To assess the efficacy of the new regulations, it is useful to ask whether Sarbanes-Oxley, the new accounting rules, or any of the other reforms would have prevented some or all of the (U.S.) 2001 scandals. In an insightful paper, Edwards asks four key questions:Edwards (2003).
- What motivated executives to engage in fraud and earnings mismanagement? Or, put differently, is there a fundamental misalignment between management’s and shareholder interests and, if so, what are the causes of this misalignment?The term “earnings mismanagement” is used in the widest sense to include not only reporting that is illegal or inconsistent with accepted accounting standards but also statements that, while within accepted legal accounting standards, are primarily meant to deceive investors about the company’s true financial condition
- Why did boards either condone or fail to recognize and stop managerial misconduct and allow managers to deceive shareholders and investors? Are the incentives of board members properly aligned with those of shareholders?
- Why did external gatekeepers (e.g., auditors, credit rating agencies, and securities analysts) fail to uncover the financial fraud and earnings manipulation, and alert investors to potential discrepancies and problems? What are the incentives of gatekeepers, and are these consistent with those of shareholders and investors?
- Why were shareholders themselves not more vigilant in protecting their interests, especially large institutional investors? What does this say about the motivations and incentives of money managers?
The Link Between Compensation Structure and Earnings (Mis)Management
As Edwards notes, it is now widely recognized that the dramatic changes in the compensation structure of American executives adopted in the 1990s were a significant contributing factor to the higher incidence of “earnings (mis)management.” Consider that, in 1989, only less than 5% of the median CEO pay of the Standard & Poor’s 500 industrial companies was equity-based—95% or more consisted of salary and cash bonuses—but by 2001, equity-based components had grown to two thirds of the median CEO compensation.Hall and Murphy (2002), p. 42. Since stock options accounted for most of this increase, executive pay became far more sensitive to short-term corporate swings in performance.It is now also recognized that a change in tax law—the addition of section 162(m) to the IRS code—was a major contributor to the increased use of stock options. For more on this subject, see Chapter 8 "CEO Performance Evaluation and Executive Compensation" in this volume. As long as stock prices climbed, executives could exercise these options profitably. The incentive to report (or misreport) continued favorable company performance was therefore substantial. Enron’s executive compensation was closely linked to shareholder value. Enron senior managers, therefore, had a strong incentive to increase earnings and the company’s (short-term) stock price.Edwards (2003).
This analysis suggests that we must reevaluate how equity-based compensation is used to motivate executives and, in particular, whether there are pay structures that mitigate or eliminate incentives to misreport. The basic rationale behind equity-based compensation is sound: to motivate managers and better align manager and stockholder interests. But such pay structures must promote long-term value creation rather than reward short-term fluctuations in share prices.
Were Boards Asleep at the Switch?
Why were boards not more alert to managerial misbehavior? To answer this question, Edwards once again turns to the Enron scandal.Edwards (2003). The company met or exceeded most governance standards. Its 14-member board had only 2 internal executives: its chairman and former CEO Kenneth Lay and President and CEO Jeffrey Skilling. The remainder of the board consisted of 5 CEOs, 4 academics, a professional investor, the former president of one of Enron’s wholly owned subsidiaries, and a former U.K. politician. So, on paper, at least, the vast majority of Enron’s directors met the “independence” requirement.See Enron’s proxy statement, May 1, 2001. Subsequent to Enron’s collapse, the independence of some Enron directors was questioned by the press and in Senate hearings because some directors received consulting fees in addition to board fees. Enron had made donations to groups with which some directors were affiliated and had also done transactions with entities in which some directors played a major role. Moreover, all had a significant ownership stake in Enron, so their interests should have been aligned with those of Enron’s shareholders.The beneficial ownership of the outside directors reported in the 2001 proxy ranged from $266,000 to $706 million. See Gillan and Martin (2002), p. 23.
Enron’s board structure was also strong; the audit (and compliance), compensation (and management development), and nominating (and corporate governance) committees all were made up outside independent directors. In fact, the audit committee’s state-of-the-art charter made it the “overseer of Enron’s financial reporting process and internal controls,” with “direct access to financial, legal, and other staff and consultants of the company,” and the power to retain other (outside) accountants, lawyers, or whichever consultants it deemed appropriate.See Gordon (2003).
Yet, what actually happened at Enron is very different. The Congressional Subcommittee on “The Role of the Board of Directors in Enron’s Collapse” concluded that the board failed in its fiduciary duties (its duties of care, loyalty, and candor) because it permitted high-risk accounting, inappropriate conflict of interest transactions, extensive undisclosed off-the-books activities, inappropriate public disclosure, and excessive compensation.This subcommittee is administered by the Permanent Subcommittee on Investigations, Committee on Governmental Affairs, United States Senate, July 8, 2002.
Whether or not this is a fair assessment of Enron’s board performance, it shows that in an environment of short-term, equity-based incentives combined with less than transparent financial disclosure, the potential for manipulating financial results is real and that boards must be especially diligent. Many believe the Enron board did not meet this higher standard of care.
Would Sarbanes-Oxley and the new NYSE governance rules have prevented the Enron debacle? It is hard to say. The company already met some of the new requirements, such as independence for board members and key committees. Others, for example, the new rules requiring the elimination of conflicts of interest among board members and greater disclosure of off-balance sheet arrangements and other transactions to investors, might have made a difference. In the end, however, it is highly questionable whether ethical behavior can be legislated into being. Changing the ethics of business behavior and the “sociology” of the boardroom cannot be accomplished through structural changes alone; they require fundamental cultural change, which is a far greater challenge. In his 2003 letter to shareholders, Warren Buffett summed it up well when he confessed he had often been silent on management proposals contrary to shareholders interests while serving on 19 boards since the 1960s. Most boards, he said, had an atmosphere where “collegiality trumped independence.”Warren Buffett’s letter to Berkshire Hathaway shareholders, as quoted in USA Today, March 31, 2003.
Did the Gatekeepers Fail?
What role could gatekeepers—external auditors, investment bankers, analysts, and credit rating agencies—have played in staving off the Enron and other scandals?
As noted in Chapter 1 "Corporate Governance: Linking Corporations and Society", one view holds that gatekeepers are motivated and well positioned to monitor corporate behavior because their business success ultimately depends on their credibility and reputation with investors and creditors. Lacking this credibility, why would firms even employ gatekeepers? While this may be true, we should also inquire whether the interests of gatekeepers may be more closely aligned with those of corporate managers than with investors and shareholders. Gatekeepers, after all, are typically hired, paid, and fired by the very firms that they evaluate or rate, and not by creditors or investors.Edwards (2003). This holds for auditors, credit rating agencies, lawyers, and, as we learned in a number of high-profile law suits, security analysts as well those whose compensation (until recently) was directly tied to the amount of related investments banking business their employers (the investment banks) did with the firms that they evaluated.As noted by Edwards (2003), Citigroup paid $400 million to settle government charges that it issued fraudulent research reports; and Merrill Lynch agreed to pay $200 million for issuing fraudulent research in a settlement with securities regulators and also agreed that, in the future, its securities analysts would no longer be paid on the basis of the firm’s related investment-banking work. Also see Coffee (2002, 2003a, 2003b); Stewart and Countryman (2002). Thus, an alternative view is that most gatekeepers are inherently conflicted and cannot be expected to act in the interests of investors and shareholders. And while recent reforms separating consulting from auditing services, restoring the “Chinese Wall” between analysts and investment banks, and mandating term limits for auditors help mitigate these problems, it is unlikely that they would have prevented or minimized scandals, such as Enron and WorldCom.
Could Institutional Shareholders Have Made a Difference?
It is a basic tenet of free-market capitalism that the system rests on the effective ownership of private property—that is, that owners choose how their assets are used to their best advantage.The popular question, “Do you know anyone who washes a rental car?” is appropriate here. Yet, the largest single category of personal property—stocks and shares (including the beneficial interest in stocks and shares held collectively via investment institutions, mainly to provide retirement income)—lack effective ownership. Those who hold shares directly—in the United States, 50% of all shares are held directly—are individually so small as to be virtually powerless. Only if shareholders can unite effectively—and, in practice, this applies only to institutional shareholders—will corporate managements be held accountable. This seldom happens except in a rare corporate crisis, by which time the damage often has been done.
In the United States, more than half of all shares are owned by life insurance companies, mutual funds, and pension funds. So-called 401(k) plans, retirement savings plans funded by employee contributions and matching contributions from the employer, have become a major factor. Mutual funds compete heavily for this business. In theory, therefore, their corporate governance activities, if any, can make a crucial difference. With the exception of few public pension funds, however, institutional investors have not played an active role in monitoring corporations. Instead, they have been content to do nothing or simply sell the stock of companies where they disagree with management’s strategy. One could argue this behavior is rational. Any other course of action is likely more costly and less rewarding for their shareholders and beneficiaries. Moreover, institutional fund managers themselves have serious conflicts of interests that incentivize them against direct intervention to prevent corporate misconduct. Their compensation—typically a flat percentage of assets under management—depends largely on the amount of assets under management. Retirement funds originating with corporations have been the most important source of new funds. Mutual fund managers, therefore, are unlikely to engage in corporate governance actions that antagonize corporate managers for fear of losing these pension funds. The law also discourages institutional investors from acquiring large positions in companies and taking a direct interest in corporate affairs, which would give institutional investors a greater incentive to engage in active corporate governance. For example, the “five and ten” rule in the Investment Company Act of 1940 is a clear attempt to limit mutual fund ownership, and section 16(b) of the Securities and Exchange Act of 1934 (the “short-swing profits” rule) discourages mutual funds from taking large equity positions and from placing a director on a portfolio company’s board of directors.The Securities and Exchange Act of 1934 requires that at least 50% of the value of a fund’s total assets satisfy two criteria: an equity position cannot exceed 5% of the value of a fund’s assets, and the fund cannot hold more then 10% of the outstanding securities of any company.
Thus, making institutional investors more active and more effective corporate monitors—while attractive from a theoretical perspective and consistent with the basic tenets of American capitalism—involves complex legal, structural, and philosophic issues: Should we encourage larger ownership in firms and more activism by institutional investors? What are the motives and incentives of fund managers, and are they likely to be consistent with those of shareholders? If we do want to encourage more institutional activism, do we want to encourage active ownership by all institutions and, in particular, by public pension funds, which may be conflicted by public or political interests? Finally, what structural and legal changes must be made to change the culture of institutional passiveness and bring about more activism?These questions are adapted from Edwards (2003). We also note that the Securities and Exchange Commission (SEC) recently made progress on this issue by requiring that a majority of mutual fund boards be comprised of “independent” directors, and by changing the definition of “independence” to be the same as that employed by Sarbanes-Oxley and the New York Stock Exchange.