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Corporate Scandals and the Economy

Tom Campbell

Published December 8, 2002, in the Santa Cruz Sentinel

The decline in the stock market and the disclosure of corporate and accounting abuses have occurred at the same time. It is tempting, therefore, to blame one on the other. It is also dangerous. Such linkage can lead us to make changes in our country’s financial system that would be harmful. Further, putting such changes into law might give us the false sense of having addressed the problems, allowing more necessary reforms to be ignored. And, by linking the corporate scandals to stock market decline, we guarantee further market declines at a time when our economy’s fundamentals are pointing for an upturn.

The economy’s fundamentals are very good. The most recent reports include a huge increase in productivity during the last quarter. Real growth over the last quarter was at a strong annual rate. Jobless claims are falling. Consumer confidence has rebounded. Capital investment is up. Positive earnings are being reported by the vast majority of companies, often exceeding market expectations. All of these are classic signs of a recovery. Unemployment rises in a recession, the remaining employees’ productivity rises, eventually this causes more investment in enterprises. Then, unemployment starts to fall as the market picks up.

Moving beyond the general statistics, market analysts are searching for the next specific engine of growth, the "next Internet." The answer may well be--the Internet. This time, it would be an internet made tremendously faster by the advances of technology in packaging and transmitting signals, and tremendously more convenient by the development of wireless means of connecting up to it. Among greater uses for such a versatile Internet that, as of yet, have hardly been touched are distance diagnosis, allowing one medical doctor’s ability to reach hundreds more patients; the connection of "smart" consumer appliances to remote access; and voice-recognition software allowing the eventual elimination of the cramped keyboard or stylus for instant messaging.

Despite these positive fundamentals, whenever another scandal breaks on the corporate scene, the market falls and politicians of the class warfare persuasion pronounce further evidence of the corruption of our economic system. The upsetting truth is that so many stories have surfaced; but even more upsetting would be to learn the wrong lessons from them.

Fraud in corporate affairs has been in existence as long as corporations have. Attempts to manipulate markets are equal in their longevity. It follows from human nature. A corporation possesses great wealth, held in common for common use. If the market is rising, there are very few inspired to invest the time to scrutinize some use of that common wealth for the personal gain of individuals. Indeed, if the person in question is a top-level executive in the company, and the personal gain is disclosed to the Board of Directors, the practice might not even be wrong. If it takes a chef and a suite at Trump Tower to keep Jack Welch at GE, and GE’s earnings show he was a super manager, then the Board of Directors can legitimately OK that use of GE wealth for Welch’s gain. After all, that’s what a salary is: corporate wealth directed to an individual’s own gain, in order to induce that person to provide gain for the corporation’s employees, shareholders, consumers and fellow citizens.

Similarly, the urge to take account of market opportunities is as old as markets themselves. When a set of poor regulations allowed energy companies to have influence on the prices for their energy, some took advantage. If they deliberately withheld energy to manipulate the market, it’s wrong. If they took advantage of a market that was high through no fault of their own, it’s not. Which was which will be sorted out in courts for years to come.

But the concept of taking advantage of a market opportunity is not novel; and nothing any would now call wrong was right when it was done. Fraud was, is, and will be against the law. Market manipulation was, is, and will be against the law. When markets fall, corporate directors and regulators both look more carefully for fraud. When disaster hits the energy market, consumers and regulators look more carefully for illegal manipulation.

The danger is that, instead of putting these episodes in their proper context, some have used them to argue the entire system of investing and making wealth grow in our culture is corrupt. Such attitudes, if prevalent, could actually retard the economic recovery on which so many individuals’ hopes rest for a job, higher education or a better life. And such attitudes, identical to what we would call class envy in good economic times, direct public support to pet "reforms" that really have nothing to do with the problems that have been encountered.

One such example is the attempt to make corporations pay a tax for granting stock options. None, I repeat, none, of the present scandals was caused or made worse by stock options. Rather, stock options are a means for companies short of cash to attract and retain workers. The economic miracle of Taiwan was built largely on this device--otherwise, virtually every qualified engineer and entrepreneur in Taiwan would have come to Silicon Valley instead. The prospect of large gain allowed the Taiwanese electronic firms to retain their best talent. No one was made worse. Furthermore, the opportunity to enjoy stock options extends quite broadly into the work force of Silicon Valley; they are not reserved for the top managers only.

So, if we should not let the recent scandals color our perception of our economic system generally, and if we should be careful not to adopt the wrong prescriptions, proffered by the envious, what should we do?

The best approach, I believe, is to look to structure. People will always be tempted to take advantage of opportunities for self-enrichment. Their imagination will outstrip that of any legislator or regulator. The counterbalance, rather, should be found in the natural guardian of the shareholders. These are two: the outside directors and the independent auditor. An outside director is most often chosen by management; such appointments will naturally be based on the management’s esteem for the individual. Esteem often means friendship, and friendship can create a sense of reciprocal obligation. This cannot entirely be eliminated.

But to the extent an outside director is a bit lax in her or his job out of a hope to be reappointed to a position with substantial fees and perks, the tendency can be diminished by limiting outside directors to a set number of years on the board. No reappointment being possible, the risk of personal liability in case of a mistake will loom larger and the attraction of "going along" will diminish.

Similarly for the outside auditor: the audit functions bring income to the accounting firm and the risk is to overlook a problem lest the accounting firm not be hired next year. The best way to cut that potential cord is to have the auditor chosen not by the corporation, but by the exchange on which its stock trades. Let the New York Stock Exchange decide which firm should audit General Motors’ books, and the accounting firm will have no incentive to look the other way on any matter lest its own reputation suffer.

Some such changes in corporate governance are already being implemented by corporations on their own. Others will have to come forward as rules of the exchanges. Still others might be mandated by the Securities and Exchange Commission, or by Congress. It would be wiser if the engine for adopting such structural changes were corporate and exchange driven, rather than imposed by law; since any one of these might or might not work. Changes imposed by law are very hard to undo: lest the commissioner or the member of Congress appear to be lax on corporate fraud. Better by far is for corporations to announce the changes in their governance structure, and let investors choose whether or not those changes are adequate, insufficient, or overkill. A domestic code of conduct could be developed, whereby companies abiding by certain governance structures could advertise their compliance, just as in the days of apartheid, the Sullivan Principles identified companies doing business in South Africa that, nevertheless, were certified as not contributing to the perpetuation of that loathsome system.

Lastly, one should not exclude the prospect of changing individuals’ behavior. The overwhelmingly vast majority of corporate executives are honest. To believe otherwise is to damage confidence in the greatest engine for the creation of wealth that the world has ever seen--and without wealth creation, there is no wealth sharing. Nevertheless, each of us has encountered the allure of shaving a corner now and then; the best preventive against doing so is the knowledge such a temptation is coming. In that regard, business schools can play a significant role. Knowing the law is a basic minimum. Identifying and discussing the most common invitations to behave unethically should be part of what every business school teaches. At Berkeley, I have encouraged all business professors to share an actual example from their own lives with their students. The awareness that one does not have to say yes to save one’s job has gone a long way to eliminating sexual harassment from the workplace; the same is true with temptations to make an accounting accommodation, to claim a sale, or postpone an expense, at the end of a quarter. As the generation of business students from this era of crisis enter the business world, they can be armed with this heightened awareness.

It’s not enough to make a dishonest person honest, no school can do that; but as any victim of pressure will tell you, it helps a lot to know others have said no and survived.

 

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Dean Campbell

Tom Campbell, Dean,
Haas School of Business

 
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