Crisis in the corner office

With one scandal after another rocking the credibility of corporate America, investment legend Warren Buffett wrote a letter to shareholders earlier this year in which he ventured a tart explanation of why so many management misdeeds are coming to light.

"You only find out who is swimming naked," he said, "when the tide goes out."

In terms of the economy and stock market, the tide has been ebbing for a couple of years now. At companies such as WorldCom, Xerox, Tyco International, Enron, and Adelphia Communications these hard times helped expose ethical lapses that have cost employees and shareholders dearly.

The details vary by company. But a common thread is fudging the numbers to make profits look better and, not so coincidentally, boost the CEO's paycheck.

Why focus on the conduct of chief executive officers? Others clearly contributed to the climate that made the misdeeds possible – including accountants, directors, and lawyers who traditionally play a watchdog role.

Still, CEOs have a profound impact on the corporate culture and ethics, even at the largest companies. They are in a position to veto dubious schemes by subordinates and, in the words of Nancy Reagan, to "just say no."

For example, the Securities and Exchange Commission (SEC) complaint last week against WorldCom for hiding a whopping $3.8 billion in expenses alleges a scheme, "directed and approved by its senior management."

Next week, President Bush will make a speech on Wall Street in which he is expected to unveil proposals for tougher penalties on executives who engage in unethical behavior. His speech will come the same week the Senate is scheduled to take up business reform legislation.

"It is clearly the job of the CEO to set the proper tone," says Henry Paulson Jr., chairman and CEO of the Goldman Sachs Group, a $31 billion investment bank.

Management lapses are no surprise. In fact, experts say they are a telltale sign of the final stages of a boom. "The scandals were much worse in Europe in 1927-30 and in the US in 1932-34 and in 1936-37," says management expert Peter F. Drucker.

The extent of CEO misdeeds during the 1990s is not yet fully known. Reported incidents affect only a small fraction of the 17,000 public companies or even the 1,000 largest firms. It is this latter group whose missteps are attracting the most public attention.

Whatever the ultimate size of the problem, the dishonesty discovered to date has already exacted a high price in lost jobs for employees, vanished pensions, diminished confidence in the stock market, reduced trust in the US as a haven for foreign investors, and a drop in the public's already meager respect for corporate America.

"The effect of abuses is much more dramatic today," says SEC Chairman Harvey Pitt. Today's financial markets are more sophisticated and interrelated. As a result, negative news about one company "can an have a dramatic impact on other companies in the same industry, and that fact will be felt instantaneously."

The scandals have also given an added push to calls for reform. Last week's news about major problems at WorldCom and Xerox quickly revived prospects for accounting reform legislation in Congress. And a number of business groups, including the New York Stock Exchange, have proposed reforms on their own.

There is considerable disagreement about the scope of CEO abuses. Last Friday, President Bush said that "the vast majority of our leaders in the business community are honest and upright people." Earlier he used the phrase "some bad apples" to describe the situation.

Mr. Paulson of Goldman Sachs takes a middle view. "The overwhelming majority of CEOs, boards, and regulators are men and women of high integrity, competent, and working hard." But he adds, "I certainly don't take the view that this behavior was limited to an isolated few. And I have to say there were more abuses and problems than I would have hoped."

The view from outside the corporate community is more stark. "I am convinced it is very widespread. It comes up in many ways in many different companies," says Arthur Levitt Jr., former chairman of the SEC.

Paul Volcker, former chairman of the Federal Reserve Board, agrees the misconduct is widespread. "It depends, I think, partly on what industry you are in. But you have a whole profession that has arisen in the past 15 years – so-called financial engineering.... A large part of it is how to get around accounting rules and IRS rules using very abstruse techniques."

"We have only seen the tip of the iceberg," predicts Michael Josephson, president of the Josephson Institute of Ethics in Marina del Rey, Calif. "The scope and enormity of the companies that have gone under... make Teapot Dome [a scandal in the Harding administration] look like kindergarten."

Still, in some ways, the expectations of CEO behavior have improved over time. "What is ethical in the public perception has changed markedly," notes Walter Wriston, former CEO of Citicorp and a longtime director of General Electric Co.

He cites the example of a former boss who had an impressive house. When Wriston asked how he could afford the place, the boss said he had bought stock in a company he knew was about to be acquired. Today that would be considered illegal trading on insider information. "It is hard to believe, [but] everybody did it and it was perfectly legal," Wriston notes.

The world in which today's CEOs operate has changed dramatically. Corporate governance experts say the changes help explain – but not excuse – recent lapses in CEO behavior.

Today's CEOs operate in a much tougher, more competitive environment than their predecessors. Due in part to the increased pace of global competition, "the jobs are substantially more demanding than they used to be" says Peter Peterson, chairman of the Blackstone Group. He is also a former Commerce Secretary and chairman of the Conference Board's Blue-Ribbon Commission on Public Trust and Private Enterprise.

One model for the CEO-statesman of the past was Reginald Jones, the chairman of General Electric from 1972-81. Tall, patrician, reserved in public, Jones oversaw a doubling in the size of GE's revenues while leading two prestigious business groups and serving as an adviser to three US presidents.

"Reg Jones's job was about one-half as demanding as [current GE chairman] Jeff Immelt's," notes Goldman CEO Paulson. "What it takes to be a good CEO is so much more difficult today than it was ... even 10 to 15 years ago. The complexity, pressure, and impact of decisionmaking is greater. There is far more political and press scrutiny."

One key change in the business climate has been in how companies view their core mission. In the past, some corporate leaders, including GE's Reg Jones, "viewed large businesses as public institutions. There was a shift and businesses became viewed – rightly so – as fundamentally profitmaking ventures," notes Charles Elson, director of the Center for Corporate Governance at the University of Delaware. "Focusing on society was viewed as in the realm of politicians."

The focus on profits, some say, came at the expense of a long-term view of goals.

Corporate leaders "are much more narrowly tied to ... return to the shareholder and answering to the market on a very short-term basis," says Bradley Googins, executive director of the Center for Corporate Citizenship at Boston College. "By and large, the demands of the market have really crowded out what [many] used to see as statesmanship."

The booming economy and stock market also played a role in affecting corporate conduct. Prolonged booms "breed financial scandals," says former SEC chief Arthur Levitt. "A culture of 'What can we get away with?' takes hold, rather than 'What is best for the investor?' A boom environment provides fuel for a meltdown that is at once economic and moral."

But perhaps the most powerful force tempting CEOs to cook the books is the greatly expanded use of stock options as a key part of executive compensation. Options give the right to purchase shares at a fixed price for a certain period.

The use of options flourished in the 1990s. The theory was that boosting the share of CEO pay given through options would give corporate managers an incentive to produce strong results for shareholders. If the stock price went up, all would benefit together.

Stock options now make up roughly 80 percent of CEO compensation. They have been used so widely that options in the hands of executives account for 15 percent of all shares outstanding.

The approach has moved CEO compensation to a lofty new level. When Business Week first began tracking CEO compensation in 1950, the best-paid executive was General Motors Board Chairman Charles Wilson who earned $4.4 million in today's dollars. The best-paid executive in 2001 was Oracle Corp. chief executive Lawrence J. Ellison, who took home $706.1 million.

Not surprisingly, the rapid jump has widened the pay gap between CEOs and average workers. In 1980, CEOs at the largest companies made 42 times what the average factory worker earned. In 2001, CEO's made 411 times as much, according to figures from Business Week.

"The technical term is, it is nuts," says Walter Wriston, describing the new CEO pay levels. And in his new book "Wealth and Democracy," Republican political analyst Kevin Phillips argues that "as the 21st century gets under way, the imbalance of wealth and democracy in the U.S. is unsustainable."

Sustainable or not, the increasing role that options play in executive pay produces a strong motivation to show ever rising profits so that share prices climb.

"By increasing shares a few dollars [in price], you can make a very large sum of money," notes Peter Peterson. "As you get near the chalk line of what is proper or improper, licit or illicit, right or wrong, it probably gets a little more tempting" when the executive in question has millions of options at stake.

Critics charge that options are misused when corporate boards either make massive options grants not tied to stellar performance or reprice options so a CEO collects even when the price of the stock falls. They also argue that options should be counted as an expense for the corporation, which is not now the case.

"The abuse of stock options has been enormous," says Paul Volcker. "An instrument that was rationalized as aligning the interests of management with the stockholder has, in my opinion, too often become an instrument for aligning the stockholder with the interests of management."

Goldman CEO Paulson takes a different view of the scale of problems with CEO compensation. "There are a number of situations – nothing like the majority – where compensation is out of line with performance or there is clearly over compensation." He adds that "most of the CEOs I have worked with ... are driven by wanting to do well, a sense of honor and purpose. They don't need huge megapackages."

In a widely noted speech last month to the National Press Club in Washington, Paulson argued that shares a CEO receives should be held for a significant period of time and that CEOs who sell before their company goes bankrupt should have their profits clawed back for up to one year.

Paulson's extensive reform proposals are among a wide number of plans being developed by industry groups like the New York Stock Exchange, by regulators like the SEC, and by Congress.

Thus the framework in which CEOs work is likely to change significantly in the months ahead.

"Changes will probably come from both the government and the private sector," says Timothy Smucker, co-CEO of the J.M. Smucker Co. "I would venture that ones from the private sector – self-policing – will be the ones that will be more lasting."

Already, the business press is reporting that companies looking for new executives are asking search firms to pay special attention to candidates' ethics. And corporate directors now feel new pressure to scrutinize CEO pay more closely.

"Behavior is already changing without rules," contends former SEC Chairman Levitt. "Humiliation and embarrassment tend to change behavior faster than rules and legislation. Legislation and rule making can be effective in prolonging changes in behavior."

In the end, though, external regulations are not what matters, observes Citicorp veteran Walter Wriston. "None of this stuff will work. Only integrity will work. You can't do good business with bad people. Period."