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FOR FURTHER INFORMATION: Helen K. Chang, 650-723-3358,
Fax: 650-725-6750
October, 2003
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."
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.
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.
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