Saving Capitalism from the Capitalists

Rarely has a president, sitting atop record-high approval ratings, been so quickly bypassed by events, and abandoned by his own party. Last Tuesday George W. Bush dropped in on Wall Street to tell a select crowd of biggies how he planned to cope with all the bad apples that have turned up in America’s executive suites. Crooks should be forced to disgorge their ill-gotten gains, and should go to jail for extended periods. Enforcement agencies should be given adequate resources. Corporate executives should be held responsible for the accuracy of what they tell shareholders, disclose their compensation in annual reports “prominently, and in plain English,” and “explain why his or her compensation package is in the best interest of the company he serves.” Board members should be independent and “ask tough questions.” Shareholders should speak up. Most important, chief executive officers must create a “moral tone” that ensures that the company’s top managers behave in accordance with the highest ethical standards.

The reaction was swift. No surprise: the president’s supporters hailed him as a latter-day reformer in the mold of trust-buster Teddy Roosevelt and the creator of banking and securities regulation, Franklin D. Roosevelt. No surprise: more than a few chief executive officers called the White House in outrage at the notion that they should publicize their salaries in an easily accessible format. One told me some years ago that if he revealed his earnings he would become a target for kidnappers, the potential thugs apparently otherwise unaware that the CEO of a top Fortune 500 company is well paid.

Surprise: by Thursday every member of his party in the Senate voted for a Democratic version of a reform bill containing much stronger criminal sanctions than the president recommended. He wanted to jail crooks for five years; the Senate said longer is better, and voted to make any executive engaged in “a scheme or artifice” to defraud investors an involuntary guest of the government for ten years. The president was content to call for more vigorous enforcement of existing laws; the Senate created new classes of felonies. The Senate version will now have to be reconciled with the weaker, Republican-backed version passed by the House of Representatives.

Meanwhile, the pace of reform quickens. Although regulation has failed to prevent the current disaster, Congress wants to set up a new agency to monitor accountants, and add substantially to the staffs of existing enforcement agencies. Never mind that key private sector institutions such as the New York Stock Exchange and the Business Roundtable (an organization of top CEOs) have enlisted in the ranks of the reformers, not because their memberships are dominated by a bunch of goodie-two-shoes, but for the more reliable reason that honest markets and accurate profit reporting are in their self-interest. In addition, several companies are scrambling to adopt governance rules and accounting practices that will reassure investors that the game is not rigged against them by the imaginative treatment of revenues (claim them now, before the customer pays or even considers paying) and of costs (capitalize rather than expense every outlay, regardless of the life of the item purchased).

But, if capitalism is to be saved from the capitalists, the government will have to play a role. As Milton Friedman, no fan of big government, has written, society needs rules and an umpire “to enforce compliance with rules on the part of those few who would otherwise not play the game.” If those rules concentrate on getting the players’ incentives right, further on-going intervention by government can be minimized.

Senator John McCain, the Republican maverick whose supporters still resent his treatment by George Bush in the Republican presidential primaries, has proposed that auditors be barred from accepting consulting assignments, and also wants to mandate the separation of investment banking from the share analysis business. He is right. Enron awarded large consulting contracts to its auditor, and WorldCom paid Andersen $4 million for auditing and $12 million for consulting services. It would take a brave auditor willingly to antagonize the CEO who awards these contracts, especially when American practice only requires him to certify that the books follow generally accepted accounting principles, many of them arcane and susceptible of multiple interpretations. Little wonder that 70 percent of the directors surveyed by McKinsey & Co. now say that they will in the future oppose the granting of consulting contracts to the firms that prepare their audits. Lead the accountants not into temptation, and regulation or reliance on porous Chinese Walls becomes unnecessary.

So, too, with investment analysts, some of whom are now famous for privately characterizing as “shitty” the shares they were publicly recommending. Jack Grubman, the Solomon Smith Barney (a division of Citigroup) analyst famous for his enthusiastic recommendations of WorldCom stock, last week told the House Financial Services Committee that part of his salary, which reached $15 million per year, came from the $140 million in underwriting fees that his firm received from WorldCom over the past five years. He denied that the banking fees influenced his decision to recommend WorldCom shares, but most observers say that it is the rare CEO who will hire an investment banker whose analyst-partner is rubbishing his company’s shares.

Finally, there is the question of executive compensation. The president wants such payments to “square with reality and common sense,” a notion considerably less precise than basing pay on performance. Since there is no way to tell how much is too much, the best bet is to get the process of compensation right by having lists of prospective directors drawn up by investors rather than managers, and prohibiting directors, especially those serving on compensation committees, from accepting consulting assignments, airplane rides, and other favors from CEOs.

Congress is now turning its attention to these issues, and to the president’s suggestion that the CEO be required to attest to the essential accuracy of company financial statements, and be barred from accepting loans from his company. Meanwhile, investors continue to worry, but whether they are concerned about shoddy-to-crooked corporate reporting, or the outlook for earnings—real, honest-to-goodness earnings—no one knows.

This article originally appeared in London’sSunday Times on July 14, 2002, and is reprinted with permission.