Wednesday, October 15, 2003

What Led to Enron, WorldCom and the Like?

STANFORD GRADUATE SCHOOL OF BUSINESS—Increases in executive compensation and stock options, jumps in incentives to manage earnings, and major shifts in the structure of auditing firms are just a few of the changes that led to loss of money and public confidence in corporations during the past decade, Stanford Business School Professor Maureen McNichols told an alumni audience.

McNichols, who is the Marriner S. Eccles Professor of Public and Private Management at the Business School, directs the Corporate Governance Executive Program for directors of public corporations.

Oversight mechanisms already in place failed to prevent recent scandals involving the likes of WorldCom, Waste Management, Sunbeam, and, of course, Enron, she said, asking rhetorically: "If the system is not, in fact working, what are its weaknesses?"

The crises in corporate governance are not new she said and proceeded to play a "Name That Governance Scandal!" guessing game with the audience. What publicly traded construction management company had directors who were also secretly the owners of another company that did the actual construction work—and fraudulently collected all profits? When the scheme was discovered, the directors transferred shares of stock to members of Congress in a failed attempt to forestall investigation. The company in question? The Boston Pacific Railroad—in 1872. "Bad behavior is not new," said McNichols. "There have been scoundrels and rogues throughout history."

The same is true in executive compensation, she said. Eugene Grace, president of Bethlehem Steel in 1929, earned a 1.6 million cash bonus on a salary of just $12,000. "This would be equivalent to a bonus of over a billion dollars on a million-dollar salary today," said McNichols.

An unexpected resource for the October 18 Alumni Weekend talk was Robert "Steve" Miller, MBA '68, who was sitting in the front row. A renowned turnaround expert who has been brought into companies facing financial crisis like Chrysler, Waste Management, and—most recently as CEO of Bethlehem Steel, Miller, added ruefully: "I guessed I missed the boat."

Trends in Governance Failures in the 1990s

Although bad behavior is not new, McNichols said, the world changed in the 1990s. The corporate governance failures seen in the 1990s reflect significant changes in the incentives of managers. For starters, there were dramatic changes in CEO compensation. Between 1990 and 2001, worker pay increased 42 percent; corporate profits increased 88 percent; the Standard & Poor 500 index increased 248 percent; and CEO pay rose a whopping 463 percent.

At the same time, the number of earnings restatements, a serious step taken to correct inconsistencies, also increased dramatically. In 1997, 116 firms restated their earnings; by 2001, that number had more than doubled, to 270. What these metrics reflect is "management's growing incentive, willingness, and ability to manipulate earnings," said McNichols.

But management greed wasn't the only driving factor. In the 1990s, auditing firms became "client-focused," a euphemism for increased attempts to sell clients a significant bundle of non-auditing services. This provided a clear conflict of interest to the auditing firms that now had incentives to look out for clients' interests while still shouldering primary responsibility to look out for stockholders. Participants viewed a short film clip on the fraud at Waste Management and saw Roderick Hills, former Securities Exchange Commission Chairman note that in the nine cases where he had served on a board that replaced the CEO, the auditors later provided information they had not made available to the board when the former CEO was in place. Steve Miller added his eyewitness account, describing his and Roderick Hills'role in responding to the governance failures at Waste Management. "Can you just travel around with me as I give this lecture?" joked McNichols.

Add a record number of new offerings to capital markets, "and we saw that governance structures were not adequate to meet all these increased pressures," said McNichols. A report by former SEC chairman Richard Breeden made not one or two but 78 different recommendations to change corporate governance at WorldCom.

Discretion As the Better Part of Accounting

Arising out of the governance mayhem of the past decade are key lessons for regulators, auditors, investors, analysts, managers, and directors, McNichols said. Due to the large and complex nature of the checks and balances of an evolving system, it is imperative that each member of the governance system understands how the role he play fits into the big picture.

For regulators, there is the sobering fact that redundancy in governance systems do not preclude failures and that the oversight processes and self-regulation of auditors, analysts, and boards of directors are "only as strong as the weakest links." The focus of the Sarbanes-Oxley Act of 2002 on financial statements and auditors and strengthening the role of the audit committee is a move in the right direction, she said.

The key lesson for auditing firms is to provide auditors with incentives to convey all relevant information to the board of directors or audit committee. Regulators will respond to audit failures and obstruction of justice with very significant penalties.

She argued that for analysts to generate truly independent research, they must be rewarded for the quality of the research they provide, and they must examine the quality of corporate earnings and financial statements diligently.

Corporate managers, for their part, must understand that distorting financial statements imposes huge costs on the rest of the economy. Furthermore, she said, financial statements that provide a misleadingly-glowing view of future growth may provide incentives for the company itself to act inappropriately by making excessive capital investments, as the telecom bubble illustrates.

Managers, instead, need to understand that they are best serving investors by presenting credible financial statements—and that firms with better reporting will be valued more highly by investors. Not insignificantly, managers must also take to heart that "misleading investors can lead to civil and criminal prosecution," said McNichols.

She argued it is neither possible nor desirable to turn preparation of financial statements into a mechanical process. Indeed, the level of discretion and judgment required to prepare financial statements that represent the economic state of the organization fairly and transparently will increase, not decrease, in coming years.

Finally, McNichols outlined a number of critical lessons for directors. First, the oversight role of directors has increased substantially, though the advisory role is no less important. Secondly, the legal standard for a director is to demonstrate good faith judgment, and this requires that decisions are arrived at through a sound process. A critical aspect of a good process is ensuring that directors receive all relevant information.

McNichols recommended the "TV test" described by faculty colleague Bill Miller, who attributes it to the Business School's Dean Emeritus Arjay Miller. His test for good decision-making was whether he would feel comfortable explaining the board's decision on the evening news. "If you're not comfortable with that, you probably need to go back and examine your process for arriving at judgments," said McNichols.