In Infectious Greed, two leading financial experts offer a powerful new explanation of why the corporate scandals happened—and propose market-driven reforms that don’t just “patch” the system but fix it for generations to come. Discover how the system came to provide massive incentives for malfeasance by CEOs, boards, auditors, analysts, and investment houses—and learn how those “bad” incentives can be replaced by even more powerful incentives for integrity.
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1. The Importance of Investor Confidence.
Asleep at the Wheel. Investor Attitude. Investor Confidence and the Stock Market. Long-Term Economic Effects. Our Approach. Endnotes.
Business Forms. People in Business. Separation of Ownership and Control. Can Investors Influence Managers? Are Investors Helpless? A System of Problems. International Monitoring. Summary. Endnotes.
I. The Failure of Executives.3. Executive Compensation and Incentives.
Types of Executive Compensation. Base Salary and Bonus. Stock Options. Options and Accounting. Stock Options and (Mis)Alignment. Who Gets Options? CEO Pay Around the World. Hidden Compensation. Summary. Endnotes.4. Executive Behavior.
Options and Fraud. Timing of Sales. Company Loans-A Potential Abuse. Grand Theft. Adelphia. Enron. Tyco. Why Do Some Executives Misbehave? Summary. Endnotes.
II. The Failure of Monitoring Systems.5. Accountants and Auditors.
Accounting Functions. Auditing. The Changing Role of Accounting. From Management to Fraud. Fraud, Plain and Simple. Consultants. When the Auditor is also a Consultant. Fear of All Sums. An International Perspective. Summary. Endnotes.6. The Board of Directors.
Current Board Regulations. More Attention on Directors. Who Are Directors? The Board's Functions. Problems with Boards. Is Enron's Board Partially to Blame? Summary. Endnotes.7. Investment Banks.
Some Historical Perspective. Investment Banking Activities. IPO Problems. IPOs and Fraud. Structured Deals. Summary. Endnotes.8. Analysts.
The Traditional Role of the Analyst. Can Analysts Predict? Analyst Compensation. Potential Conflicts of Interest. Analysts at Investment Banks. Just Who Is the Client? Changing Roles. Summary. Endnotes.9. More Failed Monitors: Credit Rating Agencies and Lawyers.
Credit Rating Agencies. A Brief Historical Perspective. The Ratings. Criticism. Enron. Summary of Credit Agency Problems. Attorneys. Protecting Lawyers. Summary of Attorney Problems. Endnotes.
III. Shortcomings in Enforcement and Investor Activism.10. The Securities and Exchange Commission.
The Securities Acts. Organizational Structure of the SEC. Assessment of the Acts and the SEC. SEC Problem Areas. Arthur Levitt's I Told You So. The Man in the Middle: Harvey Pitt. Summary. Endnotes.11. Investor Activism.
What Is Shareholder Activism? Does Institutional Shareholder Activism Pay Off? Potential Roadblocks to Effective Shareholder Activism. The Future Role of Shareholder Activists. Summary. Endnotes.
IV. Restoring Confidence.12. New Rules, Regulations, and Policies.
A Review of the Corporate Problems. Sarbanes-Oxley Act of 2002. Public Company Accounting Oversight Board. Auditor Independence. Corporate Responsibility. Enhanced Financial Disclosures. Analysts' Conflicts of Interest. SEC Resources and Authority. Corporate and Criminal Fraud Accountability and Penalties. Summary of the Act. Other Proposals for Change. New York Stock Exchange. Expensing Stock Options. More Change. Endnotes.13. Create Good Incentives for Long-Term Solutions.
The Power of Incentives. Our Recommendations. Stock and Stock Option Incentives. Insider Equity Sales. Changing Option Structure. Auditing Firm Incentives. Boards of Directors. Investment Banks and Analyst Incentives. Credit Rating Agencies. Shareholders. Summary. Endnotes.14. Regaining Investor Confidence.
Protecting Investors (Not). Investor Confidence. Failing to Regain Confidence. Regaining the Confidence. Summary. Endnotes.Index.
“Why did corporate governance checks and balances that served us reasonably well in the past break down? At root was the rapid enlargement of stock market capitalizations in the latter part of the 1990s that arguably engendered an outsized increase in opportunities for avarice. An infectious greed seemed to grip much of our business community.”
Alan Greenspan, Federal Reserve Chairman, Speech to Congress, July 16, 2002
Chairman Greenspan’s comments lead to some very intriguing questions. What are the “corporate governance checks and balances” that he spoke of? How and why did they fail us? Can this breakdown ever happen again?
Answering these questions is what this book is all about. We refer to the checks and balances as executive incentives and corporate monitors. Indeed, there are many participants in the corporate governance system. Although the corporate scandals take on specific names and faces (like Andrew Fastow, Martha Stewart, Enron, Arthur Andersen, and WorldCom), the problem actually involves a whole system that either allowed the misdeeds or failed to catch them.
It might be convenient to blame one group of people or another. For example, CEOs and other top executives have been blamed for being greedy, but they weren’t the only ones who acted greedily. Many politicians and the media have blamed auditors, but they weren’t the only ones who failed to monitor the companies. The problem was a breakdown of the system. For example, a board of directors, which was elected by the shareholders, gave the CEO and other executives stock options. This motivated them to maximize the stock price at a specific point when they could cash in the options for millions of dollars. The CEO then talked up his or her company to analysts. The captive analysts, impressed with the business, assigned a buy rating and hyped the stock. To meet the expectations, the CEO demanded that the accounting department manufacture paper profits. Solutions also came from consultants and often involved investment bankers. These perilous actions were either okayed or overlooked by the corporate lawyers and the auditors. Any one of these groups could have put a stop to the shenanigans, but didn’t. Why not? In this book, we thoroughly discuss the incentives, conflicts, and actions of each of the participants in the corporate system.
Some of the problems had been developing for many years. The Securities and Exchange Commission (SEC) knew about some of the problems but failed to act to stop them. Indeed, in the middle and late 1990s, the government enacted laws that reduced investor protection. When the scandals broke in 2001 and 2002, however, politicians were then lining up to speak against the “evil doers,” the greedy corporate executives—a 180-degree turnaround. And, as if by script, they worked fast to enact new laws and to restore investor confidence. New laws were passed, but confidence hasn’t been restored. Why not? Is it that the laws that were passed were not as effective as they could have been? People are naturally skeptical of these new laws, and their skepticism may not be unfounded as the participants in the corporate governance system are some of the largest donors to political campaigns. Auditing firms, investment banking firms, corporate lawyers, and the public companies themselves donate tens of millions of dollars to the two major political parties per election cycle. Should we really believe that these politicians are turning their backs on those who have made donations? This book exposes why many of the new laws and policies will only be marginally effective in improving the system.
We recognize that these new proposals are an important part of the process to restore investor confidence, but where the creators of these solutions fall short is their inability to recognize that the American corporate form of business is an integrated system with many parts. We should first realize, however, that this system has allowed the U.S. economy to become the largest and strongest in the world. Therefore, the basic system is a good one that deserves to be preserved, but it does have its problems that can be fixed. The best solutions neither overburden the basic system nor overtax or unnecessarily scare the people. After all, we want our capitalist system to continue to churn out new jobs, wealth, and revenue far into the future. In this book, we propose some incentive-driven solutions that fit within the current system to make it better. Combining our incentive-driven solutions with the punishment and regulation-based solutions that have been proposed from the government should make the system not only whole again, but better.
If you own any stocks, either as an active investor or through your retirement savings, then this book was very much written for you. The group with the greatest interest in monitoring management is the shareholders themselves. The American investor has become disengaged from the company he or she owns. Too often, investors take little interest in the inner workings of the corporation. If something about a company upsets an investor, he or she simply sells the stock and buys a different one. The dramatic decline in commission costs lends itself to this apathy. If shareholders do not take a stand for their own investment, why should executives, the board, or anyone else? Investors need to educate themselves on how this corporate system works and what their role should be. Being more knowledgeable about the system, its failures, and the solutions would also help investors regain some of the trust that was broken. This book aims to provide that education.
Finally, we believe that anyone who is interested in participating in the corporate system in the future (for example, business students) should read this book. To make sure that breakdowns like the ones that occurred recently are never to be experienced again, the future participants in the system need to learn from the past.
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