Corporate Scandals and the Economy
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
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
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
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
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
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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