, but can generate a short-term earnings boost at the expense of a company’s long-term health.
Winter suggested investors need to rely more on an understanding of strategy to bring the mid-range future into better focus. Institutional investors have the incentive – indeed a fiduciary duty – to look into the future to generate long-term returns for retirement investors and others with a similar horizon. “Strategy people have a comparative advantage in thinking about that mid-range future,” he added. “The tool kit for such analysis is substantial and badly under-utilized.”
That belief, he said, is founded “on the fact that a lot of really dumb moves seem to get made – and not just by business leaders, but by big investors who encourage them and finance them.”
Winter made two specific recommendations for improving long-term focus in the markets. “There is an interest in keeping the equity markets grounded in reality, so that they do not mess up the real economy with their tendency to bipolar disorder. The institutional investors ought to do something about it.”
He suggested institutional investors band together and fund a permanent, non-profit organization to do independent analysis of the economic environment and the strategies of public companies and entire industries in that context. The research should be free and made available to everyone.
Finally, Winter said, performance should remain a benchmark for executive compensation, but it should also incorporate an element of performance over time. “My central proposal is to backload (compensation) until well after the CEO steps down and someone else has the chance to count the chickens that come home to roost.” This would benefit patient long-term shareholders, he noted.
In thinking about ways to clean up the mess left by Enron and others, Winter urged policy makers to think in the “future retrospective tense … Move yourself 10 or 20 years [ahead] and assume one of these institutional innovations has been made,” he said. “Ask how you feel about it. That is a device of thinking that gets round the barriers to change. Some institutional changes will happen but they will only happen after a lot of controversy and arguments about who will pay and whether it will work. Then, in 10 years or less, most people will say ‘How did we ever manage to get along without that?’”