Why Smart People Do Unethical Things: What’s Behind Another Year of Corporate Scandals

mic Listen to the podcast:

You can get a sense of the breadth of the scandals that have tarnished Wall Street and corporations across America in the last few years by recounting just some of the people who have pleaded guilty, resigned under fire or are being investigated: Kenneth Lay, Andrew Fastow and Jeffrey Skilling of Enron, Jack Grubman of Citigroup, Bernard Ebbers of WorldCom, L. Dennis Kozlowski of Tyco, John Rigas of Adelphia Communications, Joseph Bernardino of Arthur Andersen, Gary Winnick of Global Crossing, Martin Grass of Rite Aid, Richard Grasso of the New York Stock Exchange, Samuel Waksal of ImClone and his friend, businesswoman Martha Stewart.

 

You might think that with the passing of another year, the scandals would be showing signs of petering out, but they are not. In the past few months, disclosures of allegedly unethical or illegal practices have rocked the mutual-fund industry and some of its blue-chip names: Strong Funds, Putnam Funds, the former Prudential Securities and about two dozen other financial firms. In December, Phil Condit quit as chief executive of Boeing, a corporate icon, in the wake of a probe of the company’s recruitment of an Air Force official while she was overseeing the company’s contracts with the Pentagon.

 

The end of the year is a season for celebration but also a time for taking stock. Knowledge@Wharton spoke to ethics experts, a business historian and a Wall Street executive in an attempt to understand why America has witnessed misbehavior of breathtaking scope in the first few years of a new century. What was it that triggered such a deluge of questionable practices, ranging from the hefty compensation package given to Grasso to the brazen activities that brought down Enron and WorldCom? Why were so many people willing to look the other way at the longstanding practice of securities analysts touting stocks to help their investment banking colleagues obtain underwriting business? What could entice someone like Strong, a millionaire many times over, to make questionable securities trades that could jeopardize both his good name and the health of a company he founded and nurtured for nearly 30 years? Why would Stewart risk her considerable fortune and her company’s brand name for $45,000, the amount she allegedly made through insider trading?

 

According to these analysts, any number of factors help explain what has been going on: The temptations inherent in the enormous amount of money which corporations and Wall Street firms found themselves awash in during the go-go days of the 1990s; compensation practices that encouraged short-term thinking by linking executive pay to a company’s stock price; a haughty sense of entitlement and a hubristic willingness to push business practices to the limit; a misguided understanding of why businesses exist in the first place; an increasing estrangement from customers; technical and opaque financial and accounting tools for which no ethical guidelines had been developed;  and boards of directors who, through somnolence or negligence, allowed so much mischief to go on under their noses and in some cases approved it outright.

 

Thomas Donaldson, an ethicist in Wharton’s legal studies department, and business historian Paul Tiffany, who teaches management at Wharton and at the Haas School of Business at the University of California, Berkeley, say that today’s misconduct is just the latest tsunami of wrongdoing to wash over the shores of American business. The country has long witnessed periods of scandals, followed by new laws and regulations to address the misbehavior, only to be followed once again, after a relatively quiet interval, by more wrongdoing.

 

These include the Teapot Dome scandal of the 1920s, which involved the secret leasing of federal oil reserves by a secretary of the U.S. interior department; the defense-contractor scandals of the 1970s and 1980s; the Wall Street insider-trading disclosures, also in the 1980s, which made household names of people like Michael Milken and Ivan Boesky and toppled the firm of Drexel Burnham Lambert; and the savings-and-loan debacle of the 1980s.

 

Donaldson says two triggers sometimes cause scandals to be uncovered and brought to public attention.  One is a depressed economic environment coming on the heels of a period of euphoria; think of the 1930s, which followed the Roaring ‘20s, or today’s scandals, the details of which began to emerge after the high-flying ‘90s fell apart and stock values plummeted in 2000. “As the level of the lake lowers,” he says, “you start to see the wrecks as they come to be exposed.”

 

The second trigger can be innovations in technology or financial instruments. “We have seen the same phenomenon in business that happens in medical ethics,” notes Donaldson. “When you get a new technology, like in-vitro fertilization, you have new problems because public morality hasn’t wrapped its arms around the mysterious new arrival.”

 

He recalls that the disclosures involving Milken had a lot to do with the new practice, pioneered by Milken during his time at Drexel, of using junk bonds to finance the hostile takeover of companies by a new breed of businessperson called the “corporate raider.” The same was true in the 1990s scandal involving the use of derivatives, which are complex financial instruments that few investors fully understand, and in the Enron case, where complex accounting structures were used to create off-the-books partnerships in an attempt to conceal debt and make earnings look better than they were. “These were all financing measures that hadn’t been tried out before,” Donaldson says. “The industries didn’t know how to keep ethical score.”

 

Tiffany says something deep-rooted also comes into play in trying to explain why scandals occur: the tension that exists at the intersection of an 18th century ideal still dear to many Americans – that small, decentralized institutions prevent the emergence of the corruption and tyranny associated with centralized power – and the reality of the ascension of the large corporation and its pivotal figure, the professional manager.

 

“The rise of the large corporation in the late 19th century was a challenge to the traditional way of doing business,” Tiffany explains. “Before, everything had been premised on a small scale so that individuals could be free to do what they wanted. The large corporation changed everything. The notion of the robber baron emerged in the 1890s,” bringing with it the idea “that the U.S. had been taken over by an evil cohort of bad guys.”

 

In Managers We Trust

Along with the corporate abuses of the nineteenth century came a new sense of corporate social responsibility – the sense that “the individual manager could be trusted to do the right thing and not abuse the public interest while he pursued private wealth creation,” says Tiffany. “There’s a lot riding on this responsibility. The U.S. has never reverted to the extreme approaches that Europe has taken, like nationalization of industries, to guard against abuse. We’ve never done that, but not doing that puts the onus on private managers to do the right thing.”

 

Also accompanying the rise of the modern corporation was the notion of limited liability. In some forms of company ownership, all of an owner’s assets are at risk in the event of a legal action against the organization. But with limited liability a shareholder’s liability is restricted to the amount of the investment he or she has in the company. Limited liability has had the benefit of encouraging the formation of corporations, but it also has sown the seeds for possible abuses because it removed the owners of companies from their daily management and oversight. With the separation of ownership and control, shareholders no longer controlled firms. Inside managers controlled companies even if they did not own shares. “The earlier notion of the corporation was that stewardship was vested in owners who were active managers,” Tiffany says, adding that separating ownership and control can lead to problems.

 

Lawrence Zicklin, chairman of the Wall Street firm of Neuberger Berman, has taught corporate governance at Wharton and New York University’s Stern School of Business for many years. Like Tiffany, he sees a similar disconnect at work in explaining today’s scandals, particularly those involving mutual funds – a growing gulf between companies and their customers. Many firms on Wall Street are currently “estranged from clients in their day-to-day dealings,” he says. “With mutual funds, you don’t even see clients. Nobody knows the client or the circumstances of that client. Clients are a computer number.”

 

Zicklin sees other forces at work: the hyper-competitive nature of the mutual-fund business and the willingness of fund executives to push ethical boundaries to add to their bottom lines. It has been alleged that some mutual funds have either broken the law or gone against their own internal policies by allowing hedge funds and other investors to engage in either market-timing or after-hours trading of a kind forbidden to ordinary mutual-fund investors.

 

But he goes on to cite a more overarching reason for unethical behavior: the general erosion of a moral culture at many companies. “Business to a large extent has lost a lot of its culture,” he says. “At one time, companies had a culture that would forbid them from” overstepping ethical boundaries.   

 

The Love of Money

In some of the many scandals of recent years, people were driven by an old temptation – making more money. But it was a matter of amassing wealth not necessarily to buy more things, but to bolster one’s self image. “I think money is more than what you can consume; it’s also this business of using money as a way of keeping score of your success,” Zicklin says. “For a man like Dick Strong to market-time his own fund [for an alleged gain of $600,000], where is the rationale in that? He’s worth $800 million. But I guess some people become so competitive they’ve got to win every single day.”

 

Wharton legal studies professor Thomas W. Dunfee, who has taught business ethics since the 1970s, sees several possible explanations for the behavior of the people caught up in today’s scandals. He doesn’t, for example, think that love of money tells the whole story.

 

“It really doesn’t seem to be the money, per se, in the sense that you can make a rational case for the risk-reward aspect of their actions,” says Dunfee. In most of these cases, there were relatively small amounts “to be gained and entire careers and reputations to be lost. It just isn’t rational that they were motivated by the dollars. So what are other possible explanations? One explanation that’s common in the field of business ethics, and this may sound shocking, is that they just didn’t recognize the ethical issue for what it really was. At Putnam, they didn’t think about how [allowing some clients to engage in market-timing] would appear to their customers. Surely they couldn’t be so out of touch with their customers that they would miss the fact that the [public] reaction would be so strong that millions of dollars would be pulled out of their funds at a time when inflows are going into other funds.”

 

Another possible explanation is that wealthy, well-positioned people felt they were entitled to just about anything. “I do believe that in the last five to 10 years there’s been a socialization of a sense of entitlement among the senior ranks of organizations,” Dunfee notes. “Even well-paid people with enormous compensation [packages] think that they are such high performers that they are underpaid. Grasso’s reaction [to the furor over his $140 million retirement package] was, ‘Hey, I’ve done great things for the exchange, and I’m a bargain.’”

 

Ronald E. Berenbeim, director of the Conference Board’s Working Group on Global Business Ethics, says the Grasso case underscores the extent to which members of the board of the New York Stock Exchange, and other boards, have lost touch with reality when it comes to proper levels of compensation.

 

“What happened with Grasso is you had a bunch of people sitting on that board who did not consider this a huge amount of money and thought it would be embarrassing to pay him less,” Berenbeim says. “Why did they think that? That was the manner in which they were compensated. Why were they compensated that way? This gets us back to the matter of stock options and how people lost any sense of reality of what was a realistic level of compensation.”

 

Berenbeim recalls how changes in the tax laws in the 1990s eliminated the ability of corporations to deduct, as a business expense, annual compensation to executives above $1 million. As a result, boards turned to stock options, tied to the company’s stock price, as an alternative way to pay their CEOs big money. He sees no end to high-flying forms of compensation until boards rethink the whole issue of what CEOs are worth.

 

“Unless you get a somewhat different view regarding the overall contribution of business to society and the contribution that the CEO makes to the performance of the company, this will not change. You have a situation where people think of a company as a movie. Movies have stars and stars are highly paid and that’s the only reason why people go to those movies. This is believed by directors and chief executives alike. As long as people believe CEOs are worth it, that’s what they’ll get paid.”

 

Berenbeim also says self-delusion played a role in the excesses of recent years, as the dot-com boom caused otherwise smart people to think that the world had entered an era when corporate earnings mattered less than the excitement over unproven start-up companies and dubious business models. It was a time when companies, in an attempt to avoid “surprises” that would upset Wall Street analysts and rattle the companies’ stock prices, began using accounting techniques to “smooth out” their earnings. Before long, the so-called “whisper number” – the insider forecast for a corporation’s earnings – became a regular feature on business TV programs.

 

For about two years before the stock market plunge in early 2000, says Berenbeim, “people believed we were in a ‘new economy.’ Remember that? They didn’t think these [profit] numbers had any real meaning anyway. If companies wanted to manage their earnings, what difference did it make? This kind of thinking was rather easily adapted to the view that [ethical] fundamentals don’t matter.”

 

Going to Extremes

R. Edward Freeman, director of the Olsson Center for Applied Ethics at the University of Virginia’s Darden Graduate School of Business Administration, says there is nothing new about business scandals. But he does think the idea that management’s only goal is to maximize shareholder value – doing just about whatever it takes to boost a company’s stock price – has been taken to extremes.

 

“There’s nothing new about [today’s scandals] and nothing’s been fixed,” he says. “Our idea of what good management is has been hijacked. We pay attention to shareholder value and managing value.  If you give a small boy a hammer, the world looks like a nail.”

 

Truly good management, Freeman says, is “paying attention to customers, having suppliers who want to work with you and want to make you better … It’s being a good citizen in your community. If you do all that you’re going to make money. We have focused on the making-money part and not the other parts. Some people say it’s shareholders versus stakeholder, but I say no. Enron didn’t go bust because the CEO stole $43 million. Enron went bust because somewhere its leadership forgot about customers. My take is we’ve got to go back to the basics.”

 

Freeman points out that in a 1994 book, Built to Last: Successful Habits of Visionary Companies, authors Jim Collins and Jerry Porros examined companies that had been around at least 50 years and had significantly outperformed their competition.  Each of these companies had as its core purpose something other than making money.

 

Far too many people, according to Freeman, believe that “business ethics” is an oxymoron and act accordingly. “It’s deeply embedded in our culture that business is about greedy little scoundrels trying to do one another in. It’s the separation of business and ethics that’s behind [many of the scandals] … We’ve got this idea that business means anything goes. No one’s arguing we need more [central] planning.  Everyone understands that business is the answer to economic prosperity. Unfortunately, we’re telling the wrong story about business.”

 

What is the right story? Says Freeman: “Business is a way to cooperate to create value that no one of us can [create] alone.”

 

Looking ahead, Wharton’s Dunfee says it is time that companies and ethicists take a hard look at a relatively unexplored area of business ethics – the role that boards of directors ought to play in ensuring that companies engage in ethical behavior.

 

“People have not adequately focused on the ethics of the boards,” says Dunfee, who is writing a paper on the subject with two co-authors. “The board sits at the apex of the corporation and has ultimate responsibility for compliance and ethical behavior. What does the board do when approached by a whistle-blower who says the CFO is cooking the books? Does a board member call the CEO and ask that the staff look into it? Or do you have independent resources to investigate?”

 

Half Full, Not Half Empty

The relentlessness of today’s scandals may set some kind of record for the number of corporate miscreants crowded into the space of a few years. But Wharton’s Donaldson sees the glass as half full, not half empty.

 

“I don’t think you can say that greed increased in the 1990s. People won’t like to hear this, but if we could measure greed, it would be a straight line. Greedy people are around all the time. What changes is the mechanism that causes people to be greedy. One bright spot to all this is we live in a culture where scandals happen. In many cultures in the world, this stuff would have been covered over. We err by hanging them too high sometimes, but we have a healthy distaste for shenanigans by public institutions. That’s a healthy American sentiment, much more so than in Europe. We’re more inclined to hang out our dirty wash.”

 

Ethicists, according to Donaldson, have learned that there are limits to the “compliance” approach to ethics, which says that employees are behaving ethically if they merely adhere to written ethical codes. Ethicists see the compliance approach as just one step above the notion that following laws and regulations are all that an employee or a manager need do to be considered ethical.

 

“With a compliance approach, you deal with problems that are old, not new; you’re fighting the last battle,” Donaldson says. “Enron won awards for corporate governance and risk-management processes, but these didn’t deal with off-the-books transactions. On three separate occasions, Enron’s board voted to allow Andrew Fastow [the chief financial officer] to head those ‘special-purpose entities.’ So will compliance take care of something like that? No. Rules are always in place. The question is, how do you prevent the mechanism from being abused? And the answer often lies much more heavily with culture, leadership and reward systems than with compliance. The level of ethical sophistication – our savvy and skill – will continue to rise. This is not to say we won’t have Enrons of the future, but we’re learning.”

 

Zicklin of Neuberger Berman, puts things more succinctly. Repeating a quotation he attributes to Alan C. “Ace” Greenberg, the legendary chairman of the executive committee at The Bear Stearns Companies, Zicklin says: “People are basically honest. And they’re even more honest when you watch them.”

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"Why Smart People Do Unethical Things: What’s Behind Another Year of Corporate Scandals." Knowledge@Wharton. The Wharton School, University of Pennsylvania, [14 January, 2004]. Web. [20 October, 2014] <http://knowledge.wharton.upenn.edu/article/why-smart-people-do-unethical-things-whats-behind-another-year-of-corporate-scandals/>

APA

Why Smart People Do Unethical Things: What’s Behind Another Year of Corporate Scandals. Knowledge@Wharton (2004, January 14). Retrieved from http://knowledge.wharton.upenn.edu/article/why-smart-people-do-unethical-things-whats-behind-another-year-of-corporate-scandals/

Chicago

"Why Smart People Do Unethical Things: What’s Behind Another Year of Corporate Scandals" Knowledge@Wharton, [January 14, 2004].
Accessed [October 20, 2014]. [http://knowledge.wharton.upenn.edu/article/why-smart-people-do-unethical-things-whats-behind-another-year-of-corporate-scandals/]


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.

 

Join The Discussion

No Comments So Far