State of the Union January/February 2006

Executive Privilege

The CEOs of too many public companies enjoy the power and rewards of ownership without the risks. Corporate values have deteriorated as a result

Hedge-fund clients are typically unaware not only of the companies (or governments, or currencies, or other financial markets) they are invested in but also of the instruments used, and the scale or nature of the risks taken. A hedge-fund investor is a pure speculator, in no way a capitalist—not even in the modern, eviscerated sense of that term. This is not to say that hedge funds serve no useful economic purpose. But they are risky, they are opaque, and they mean we are asking for trouble. Don't be surprised if more than a handful of hedge funds go off the rails in the next few years.

If a hedge fund collapsed without wider repercussions, it would hardly matter. People understand that hedge-fund investors take a big risk; they feel little sympathy (probably the opposite) for gamblers who lose their shirts. But the failure of a big hedge fund, or a cascade of failures, might well have wider repercussions. Because many funds rely on borrowing, rising interest rates might cause several to fail at once. And because these funds manipulate very large sums, any banks that had lent to them, directly or indirectly, might be put in jeopardy.

W hat is to be done? Corporate scandals have already elicited one major regulatory response: the Sarbanes-Oxley Act, known as SOX, a far-reaching reform of corporate-governance law. SOX is an important law; nonetheless, it frames the issue in a narrow way. It focuses on auditing—that is, on the quality of the information that companies put before their investors and other interested parties. The law aims to make auditors more independent of managers—for instance, by forbidding them to offer companies various non-auditing services alongside their normal work, a practice that has given rise to conflicts of interest. It obliges firms to document their internal financial controls, and requires managers—on pain of criminal penalties—to attest to the adequacy of those controls. SOX ended self-regulation in the industry and created a new body to oversee the auditing profession: the Public Company Accounting Oversight Board.

Auditing reform was surely needed, though it is not yet clear whether SOX is a well-designed answer. Its measures are complex—perhaps too complex to restore investors' trust in published accounts—and the cost of compliance is heavy.

More fundamental, the SOX prescription does not go to the heart of the problem. Essentially, its remedy is more financial controls. But the instances of corporate abuse at Enron and elsewhere did not arise from lack of controls. They occurred because the companies' most senior executives overrode controls that were already in place and then plotted to hide what they had done. SOX may make that more difficult in the future, but it certainly won't stop the practice altogether.

Beyond SOX, what? "First, do no harm" is a good rule. Modern American capitalism has charges to answer, but it is best to keep a sense of proportion. The U.S. economy remains the most productive—and by almost any measure the most successful—in the world. This cannot be because America has the wisest politicians, the most judicious regulators, or the smartest captains of industry; the global playing field in those areas would seem to be pretty level. America's economic pre-eminence must have something to do with its distinctive business model, the very model many people now question—which in different ways continues to reward success more generously and punish failure more brutally (options and parachutes notwithstanding) than the milder systems to be found in, for instance, Europe and Japan. If one values mainly productivity, innovation, and incomes in the aggregate, then the model is working beautifully compared with foreign alternatives.

New regulations could, and probably should, force companies to give shareholders more power over managers. But today's shareholders, individual and institutional alike, rarely exercise the rights they already have. Often, when managers let owners down and confidence in capitalism falters, investors are at least partly to blame. Even if they are not cheering the managers on to greater feats of daring, they are failing to demand probity and accountability. It all comes down to traditional values. One of the oldest maxims of commercial virtue is still the best: Buyer beware.

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