After the recent scandals, only a complete overhaul of business ethics can restore the integrity of the corporate and financial worlds. What is needed, above all, is leadership. Jeffrey Garten spells out what needs to be done – and who needs to do it. –

American business scandals have usually unfolded in a predictable pattern. A transgression comes to light, accompanied by the drumbeat of sensational news stories. One or more bankruptcies are involved. This is followed by high-profile congressional hearings led by legislators who purport to be outraged, and by lengthy government investigations.

Financial penalties and occasionally jail sentences are imposed, and eventually some new legislation is passed. By this time in the cycle, however, the market has generally moved on and public preoccupation is elsewhere, especially if the stock markets are rising again.

The trouble with this pattern of events is not what happens but what doesn’t happen. The lessons learnt are often obscured by the range and complexity of all that has taken place.

The evidence that the original problems have been fixed is measured in terms of legislation, even though most people understand that a good deal of human behaviour cannot be legislated for.

But, in the wake of Enron and the wide range of abuses that have occurred, CEOs should improve on this process. They should deal constructively with the damage done to the reputation of American business culture and to public confidence in the integrity of the financial markets.

Business leaders need to create a thoughtful record of what went wrong and what the long-term business remedies are, not just to fix the problems but to educate future executives. This record ought to be simply written and widely distributed and debated in business circles and beyond.

With the November 2002 midterm elections out of the way, CEOs should encourage president Bush to establish a special commission of business leaders – some recently retired and some active, as well as representatives of boards of directors – to provide their own analysis of what went wrong and what can be done.

Top business executives will benefit from the establishment of this commission by playing a leadership role. Since it is their collective reputation that has suffered, it ought to be their objective to restore maximum integrity to the markets that are now so highly suspect. The group should include men and women from other arenas – labour and academia, for example – and representatives reflecting the interests of investors.

The commission should not be asked to identify people who transgressed the law or to propose new legislation; all this will or should be handled elsewhere. Nor should the commission start from scratch when other groups have already done thoughtful work.

But the commission could start with the consensus that has been building on several fronts, including the following.

  1. Boards should have a majority of independent directors, and key committees – audit, compensation – should be composed entirely of independent directors.
  2. The CEO and CFO must take personal responsibility for ensuring that their financial accounts present an accurate picture of their company’s business; they cannot use accountants and lawyers as a crutch.
  3. CEO compensation needs to be re-evaluated to be more consistent with the creation of long-term value.
  4. Wall Street research analysts should not be paid according to the new business they bring in.
  5. The accounting profession needs much more effective oversight.
    1. Moreover, in addition to looking at these specific issues, the commission should analyze the basic tenets of business culture that were trampled on in the Enron and other scandals and articulate the concepts that ought to govern business behaviour in the future. Here are some of the issues it should highlight.

      Relieving short-term earnings pressures

      The commission should analyze why CEOs find themselves under pressure to boost earnings each quarter and to set and precisely reach their targets no matter what the cost. It should examine the means of alleviating this relentless pressure so that creating long-term value is the prime goal and incentive of both the top executives and the directors.

      It would be important to document the profile of different classes of investors, including the proportion whose behaviour is consistently short term or speculative in nature. The evidence may well show that it is not possible for CEOs to build and manage their companies for the long term, given how most shareholders behave, or how the most important ones, those who hold the most shares, behave.

      There could well be a need for a tax system that changes investor behaviour, taxing short-term gains at a higher rate than now exists, and lowering or eliminating tax on gains from shares held for several years.

      The committee should look at changing the pattern of top-level corporate interaction with Wall Street analysts who demand that companies provide “earnings guidance”, that is, a declaration of expected quarterly earnings. This pernicious ritual forces executives to gear all their actions – including playing games with how and when they book revenues and expenses – in order to precisely achieve what they “estimated”.

      Put simply, chief executives should cease the practice of giving quarterly earnings guidance. If only a few CEOs abandoned the practice, they could be penalized by adverse publicity suggesting that they don’t know enough about their firm’s situation to make an estimate. To be sure, such behaviour could be interpreted negatively by investors, who would sell the stock.

      But if business leaders abandoned the practice en masse, they could control the game. They would still discuss the future with analysts but they would talk about a series of financial targets and longer-term goals for investments, return on capital and strategic positioning. If, as a group, they have the courage to follow this course, corporate executives will help to change the short-term mind-set of the markets.

      Strengthening accounting systems

      The commission should recommend fundamental changes in the accounting system so that financial reporting is not just a matter of meeting the letter of the law but also a matter of presenting a clear and accurate picture of a company’s business and its prospects. Several top figures in the accounting profession are calling for an overhaul, condemning the financial reporting system as too rigid and faulting it for measuring the past and not the present, and for not helping investors evaluate the future. Arguing that the current system is a relic of the industrial age, the critics say that the system doesn’t take account of the new technological era, in which research, patents and information technology are crucial to the evolution of most companies.

      They say the accounting rules have grown in volume and complexity, in the same way that the tax code has. “In the process, we have fostered a technical, legalistic mind-set that is sometimes more concerned with the form, rather than the substance of what is reported,” said Steven Butler just before his retirement as chairman of KPMG. “In our post-industrial economy, our accounting system doesn’t do a very good job of describing any modern company.”

      Besides taking a look at the standards that the International Accounting Standards Board is proposing – which are discussed later – the SEC should establish a group consisting of accountants, business leaders, lawyers and investors to outline what financial reporting ought to look like a decade from now.

      Also, the commission should take a hard look at the issue of disclosure of information. Everyone is for more and faster disclosure, but that solution is not a silver bullet.

      The fact is that most investors are overwhelmed with the volume and complexity of the information they already receive. They need less material, but content that is more fundamental to a company’s performance, and written in plainer language.

      Reining in executive compensation

      The commission should analyze executive compensation and the behaviour it encourages. Few Americans would argue that CEOs should not be rewarded for a company’s outstanding performance but most are sure to object to rewarding them when performance is poor.

      Several analyses of executive compensation have shown that the total compensation of many chief executives rose even as their company’s performance deteriorated. In virtually every case the reason could be attributed to sizable allotments of stock options.

      To be sure, the accurate calculation of remuneration is often more complicated than the media indicate. Options packages are issued in a way that usually permits their being exercised for a 10-year period, whereas the actual markets for trading options are much shorter term. Some formulas assign a value in the absence of real market prices, but they are highly imperfect.

      Nevertheless, in the 1990s, stock options were being awarded as if they were free, and by 2002 they constituted 75% of top executive compensation. Particularly egregious was the technique of allowing CEOs to swap their out-of-the-money, high-priced options for lower-priced ones – something not available to shareholders or ordinary employees.

      Roy Smith and Ingo Walter, professors at the Leonard N Stern School of Business at New York University, described the inappropriate compensation of executives: “The methods used to reward management have become absurd. They are paid to sign up, paid to stay, even paid to go – often at eye-popping rates that bear no relation to the results achieved.”

      All the questions surrounding stock options – the amounts awarded, the way they are accounted for, the performance criteria on which they are based – must be re-examined. Options cost a company nothing, since it need not deduct them as an expense as it must do for most other kinds of compensation, but they are a tax deduction when they can be ultimately exercised. The people who do pay are the shareholders, whose holdings are diluted when the options are converted into stock.

      Major investor Warren Buffett poses these questions: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into calculations of earnings, where in the world should they go?” He was once a lone voice, but others have joined him – including Federal Reserve chairman Alan Greenspan and former chairman Paul Volcker.

      A post-mortem on the Enron era must come to grips with the sheer magnitude of unexpensed options, which are creating perverse incentives, driving CEOs and top management to push the envelope to drive up stock prices in the short term. It would be far better to report the options as an expense, at least when they are exercised (when the true value can be determined), and to issue them in far smaller quantities.

      Moreover, stock options should not reward CEOs just because the overall stock market is rising but only when the stock appreciation of their companies outstrips those of peer companies as well as an index of stocks over a period of, say, three years.

      Similarly important, quarterly financial reports should clearly describe a company’s total exposure to outstanding options – not just to those held by top management – and the potential impact on the value of the existing shareholders’ stocks when the options are exercised.

      Better still, CEOs and other top executives should be rewarded with actual stock that can be sold only over a long time. This would ensure that their interests are aligned with those shareholders who are also interested in the creation of value not just for this quarter, but for many more to come.

      According to calculations at Business Week, in 1980 CEO compensation was 42 times that of the average worker, whereas in 2000 it was 531 times the average. Still, were some CEOs to take the lead on establishing a better system for executive compensation, it would be the right thing to do – the public-interest thing to do – and if a handful of America’s top leaders spoke up together, they could have significant influence.

      Rethinking the role of boards of directors

      The commission should discuss the full obligations of boards of directors in the future. It should pay attention to the independence of the board, the qualifications for membership and the means of compensating directors so as to ensure a longer-term perspective.

      These questions have been debated in the SEC as well as in the stock exchanges and academic institutions, but what makes the situation different today is the sheer difficulty of overseeing big companies in complex global markets.

      The commission ought to give serious attention to a proposal made to elevate corporate governance standards. In April 2002, John Whitehead, former chairman of Goldman Sachs, and Ira Millstein, senior partner of Weil, Gotshal & Manges, a law firm in New York, advocated that the SEC establish a national code of conduct for boards of directors, something that does not now exist.

      Although companies would not be obliged to follow all the guidelines, they would be required to provide an explanation of where they chose not to, and why.

      The Whitehead-Millstein proposal echoes others that go in a similar direction, and it is an idea whose time has come. The proposal itself doesn’t explain the specific standards to be followed but here are some of the most important categories: defining the meaning of “independent” director; defining the precise relationship between directors and outside audit committees; defining whether directors should be paid in cash, stock options or stock; defining whether there should be a separation between the chairman of the board, who would be an independent director, and the CEO.

      The commission should also raise other issues. Beyond vouching for the financial position of a company, and beyond hiring, firing and determining the compensation of the CEO and other top management, to what degree should directors become involved in the strategy of a company, particularly in public policy issues, such as domestic and foreign environmental and labour policies?

      The role of institutional investors

      The commission should take a hard look at the role that big institutional investors play in our financial markets.

      These institutions could play a pivotal role in upgrading corporate governance, were they so inclined. At the beginning of 2001, for example, mutual funds controlled by the 70 largest fund managers owned $2.9 trillion of US publicly listed equity, 20% of the entire market capitalization.

      If the value of the pension funds and other institutions whose funds are controlled by these managers were to be combined, their total voting power would reflect the 44% of the shares that they own.

      Are these institutions up to the challenge? John Bogle, founder and former chairman of the Vanguard Group of mutual funds, says: “The record shows only sparse attention to corporate governance issues by [these institutions].” Nevertheless, he is a strong advocate of a more activist stance on the part of the big funds.

      In recent months there appears to have been additional momentum on the part of leading institutional investors, as the International Corporate Governance Network, a global organization of pension funds that controls $10 trillion of assets around the world, was gearing up to establish guidelines for corporate governance of the companies in which they invest.

      The commission ought to give this overall movement a big push.

      Reviewing business culture itself

      The commission should also take a look at America’s deteriorating business culture itself, with the goal of recommending ways in which to improve the climate. What is required is no less than an explanation of how and why trust and integrity deteriorated so badly in the 1980s and 1990s.

      This is not a call for a broad indictment, for the US and the rest of the world greatly benefited from the incredible burst of technological innovation that CEOs largely led during this period. But along the way, business lost any sense of a moral compass.

      Companies became just bundles of assets to be bought and sold. Employees became commodities to be hired and fired. The very notion of what constituted real value in the new economy was conflated with getting bigger and moving faster – but not with profitability, not with the welfare of employees, not with the development of communities. How did this happen? What can be done to prevent a recurrence?

      One major issue of integrity that needs examination is the notion of conflict of interest in today’s modern, complex markets. The clearest recent transgressions are instances in which Wall Street analysts recommended stocks to help their firms get other business from firms that benefited by the analysts’ “buy” recommendations.

      The CEOs of these investment banks – indeed, a good deal of the investment community – showed complicity towards this charade. But this wasn’t the end of conflicts of interest. Investment banks issued scarce shares in new initial public offerings to favoured clients in return for new business.

      Auditors performed consulting work for clients, work that was often more lucrative than the auditing itself. Directors compromised themselves by having financial relationships – over and above their board compensation – with the firm on whose board they served.

      The buzzwords – “convergence”, “virtual companies”, “centreless corporations” – said it all. Companies formed partnerships with their customers and with their competitors. The emergence of big conglomerates such as GE, Citigroup and AOL Time Warner was in part an effort to facilitate cross-selling of products of one division to the customers of another. Lawyers and consultants invested in their clients.

      The distinctions between companies engaged in finance, technology and communications became blurred. It’s no wonder that executives lost a sense of moral direction.

      It is easy to say that business leaders should do the right thing. But doing the right thing is not that simple. If an activity is legal, then is it automatically right? If there is no law prohibiting a certain action, then is it appropriate to do it?

      We live in an environment in which the tyranny of Wall Street’s pressure on short-term results drives so much, in which accounting rules are subject to a wide range of legitimate interpretation, in which regulations are in flux – indeed, in which the world is moving quickly and unevenly from an industrial to an information age.

      In this environment, there is no substitute for reasoned judgment that takes account of the broadest array of factors in addition to the law. The executives most capable of such behaviour will put the highest premium on who they surround themselves with, how they get their information and how open they are to challenges by their colleagues. These executives will be concerned not just with winning a deal but with how they win it.

      How far does responsibility extend?

      Another aspect of trust and integrity concerns the following question. If some employees in a firm transgress the law or internal ethical standards, are both the firm and the CEO themselves culpable?

      In a world in which companies have been consolidating via mergers or a mind-boggling array of strategic alliances, the question of who bears the responsibility for the parts or subparts of a multifaceted organization is of no small consequence.

      Top officials at Arthur Andersen complained that the entire company did not deserve to be punished just because a few of its staff shredded documents.

      At Merrill Lynch, the former chairman and CEO, David Komansky, admitted that some stock analysts had violated the firm’s standards but said he did not think it was fair to point a finger at all the 800 professionals in Merrill’s research department.

      He later told CNBC that, as CEO, “anything that happens on my watch I’m responsible for.” But it is not clear what these statements add up to. Who is properly accountable, and who should bear not just the blame but also the punishment?

      Although a CEO cannot know everything that is going on in a huge multinational company, the top management is responsible for the culture of the company and its organizational systems of checks and balances. In the case of accounting and financial firms, if brand name doesn’t stand for reliability and integrity throughout all its products and services, then exactly what does it represent?

      The commission should examine how the reforms taking place in the US interact with the framework for auditing and corporate governance abroad.

      Numerous foreign companies have shares listed on US stock exchanges, and many American corporations issue their shares abroad. Foreign companies should be under the same pressures to disclose information and otherwise govern themselves as do American firms.

      Take just one example. Today you can buy shares of several Chinese companies on the New York Stock Exchange, yet in China the tradition of independent directors on companies’ boards doesn’t exist. From the perspective of American investors, who then is minding the store with regard to these Chinese entities? Who should be minding it, and how should they be doing so?

      In fact, the international issue of corporate governance ought to loom very large in the post-Enron agenda. In a global economy, multinational companies should be managed according to some common standards.

      Very often in the past, the US arrogantly assumed that its standards of corporate governance – including its accounting standards – were so superior that the rest of the world needed to adopt American techniques, and that the US had nothing to learn from others.

      Now that the debacles of Enron and Arthur Andersen have revealed problems in the American system, the US can – and must – work together with other countries to come up with global standards.

      One place to begin would be with the accounting system. What, after all, could be more fundamental than having a single financial language for global business? Yet such a universal language doesn’t exist; the US uses one system, and European countries use different methodologies, as does Japan.

      Since 1993 the International Accounting Standards Board, an international group based in London, has been trying to develop one set of rules that everyone can use.

      It is time for the US to put its full weight behind this search for one system that companies can use and investors can understand. Unlike the American system, it should be simpler and more comprehensible to non-specialists. It should have a clear business purpose, not just a legal justification.

      An international system must not represent a dilution of US standards but must stand for the highest common denominator of what exists around the world. Moreover, where there are gaps, international standard setters ought to move quickly to fill them.

      Beyond working on business accounting standards, the commission should give attention to the movement for improving corporate governance in Russia, China and other countries. As the US improves its own system, it should be working with the public and private sectors elsewhere to improve theirs. Poor corporate governance abroad increases the likelihood of corruption, slow growth and financial crises that can easily spill over borders.

      The American business community could take a number of actions. As the New York Stock Exchange and the Nasdaq exchange proceed to upgrade corporate governance standards for their members, they should work with their counterparts in London, Frankfurt, Hong Kong and Tokyo to press for higher governance standards for all companies.

      The Enron debacle ought to usher in a new era of corporate governance in general. American business leaders will find that a thoughtful assessment of the new business environment and the required new standards will be a difficult and painful exercise.

      But if CEOs abdicate this assessment by default to Congress, the administration and regulators, then they will invite new government intrusions that meet the public clamour to do something, but which will inevitably include overregulation. “We have to be careful not to look at a significant expansion of regulation as the solution to our problems,” said Alan Greenspan.

      But there is another possible outcome, one in which the government does very little to respond to the corporate crisis because it is paralyzed or distracted by other issues.

      This outcome would also be unfortunate, since the transgressions that have damaged America’s companies, markets and investors would go unattended.

      There is a crying need for leadership, and the people who ought to provide it should come from the best of the corporate world.

      Jeffrey E Garten
      Jeffrey Garten is dean of the Yale School of Management and William S Beinecke professor in the practice of international trade and finance. He writes a monthly column for Business Week on major challenges facing global business leaders. This article is extracted from his latest book, The Politics of Fortune: A New Agenda for Business Leaders.