How to Fix Corporate Governance

Excessive pay, corrupt analysts, auditing games: It all adds up to capitalism's biggest crisis since the trustbuster era

A disenchanted investor vows to vote in favor of every shareholder resolution he can find. An angry employee says she feels betrayed by bosses who have grown rich on stock options while putting the squeeze on health benefits and salaries. A dealmaker, trying to close a sale, hears yet another buyer grouse: "Who's to say this guy isn't lying about the numbers like everyone else?"

Faith in Corporate America hasn't been so strained since the early 1900s, when the public's furor over the monopoly powers of big business led to years of trustbusting by Theodore Roosevelt. The latest wave of skepticism may have started with Enron Corp.'s ugly demise, but with each revelation of corporate excess or wrongdoing, the goodwill built up by business during the boom of the past decade has eroded a little more, giving way to widespread suspicion and mistrust. An unrelenting barrage of headlines that tell of Securities & Exchange Commission investigations, indictments, guilty pleas, government settlements, financial restatements, and fines has only lent greater credence to the belief that the system is inherently unfair.

Some corporate chieftains claim that the backlash is overblown, a form of "corporate McCarthyism," in the words of Joseph P. Nacchio, head of Qwest Communications (Q ), which is one of dozens of companies under investigation by the SEC for questionable accounting. But increasingly, the public perception is that too many corporate executives have committed egregious breaches of trust by cooking the books, shading the truth, and enriching themselves with huge stock-option profits while shareholders suffered breathtaking losses. Meanwhile, despite a decade or more of boardroom reforms, many directors seem to have become either passive or conflicted players in this morality play, unwilling to question or follow up on even the most routine issues. If the governance of the modern corporation isn't completely broken, it is going through a severe crisis of confidence.

The sight of Enron employees tearfully testifying before Congress was a watershed moment in American capitalism. They painted a picture of betrayal by company leaders that left them holding huge losses in their pension plans. Enron added to the sense that no matter how serious their failure or how imperiled the corporation, those in charge always seem to walk away vastly enriched, while employees and shareholders are left to suffer the consequences of the top managers' ineptitude or malfeasance.

In many ways, Enron and its dealings with Arthur Andersen are an anomaly, a perfect storm where greed, lax oversight, and outright fraud combined to unravel two of the nation's largest companies. But a certain moral laxity has come to pervade even the bluest of the blue chips. When IBM (IBM ) used $290 million from the sale of a business three days before the end of its fourth quarter last year to help it beat Wall Street's profit forecast, it did what was perfectly legal--and yet entirely misleading. That one-time undisclosed gain, used to lower operating costs, had nothing to do with the company's underlying operating performance. Such distortions have become commonplace, as companies strive to hit a target even at the cost of clarity and fairness.

The inevitable result is growing outrage among corporate stakeholders. "I feel thoroughly disillusioned and disgusted," complains Eugene J. Becker, a small investor living near Baltimore. "These people cannot police themselves. Greed is their driver. It's time for stockholders to start showing their disillusionment in tangible ways." This year, for the first time, Becker is casting "no" votes against management at the eight public companies in which he is a shareholder.

Unchecked, that rising bitterness and distrust could prove costly to business and to society. At risk is the very integrity of capitalism. If investors continue to lose faith in corporations, they could choke off access to capital, the fuel that has powered America's record of innovation and economic leadership. The loss of trust threatens our ability to create new jobs and reignite the economy. It also leaves a taint on the majority of executives and corporations who act with integrity. Directors who fail to direct and CEOs who fail at moral leadership are arguably the most serious challenge facing Corporate America today.

More than a half-century ago, Columbia University professors Adolf A. Berle and Gardiner C. Means made clear the divergence between the owners of the corporation and the professional managers hired to run it. They warned that widely dispersed ownership "released management from the overriding requirement that it serve stockholders." A great irony of the boom era is that after years of lavish stock-option rewards meant to remedy the problem, this divergence is more extreme than ever. The senior executives of public corporations today are often among the largest individual owners of those enterprises, and board members are far more likely to have major equity stakes as well.

In theory, this ownership was supposed to align the interests of management and directors with those of shareholders. The law of unintended consequences, however, took hold. Whether through actual stock ownership or option grants, many executives and directors realized that their personal wealth was so closely tied to the price of the company stock that maintaining the share price became the highest corporate value. Investors rode the boom along with management, leading to the "irrational exuberance" of the late 1990s.

But there was a dark side to runaway stock prices. As the market overheated, it became less and less tolerant of even the slightest whiff of bad news--rumors of which could wipe out hundreds of millions of dollars of market value at a stroke. "Through the 1980s and 1990s, we constructed an architecture that emphasized reporting good news, to the point where CEOs and CFOs could not be frank with the investment community," says Anita M. McGahan, a Boston University business professor. "Many of these companies needed a course correction. But the stakes in admitting problems were very high, both because the market overvalued their stock and because of executive pay."

The tyranny of the daily stock price has led to borderline accounting and in some cases, outright fraud. And why not, when every upward tick of the stock means massive gains for option-rich executives? "Excessive CEO pay is the mad-cow disease of American boardrooms," says J. Richard Finlay, chairman of Canada's Center for Corporate & Public Governance. "It moves from company to company, rendering directors incapable of applying common sense."

A study by Finlay shows that many boards devote far more time and energy to compensation than to assuring the integrity of the company's financial reporting systems. At Oracle Corp. (ORCL ), where CEO Laurence J. Ellison's exercise of stock options just before the company issued an earnings warning led to a record $706.1 million payout last year, the full board met on only five occasions and acted by written consent three times. The compensation committee, by contrast, acted 24 times in formal session or by written consent. "Too many boards are composed of current and former CEOs who have a vested interest in maintaining a system that is beneficial to them," says Finlay. "If you look at the disconnect between audit and compensation committees, you begin to understand how misplaced the priorities of many boards are."

Enron's implosion is the most visible manifestation of a system in crisis. Self-interested executives gorged with stock-option wealth, conflicted outside advisers, and a shockingly uninvolved board: Rarely has a total breakdown in corporate governance been so clearly documented--and oddly enough, by other directors, in a report filed by William C. Powers Jr., an Enron board member. He and his colleagues found an almost total collapse in board oversight. The Powers report concluded that the board's controls were inadequate, that its committees carried out reviews "only in a cursory way," and that the board failed to appreciate "the significance of some of the specific information that came before it." That is as complete a definition of "asleep at the wheel" as you'll ever find.

With many directors lulled into complacency by climbing stock prices and their own increasing wealth, all too often the last vestige of internal control was lost. "There was this convergence of self-interest," says Edward E. Lawler III, director of the Center for Effective Organizations at the University of Southern California. "They were all doing well, and nobody wanted to rock the boat. With the escalation in board compensation through stock options, directors were the last people to the feeding trough. Once they got tied in, there was really no restraining force."

It's not just the corporation that is at fault. Many of the corporation's outside professionals fell prey to greed and self-interest as well, from Wall Street analysts and investment bankers to auditors and lawyers and even regulators and lawmakers. These players, who are supposed to provide the crucial checks and balances in a system that favors unfettered capitalism, have in many cases been compromised.

Many analysts urged investors to buy shares in companies solely because their investment banker colleagues could reap big fees for handling underwriting and merger business. Far too many auditors responsible for certifying the accuracy of a company's accounts looked the other way so their firms could rake in millions from audit fees and millions more from higher-margin consulting work. Some outside lawyers invented justifications for less-than-pristine practices to win a bigger cut of the legal fees. Far too often, CEOs found they could buy all the influence they wanted or needed. Enron managed to help write energy policy in the Bush Administration, while the Business Roundtable and Silicon Valley combined to derail efforts to change the accounting treatment for stock options.

Ending the crisis in Corporate America will take more than a single initiative or two. The breakdown has been so systemic and far-reaching that it will require major reforms in a number of critical areas. Here's where to start:

By John A. Byrne, with Louis Lavelle, Nanette Byrnes, and Marcia Vickers in New York and Amy Borrus in Washington

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