American Institutional Integrity

The pride America has for its firefighters, police and soldiers - who sacrificed so much in response to the terrorist attacks - stands in sad contrast to the failure of our political and corporate leadership to restore confidence in our financial and economic system. The unbridled self-interest of corporate CEOs, the willful indifference of auditors and stock analysts, the incompetence of corporate boards, and the self-interest of political leaders have undermined American integrity in ways unseen since the 1930s.

A quick tally of some recent scandals reveals hundreds of billions of dollars in fraudulent transactions: MCI WorldCom (CEO borrows $400 million from company while it hides $3.8 billion in unrecorded expenses and incurs a $150 billion drop in market value), Enron (executives receive hundreds of millions in compensation while company collapses), Global Crossing (CEO stock sales of $730 million over last three years while company has a $52 billion drop in market value and then declares bankruptcy), Qwest (CEO compensation of over $100 million in last year while company drops $100 billion in market value), Adelphia ($2.3 billion in "co-loans" to its officers while company drops $2 billion in market value), Tyco International (CEO and CFO stock sales of $500 million while company has $100 billion drop in market value), ImClone Systems (insider trading by CEO and his family), Xerox ($6 billion in falsely accelerated revenue), Cendant ($3 billion in alleged shareholder fraud), Waste Management (shareholder fraud of $500 million), Arthur Andersen (criminal conviction for concealing evidence), and Merrill Lynch ($100 million in penalties for false touting of stock).

The Conference Board of Corporate Ethics Officers (the "Conference Board") reports that a majority of its members believe that six to ten more major scandals will occur this year, while 20% believe that up to 20 major scandals will occur.

We are confronted by a national embarrassment. It is not enough to propose self-regulation, to claim that the scams are isolated or to simply require more disclosure. Henry Paulson, the CEO of Goldman Sachs, notes that, "American Business has never been under such scrutiny. To be blunt, much of it is deserved." Richard Kavanagh, the CEO of the Conference Board, states that "trust in business is at its lowest ebb" since 1916, when the business research organization was founded.

We now have many calls for reform, with proposals being made by notables ranging from Alan Greenspan, Goldman Sachs, New York Stock Exchange, President Bush, the Senate Finance Committee and many others. Columnists in periodicals such as Business Week deride most of the proposals from the political leadership as "Reform Lite." In June the New York Times reported that, "Six months after the collapse of Enron, a wave of enthusiasm for overhauling the national' corporate and accounting laws has ebbed and the toughest proposals for change are all but dead."

There has never been a more important time for political leaders to restore confidence in our financial and business institutions. Whether in a federal or state office, political leaders must explain what they will do to restore American institutional integrity. This report reviews several proposals to restore public confidence in our economic institutions.

The Erosion of Corporate Ethics

Interestingly, the loudest calls for reform come from leading financial institutions whose own stability is most affected by public confidence. Public trust is not an optional ingredient for capitalism; it is essential. Without public trust, capital availability and market liquidity is threatened. Our financial system depends upon the free flow of capital, which in turn occurs only when there is confidence that the stock exchanges and the marketplace have the necessary checks and balances to ensure reasonable fairness for investors.

Over the past twenty years, corporations have come to rely more heavily on the stock market, rather than banks or the bond market. As corporations became more dependent upon the stock market, top executives became fixated in the need to meet investor demands for increased profits and higher share prices. CEOs were given generous stock options to make sure they aligned their interests with the shareholders. In response to investor demand for immediate returns, CEOs transformed operational corporations into holding companies that bough and sold companies in order to create quicker returns. As typified by the behavior of Enron executives, long term projects involving the construction of industrial plants simply took too long to satiate corporate executive' appetite for higher stock value. To do so, too many chief executives used "creative accounting" to keep their stock afloat while their capital intensive infrastructures were built.

In the end, the corporate culture of the "new economy" evolved to the point where stratospheric remuneration was seen as the sole measure of success of a chief executive officer, and became the main objective of executives. Gordon Gekko of Wall Street may have been evil in 1987, but by 1999 he was not only socially acceptable but also an MBA hero. Former Federal Reserve Board Chairman Paul Volker recently described this Gekko Transformation:

Corporate responsibility is mainly a matter of attitudes, and the attitudes got corrupted by the mentality of the markets in the 1900'... We went from greed is good being said as a joke to people thinking that greed is good is a fundamental fact.

To restore trust in our economic institutions, we need to change this culture of greed:

1. Boards of directors must represent the interests of employees and shareholders/equity investors.

2. Professionals such as auditors and stock analysts, who are supposed to be investor watchdogs need to act as such and not be lapdogs for the chief executive.

3. Chief executive officers must be paid at a level more in line with the compensation of the average worker.

4. State attorney generals and other law enforcement officers need to prosecute violators and cannot rely on Congress or federal agencies to do so.

5. Pension funds and institutional investors need to step to the plate and enforce the securities law via private lawsuits that are vigorously prosecuted.

Chief Executive Officers Must Focus on the Interests of the Corporate and All of its Stakeholders

The use of stock options was supposed to align the chief executives of industry with the interests of the shareholders. Unfortunately, it appears that all too often the financial remuneration was so large that it distracted the CEO' interest from the best interests of the corporate ship to his personal yacht. Numerous commentators lament that the almost myopic focus on stock value has nurtured a culture of greed and self-interest at the helm of the corporations which has permeated into the ranks of many companies.

Gary Winnick, who ran Global Crossing out of a Beverly Hills mansion, sold more than $730 million in stock options of the company before driving it into bankruptcy. Bernie Ebbers, who presided over the loss of over $150 billion in market value of Worldcom stock before his departure, was able to garnish approximately $360 million in loan guarantees from the company. Joe Nacchio, the CEO who presided over the loss in $100 billion of market value of Qwest, was able to get a $20 million severance package as he walked out the door. John Rigas of Adelphia was able to get billions in loans from the company before he was removed as chief executive officer. Dennis Kozlowski and his CFO unloaded more than $500 million in Tyco stock while driving down the market value of the company by $100 billion. Ken Lay received $67 million in compensation during the year prior to Enron' bankruptcy, while Jeffrey Skilling pocketed $40 million and Andrew Fastow pocketed $5.6 million. Over $680 million was paid to 140 Enron executives in the last year, an average of $4.7 million each.

This greed by failed executives, at the expense of shareholders, employees, creditors and pensioners, is a national scandal. It is unacceptable that age restrictions and other barriers should lock in people with 401(k) plans while "highly compensated employees" are free to unload their stock. The following would hopefully reign in some of the greed and restore confidence by employees and investors in the leadership of corporate America:

1. Prohibit Loans: Public corporations should be prohibited from making loans to high-compensated employees. For obvious reasons the laws don't permit a bank to make a loan to its officers. For the same reasons, public corporations shouldn't be able to do so either.

2. Stock Options, Holding Period: The quickest way to lengthen the attention span of an executive is to prohibit the executive' sale of any company stock until one year after he or she has left the company. By doing so, the interests of the executive are more aligned with the long-term interests of the corporation. It would also act as a disincentive for an executive to shift revenue and expenses in order to accelerate profits and make a quick kill on the increased stock value.

3. Stock Options, Parity: The 200 largest corporations have set aside nearly 10% of their stock for top executives. In almost all cases it is the CEO who takes the lion' share of the options. 75% of options should be required to be distributed to non-highly compensated executives.

4. Stock Options, Reporting: Several companies, expense stock options in the year they are granted. By doing so, the corporation recognizes the effect of the dilution and the value being given to the executives. The current system masks the true compensation being paid to executives. It also hides the true impact of the stock options on the bottom line of the financial statement.

5. Salaries: In 1995 the tax laws were amended to prohibits a corporation from deducting compensation paid to an officer in excess of $1 million unless the plan was approved by shareholders. If the purpose of the law was to reign in executive greed, it doesn't appear to have succeeded. According to Business Week, in 1980 CEOs made approximately 20 times more than the average employee. Today, the average CEO salary is 600 times more than the average employee. One survey reports that in the 1990s the average CEO pay role 570% while profits rose 114% and the average employee' pay roles 37%. In 1999, when shareholder returns feel by 3.9%, CEO direct compensation roles by 10.8%. Hopefully, by adopting proposals to increase the independence of the board of directors, some balance can be restore to the compensation process. There should be a cap on how much a CEO' compensation can exceed that o the average employee.

Conclusion

Our financial system is at a critical juncture. We need all who can to call executives to account. Little faith in this regard should be placed with the federal government. Neither President Bush or SEC Chairman Pitt are sincere in their efforts - they have spent years as friends and allies of these executives. Those who can make a difference include state law enforcement and securities officials, pension funds and institutional investors.