August 11, 2003

I became dean of the Haas School of Business at Berkeley one year ago. This timing was comparable to graduating from law school at the height of Watergate. Actually, I did that, too. In Watergate, lawyer after lawyer was indicted -- indeed, I wondered whether any non-lawyer had been involved at all. What is it that you teach in law schools, we heard asked; or, more commonly, what is it that you don’t teach in law schools. In the corporate scandals, it is the MBA degree, and the CPA professional credential, that is receiving the same focus. What have business schools failed to teach, that has allowed so much fraud to devastate the investments, retirement savings, jobs, hopes for the future, of so many innocent people? What does an audited financial statement mean, if not a guarantee that the basic story being told by a company’s reported numbers is accurate—that you can rely upon it. To many, this means that the accounting profession’s self-regulation is no regulation at all. The federal government has, in most significant respects, now replaced that profession’s self-regulatory mechanisms of peer review with tri-annual audits and PCAOB review of auditing standards. At the state level, 51 different jurisdictions will tighten their own view of what constitutes ethical accounting. The conclusion has been taken that government oversight has also been too lax, not just of businesses that register under the Securities Exchange Act but also of business men and business women. Sarbanes-Oxley is but the first of many steps now considered necessary to substitute government reporting, oversight, regulation, and, if necessary, prosecution, for the market’s own scrutiny that has proved so inadequate, and for the internal compass that has been found demagnetized.

So, thirty years after Watergate, just when the legal profession was recovering some of its reputability, I resigned as a professor of law to become a professor of business, and took over as manager of an enterprise producing MBAs and CPAs instead of lawyers.

I suppose one could say, I had at least moved up from the job title, “politician.”

The concept I carry over from law to business education is one of a profession. Everyone here today has, at some point, been confronted with the issue: what does it mean to be a professional? I believe it is a concept at the heart of what you do, and what brings you together as members of the American Bar Association Corporate Law Section. You interact, every day, with business women and business men. What guides you is a sense of duty. The duty is to provide advice to your client, as to the advisability of a particular proposed course of conduct. This is a duty that, you fully understand, may compel you to act against your own pecuniary interest, from time to time. You make a living, and hold a place of honor in society, because you obey that duty. The living might be less, and the place of honor known to very few, because of the duty you have undertaken. You are regulated largely by your own profession—in the extreme, by state bar associations and Supreme Courts, in the main, by the respect of your colleagues, in the innermost by your own sense of self-respect. A professional will forego personal interest to serve the interests of one to whom he or she has a duty. And a legal professional has such a duty not only to her or his client, but also to the system of law in our country.

A professional can be positioned at the end of a spectrum that runs from legal compulsion, through rules based behavior, to principles based action. The professional not only bases actions on principle, the professional embodies the principle. At his or her best, the professional has an internal compass that dictates behavior when there is any doubt. Today, I wish to explore whether we can find that same sense in men and women who practice business—whether or not they are members of a profession.

Obviously, there have been failings in the legal profession, and in the accounting profession, so I don’t mean to say that an aura of moral invincibility descends upon passing a bar or a CPA exam. Indeed, if my description of professionalism seems particularly flattering, that’s not my intent. Rather, I am seeking to distill what it is that might be found in business men and business women who are not professional attorneys or accountants that might have guided them through the recent examples of condemnable behavior in the same way that a sense of professionalism might guide us as attorneys. I’m wondering whether we ought substitute for the concept of professionalism a broader concept of responsibility, and recognize that it binds us all, attorney and business person.

What went wrong in Enron, or World Com, is not really that apart from what went wrong at the law firms and accounting firms that advised them. The failure was a lack of responsibility -- by which I mean, a willingness to adjust one’s behavior to the minimally compulsory under law, rather than to inspire one’s behavior by a commitment to principle. It might be, when the final appeal is finished, that what happened at Enron, or World Com, or at the brokerage houses that mixed investment advice with their own portfolio’s interest, was done without any technical violation of law. That is the conclusion of two financial experts, Richard Bassett and Mark Storrie, whose policy analysis was published last February by the CATO Institute. Quoting the analysis commissioned by the Enron Board of Directors after the scandal broke, Storrie and Bassett note that the special purpose entities, used to take off the balance sheet the losses suffered in energy commodity contracts by Enron, could have been accounted for within generally accepted accounting principles. “In other words,” they claim, “all of this deception could have worked if Enron had followed the accounting rules. However, had it followed the rules, Enron would still not have achieved a bona fide economic result. The company would still have achieved only an accounting result. That is indicative of how the rules-based system that guides U.S. generally accepted accounting principles has conditioned people to look, not at whether the information presented to the market is a true and fair characterization of the condition of the company, but at whether it complied with the rules.” [“Accounting at Energy Firms after Enron,” Policy Analysis No. 469, CATO Institute, February 12, 2003, CATO Project on Corporate Governance, Audit, and Tax Reform. Emphasis added.]

A similar expression of view was voiced just a few weeks ago by a spokesman for Arthur Andersen. “Because companies today are so complex, ‘it would be impossible to test every transaction,’ this spokesman was quoted as saying in July 23rd’s Wall Street Journal. “As a result, ‘to a certain extent an auditor needs to rely on management representations. … It is virtually impossible for any audit . . . to detect deliberate fraud by top management.” [“WorldCom’s Auditors Took Shortcuts,” Cassell Bryan-Low, Wall Street Journal, July 23, 2003, p. C9.]

At the start of my remarks, I asked “What does an audited financial statement mean, if not a guarantee that the basic story being told by a company’s reported numbers is accurate—that you can rely upon it?” That question was deliberately stated provocatively. The accounting profession would respond, with close to unanimity, that an audited financial statement means no such guarantee at all. Indeed, if you read with care the phraseology at the end of the outside auditor’s statement, you’ll learn that it comes close to a tautology. “If management has given us accurate information, and if management has not withheld important information, then we attest that it is presented in a form in this document that other accountants would likely also use.”

The conclusion toward which I’m tending is that a legal compulsion standard, and even the regime next closest to it on that continuum I described, rules-based behavior, are incurably incompetent. The imagination of an intentional wrong-doer will far outpace the ability of Congress, or the SEC, or the PCAOB, or state regulators, to specify and outlaw a particular practice. The protections that America’s Constitution provides for the accused require that our criminal laws be specific and narrow; what has become apparent, however, is that the criminal law by that same attribute denies the public a level of protection it believes it has. You can’t write the laws, or the regulations, specifically enough to cover every scam.

Furthermore, the law has often erred. It was by act of Congress that thrifts were guaranteed a certain amount of good will on their balance sheets for acquiring failing thrifts, during the days of the savings and loan crisis of the late eighties. But how could an act of Congress create an asset on a corporate balance sheet? Furthermore, Congress then tried to take it back—and it required the US Supreme Court to say it couldn’t.

Congress should not be perceived as the source of transparent, and useful accounting. I have had the honor to serve in Congress when dire, urgent supplemental appropriations were passed, even though contrary to the Gramm-Rudman-Hollings Act, and contrary to the pay-go rules, because they were labeled not just appropriations, but dire, emergency supplemental appropriations. I have seen a disaster relief bill following a hurricane in South Carolina escape balanced budget requirements, and then include money to build a new court house in New York. I have been a member of the legislature that sends a man with a ladder to turn back the clock in the chamber to create a single legislative day of more than 24 hours.

Nor is the SEC gifted with such power. I have heard testimony from an SEC Chairman that he respected the absolute independence of the FASB, even as he admitted to lobbying their members for the rule he wanted on stock option accounting. In an odd example of rough balance, the FASB did not yield to the SEC influence, because Congress threatened FASB if it did! And, whatever side you take on whether and how stock options should be recorded on a balance sheet, do you want Congress to be the agency to set the rule?

I should think the precedent of having Congress establish by law what constitutes honest accounting would more than offset the temporary gain of achieving one’s policy objective in the present context.

For these reasons, relying upon positive laws, passed by Congress, the state legislatures, or administrative agencies, will, I fear, forever be inadequate to the crisis present in American capital markets.

Principles based accounting might be offered as the next response. But in virtually every recent example, I can make a decent argument that the principle was not violated. A corporation is supposed to expense, rather than carry as an asset to be depreciated, an expenditure whose value lasts a short time. World Com lay fiber optic cable. It depreciated that cost. And that was criticized—but I don’t see an issue of principle in making a judgment on how long a bit of optical fiber will last. And we instruct our accountants and governmentally sponsored enterprises not to postpone a profit made from an interest rate gamble by calling it a hedge. Freddie Mac made that error because it did more hedging than was necessary to cover its own risks. But that depends on how much tolerance Freddie Mac had for risk. A risk averse individual will call a hedge what a risk neutral person would call speculation.

My point is this: when WorldCom overstated its earnings, and Freddie Mac understated its earnings, a reasonable case could have been made that, in each case, judgment was exercised that might not have fallen below the auditing principles specified. The principle dealt with motive, and that is very hard to establish, if we are honest, even within our own minds.

Consider a brokerage firm that offers advice to investors and carries its own equity investments as well. An entire theory of finance based on the efficient market hypothesis tells us the very best measure we have of a stock’s worth is its price today. If that is respectable theory, and it is, then how can a recommendation to buy at that price ever constitute malfeasance? Indeed, the malfeasance might be not to one’s client but to one’s own account, by letting one’s hunch supersede what the market is saying. There could be wrong-doing, but in exactly the opposite direction charged: it would be wrong to invest for one’s own account and not cut the commercial customer in on the deal—but only if one had a fiduciary duty to the customer. What made that episode easy to condemn was the memo, the eternally long-lived email, describing the very same investment being offered to an individual investor as a piece of junk. As any of us who have lived through extensive discovery will testify, clients are more commonly done in by the memos they themselves create and retain than by anything a plaintiff could otherwise prove.

Or consider the rule about when earnings are to be realized? If you are General Electric, earnings close to the end of a quarter with exceptionally good news to report might be postponed a week or so later, after all, the check might have been deposited but not cleared. if you’re in Silicon Valley, earnings might be booked simply because you got a message saying “you got mail”—well, not really, but there is much judgment involved in when a deal is closed, as well as when a loss or a gain can be called exceptional. It is not the principle, in other words, that gives guidance. Directly opposite action can be justified under identical principle. Condemnation comes from proof of motive.

Principles based accounting, therefore, is vulnerable to the same criticism as setting rules by law. You give me a specific rule, and I’ll give you a way around it. You give me a specific principle, and, absent a smoking gun on motive, I’ll show you I abided by it.

We have two potential solutions, it seems to me. We have to get to motive. So we need to look for structural reforms to minimize incentives to act upon bad motives. Or we have to develop responsible individuals fewer and fewer of whom have bad motives. If the problem is unscrupulous behavior, we can try to increase the incidence of scruples.

On the first front, a number of approaches has become very familiar in the debate over and early days after implementation of, Sarbanes Oxley. Accounting firms that audit public companies may not consult with them, for instance. And CEO’s must personally sign financial statements that might previously have been the subject only of a cursory review, relying on the CFO’s assurances.

There have been many other suggestions, directed toward eliminating bad motives. Officers of a corporation might not be allowed to exercise stock options until after they have left the company for six months. A third party (perhaps the stock exchange on which a company trades) might be required to choose the company’s auditor. Recently, the SEC has proposed allowing competing slates of directors to be mailed out along with management’s choices. Former SEC Commissioners have urged that executive compensation be printed in proxy statements in large type.

Any one of these might be helpful. Indeed, if a company is known for transparency above the average, and for built-in eliminations of potential conflict of interest better than most, investors might respond by buying their stock—though, as yet, there is scant evidence for this proposition in American markets.

There is no reason not to try any and all of these protections—on a company-by-company basis. The danger, it seems to me, is to mandate such rules, lest we convey to the public that a company that has adopted these improvements in corporate governance is, for that reason, certifiably incorruptible. The same maxim I applied to rules of law will apply to self-imposed improvements in corporate governance. No set of structural preventatives can undo the fundamental source of the corporate dilemma: wealth owned by all is put under the control of some. As long as that remains, no matter what safeguards are imposed, the incentive to get around them will get around them.

Suppose, for example, a rule were adopted that all executive compensation had to be disclosed in bold type in the proxy statement. This, supposedly, will serve as a structural reform to prevent over-compensation. GE’s 1996 employment contract with Jack Welch guaranteed that, upon his retirement, he would have “continued access to company facilities and services comparable to those provided to him prior to his retirement, including access to company aircraft, cars, office, apartments, and financial-planning services.” A GE stockholder would not have known, from reading those words, that this meant a suite at Trump Tower with a private chef. So, even if that phrase were disclosed in bold type, I can’t believe anything would have been different.

I said there were two routes beyond the constraints of a rules-based or principles-based regime: structural steps to remove incentives to behave unscrupulously, and efforts we might undertake to increase the amount of scruples to be found among business individuals. All efforts at reform will be inadequate in the absence of principle. This is true for business women and business men outside of the legal or accounting professions as much as it is true for those of us within those professions.

The fundamental concept of the publicly held corporation creates temptation: A benefit meant for all can be appropriated by less than all. Principle stands in the way of this temptation far more than law does. Perception of right and wrong will operate where statute, accounting rules, or structural protections prove inadequate. To this end, what we do in business schools can be a very important part of the lasting answer—and some of these steps will have tremendous benefit in society more generally as well.

I am frequently asked whether we teach ethics at the Haas School of Business, and whether one can ever hope to teach ethics. I answer that we do, and we can—but not in the way traditionally thought. Most if not all of us in this room today took an examination in legal ethics as part of the bar exam in our respective states. That is the example of what I do NOT mean. We do not teach ethics the way bar review courses teach for the professional responsibility exam. Rather, we teach ethics in two specific ways. First, every instructor at our business school is requested to include in his or her course, at least one instance from her or his own life of being confronted with an invitation to do something less than right. I want the students to hear from actual experience of the teacher standing in front of them, not from a case-study prepared at an East Coast academic institution. (We say that a lot in California—“East Coast” as a vaguely unwholesome generic; matched only by the phrase “left coast” applied to us.) The goal of this first approach is familiarity, and the self-confidence it will produce.

We have each experienced, I suspect, the feeling of having the perfect answer to a question surface several hours after we had to answer it. In politics, I won every debate, so long as the point of measurement was long after the date of the debate’s occurrence, and my opponent had no chance of rebuttal. But to do the right thing at the time it matters—that can be helped by familiarity.

Last year, we invited to our campus to speak one of the executives at WorldCom who is currently finishing his prison term in a half-way house. That enabled him to come to the Haas School. He asked how could a company like WorldCom carry 100 million dollars of uncollectable accounts on its books without a write down. His answer was, “Because no one wanted to write down 99 million dollars of uncollectable receivables.” He had been asked by his superiors not to write down more than a small sum every year. Next year would be a better financial year, he was told—that was when the bigger write-down could happen. Besides, he thought, when is a debt really uncollectable? His willingness to go along with that was the first step in a much greater wrong—but I believe he might never have started had he said to his superior that first time, “Absolutely not. I’ll write down the larger number, I’ll write down what I think is right—I can’t believe you’d make such a request.”

That’s not such an unrealistic scenario. Just consider what’s happened to the perception of sexual harassment in America’s workplace within the lifetime of virtually everyone in this room. Remarks and behavior that would be considered absolutely unacceptable today were common practice, at companies and at law firms. The phrase, “boys will be boys,” was a generic commonly used to overlook sexual harassment in the workforce. Until 1977, no federal court had even held that sexual harassment constituted discrimination in violation of the Civil Rights Act that had become law 13 years before. If some of that type of conduct took place today, we could expect an immediate reaction from the victim—which is my point. The predator might still exist, but the potential victim has been sensitized. Environments can change. We have seen it. So also here. Since all but a very small share of wrong-doing requires the complicity of others, often of a subordinate, we can through teaching example by example build up a library of experiences that will arm the newly minted MBA or CPA going into the workforce.

The second way we deal with principle in the American workforce through business education might seem a bit indirect—but I am convinced it is quite targeted to real results. It is the celebration of the non-financial rate of return from all we do. Students in the Haas undergraduate program volunteer to tutor grade school students in Oakland’s neediest schools. Students in the Haas MBA program volunteer to commit twenty weekend days a year as mentors to Oakland’s middle and high school students so that they might qualify for the University of California. No one compels our students to do this. But, on the students’ own, and under their own supervision, those who have given more than 50 hours of community service of this or similar kind during their time in Business School receive a special designation at graduation. More important than that, they are recognized as cool. They are part of what is expected of a student at Haas.

We are educators at a public business school—I believe, the best public business school in the country. Our job is incomplete if we train only the skills to create wealth. We need to train, as well, the ways and desirability of sharing wealth. Not by government compulsion. But by personal choice. The Center for Responsible Business at our school studies, measures, advises on how corporations do more than enhance their financial rate of return. Two of our MBA graduates, five years ago, gave up their careers at Microsoft to establish a private college in Accra, Ghana. This summer, five of our MBA students went over to advise on their proposed expansion into a pre-med curriculum. We have an increasingly vibrant program in non-profit management at Haas, training students to apply the skills of accounting, finance, organizational behavior, marketing, strategy, that they learn as MBA students to careers they will take up in the not-for-profit sector. We can’t teach ethics, perhaps, but we can and do teach that values exist, values that call upon us to share the opportunity and wealth we create. The best way this is taught is by student-to-student.

What I am describing is the creation of a professionalism in the carrying out of business, and something even more. It is a sense of value, of which professionalism, the willingness to sacrifice personal gain out of obligation to another, is one part. Our graduates are the equal of any in their technical skills. And--from their own expressed desire, as well as the encouragement of their teachers-- they are the living answer to today’s question about what is taught, and what has not been taught, in our nation’s business schools.

So, we have come full circle to the concept of professionalism. It is at the core of what we do as lawyers—but it might not distinguish us. Rather, it is also at the core of the only workable solution to the challenge of the corporate scandals. Our corporations can become better, by our becoming better. Our educational institutions are not powerless to help; they need only reinforce what every one of us was raised by our parents to know: that you do not take from another, and that humans should not be judged by the things they own but by what they give away. If you believe the latter, the former is no temptation.

Robert Bolt put this very well in “A Man for All Seasons.” Richard Rich was offered a teaching post, or a position with the up and coming, if unscrupulous government official, Thomas Cromwell. He sought the advice of Sir Thomas More. More advised he be a teacher. Rich complained that if he were a good teacher no one would know. More replied, “Well, you would know, your family would know, your students would know, and God would know. Not a bad audience, that.”

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