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

W arren Buffett, one of the most successful investors the world has ever seen, is also the epitome of a particular style of business leadership—the supreme practitioner of, and spokesman for, old-fashioned virtues in American capitalism. Berkshire Hathaway, the diversified conglomerate he built and still runs, has for years represented prudence, patience, steady calculation, and a zealous advocacy of owners'—that is, stockholders'—interests over those of managers. This old-time, values-driven philosophy, expounded in plain English each year in Buffett's letter to shareholders, stands in deliberate contrast to Wall Street's "greed is good" ethos. Still living and working in Nebraska, munching his hamburgers and sipping his Cherry Coke, the Oracle of Omaha is affectedly unglamorous. But, reassuringly, he seems to know something the fast-buck speculators don't: as Berkshire's principal shareholder he is worth around $40 billion.

Last year AIG (American International Group), an insurance giant, came under investigation for accounting irregularities stretching back years—yet another in a long list of recent corporate scandals. The company's boss, Hank Greenberg, was forced to resign. Among the transactions that attracted regulators' attention was a deal the company had done with a subsidiary of Berkshire Hathaway. Last April, Buffett gave evidence to investigators about the transaction. Soon afterward he praised Greenberg as a great insurance pioneer, the "number-one man" in the business. In May, New York's attorney general, Eliot Spitzer, prosecuting his high-profile campaign to stop corporate abuse, filed suit against Greenberg, alleging that among other things, he had designed sham transactions to make the company appear sounder than it was.

Buffett is held in such high esteem that almost nobody believed he had behaved improperly—least of all, it seems, Spitzer, who was careful to say that Buffett was not under suspicion. "Warren Buffett is an icon," said the grand corporate inquisitor. "He has succeeded the right way. He stands for smart, long-term investing, transparency, accountability—all those things we value and support." (Quite whom he meant by "we" is unclear.) Still, had things come to this? That a man of Buffett's matchless reputation might have so much as brushed up against improper business conduct was shocking. All that talk of a crisis of values in American business must be true.

Enron, WorldCom, Adelphia, Tyco—not to mention Martha Stewart, accused of insider trading and jailed for lying to investigators: the tally of actual and alleged corporate sinners is long. It includes companies and executives once famed not just for their spirit of innovation and their shining business prospects but also in many cases for their drive, their integrity, and their values. Kenneth Lay, the head of Enron, spent last year awaiting trial on multiple charges of fraud and other crimes. He was a self-made man—the son of a part-time preacher, raised in poverty, who went on to become an acclaimed business innovator, a plutocrat-philanthropist, a model boss, Houston's hometown hero, and a good friend of the first President Bush.

Lay and others were not sleazy small-timers. That is why they raise doubts about the overarching integrity of America's business culture. Capitalism is underpinned not just by law but by trust, which can be legislated only so far. Parties to contracts need to trust each other. Investors in companies—increasingly at a distance from their assets—need to trust the managers whose salaries, ultimately, they are paying. In the broadest sense, citizens need to trust the system itself, to believe that it has their interests at heart—or at least that it serves their interests, even if it has no heart. The people who benefit most conspicuously from capitalism are parties to a social contract with the rest of us. The question is, are they in breach?

Put it this way: the terms of the contract are coming under strain. Outright fraud is just one manifestation of the problem, and a narrow one at that. The ostentatious greed of many (law-abiding) CEOs, and their broader lack of accountability to shareholders, are at least as significant.

The division of capitalism's spoils has become more lopsided in recent years. Many workers have seen their wages frozen and their benefits cut. And lately even owners haven't done well: returns to stock-market investments have been poor since 2000. The group that has continued to profit, sometimes spectacularly so, is high-end professional managers—the very group from which corporate criminals are drawn. Over the past ten years the gap in pay between top executives and their subordinates (not to mention workers at the bottom of the scale) has widened a lot, and the trend shows no sign of slowing. In many cases pay schemes that rewarded chief executives generously when share prices were soaring continued to do so as prices tanked. CEOs fired for incompetence, leaving injured companies and distressed investors behind them, sometimes walked away with multimillion-dollar payments. If it isn't fraud and false accounting, one might be forgiven for thinking, it is rapacious salaries, unexpensed options, golden parachutes, and post-retirement use of the corporate jet. Not every kind of compensation is being driven down by global competition.

Unseemly executive behavior has outlasted the stock-market boom of the late 1990s, but it nonetheless has roots within that boom. Both the prevailing corporate culture and—just as important—investors' expectations shifted significantly during that time, and neither has shifted back entirely.

In the late 1990s growth in productivity accelerated, and share prices—especially in technology—soared. It was a new economic era. As at the dawning of previous new economic eras, the old rules were said to no longer apply. Investors were prodded in the chest and told they either got it or they didn't. Financial orthodoxy and traditional business virtues were mocked. Financial inhibitions were cast aside. Rather than watching sports, investors of modest means watched television pundits pick stocks. Some quit their jobs to become day traders—and did well, because it is hard to lose money in a rising market. Accountants (accountants, for heaven's sake!) were invited to seminars on "thinking outside the box."

This climate of opinion did not merely tolerate financial heterodoxy but demanded it. In 2001 a writer at Fortune was the first to ask questions about Enron's bookkeeping—but not before the magazine had hailed the company as America's most innovative for six years running. The firm's auditors missed what was going on; but so did its creditors, its analysts on Wall Street, the press, and everybody else. The mood of the moment prevailed.

In this environment CEOs were often anointed as visionaries. Naturally, celebrity bosses are expected to be buccaneers—and they often are, disdaining advice and believing what they read about themselves in the papers. Many disdain the rules as well; rules are for the timid. Most hazardous of all, they tend to forget that (in the case of public companies) they are employees of the firms they lead, and not owners—that they are fiduciaries, entrusted with the care of other people's money. Hence their too frequently outlandish pay deals; hence, in many instances, their taste for ventures that a conscientious fiduciary would have regarded as too risky.

How did the real owners come to let this happen? The answer lies partly in the changing pattern of shareholding. Large shareholders in a company have both the means and the motive to remind managers whom they are working for—to insist that costs (including managers' pay) be contained and assets not squandered on reckless new ventures or vanity projects. Shareholders with small diversified holdings are unable to exercise such influence; they can only vote with their feet, choosing either to hold or to sell their shares, according to whether they think that managers are doing a good job overall. Shareholdings have become more dispersed in recent decades, and the balance of power has thereby shifted from owners to managers.

The growth of institutional investment—through pension funds and mutual funds—accelerated this trend. In many ways, of course, it has been a boon for popular capitalism, giving people who are not wealthy the opportunity to save more effectively, and giving millions of Americans a real stake in the economy for the first time. But it has also created a class of owners who do not behave like traditional owner-capitalists. The typical investor in pension or mutual funds may be entirely unaware of what shares the funds hold. The institutions themselves, it was once believed, would behave like owner-capitalists—but on the whole, for a variety of reasons, they have not. They see their job as picking stocks and trading them; except in the most extreme cases, they think, it is not their role to hold company managers to account. Index funds, which have grown in popularity, take this practice to the extreme—they explicitly refuse to make any judgments about companies, and instead seek to hold a representative basket of stocks, with no attention to the performance of individual companies.

Ownership has grown more distant and diffuse only slowly, over decades. But in the late 1990s the effect of that diffusion on the control exercised over managers was suddenly magnified by a complacency born of strong returns. Investors came to expect extraordinary returns all the time, without paying much attention to how they were generated. The message to managers was clear: gung-ho risk-taking was in, and cautious stewardship was out. Far from resisting this shift, investors cheered it on.

Even though the boom is now over, surprisingly little has changed. If anything, the structure of ownership is more diffuse. And investors have only partly lost their appetites for vainglorious corporate leadership. Today celebrity CEOs are no longer quite the rage they were in the late 1990s, but the delusional desire to crown corporate bureaucrats—not merely the handful of genuine visionaries—as business heroes is still there. If an outright economic slump had followed the stock market's fall in 2001, bubble modes of thinking might have been more thoroughly renounced. But Alan Greenspan's Fed contrived a soft landing, so the mental correction was comparatively mild as well.

To be sure, the boom of the late 1990s had a real foundation, and the economy continues to benefit. Behind the stock market's astonishing rise lay a surge in economy-wide productivity; behind that lay the growth of the Internet and the development of new business processes aimed at taking advantage of information technology. Those forces are by no means spent. If, as many economists now believe, long-term productivity growth has increased by a full percentage point from its average in the 1970s and 1980s—from 1.5—2.0 percent a year to 2.5—3.0 percent—that represents a genuine transformation in the country's economic prospects.

The catch, it seems, is lower standards of corporate governance. This is a shame, but it may just be the way of the world. Eliminating episodes of irrational exuberance and the errors that attend them would require eliminating the underlying economic transformation as well—which would be undesirable even if it could be done.

Nowhere is the noxious blend of unwarranted expectations and occluded oversight more apparent today than in the growth of hedge funds: largely unregulated companies that invest in a wide range of sometimes exotic financial instruments, generally leveraging their holdings (that is, multiplying risk and return with borrowed money). Precise figures are hard to come by, but the amount under management by the 8,000 or so such funds appears to have doubled over the past five years, to about $1 trillion.

Driving this growth is disappointment at stock-market returns since 2000. The boom taught investors to expect high returns year in and year out. For most investments this was too much to ask after the tech bubble burst, yet some hedge funds were able to maintain impressive returns even as equity markets sank. Exactly how they did it remains a mystery, because they typically disclose little about their investment methods. For some investors that seems only to increase their allure. To the mystique of the corporate shaman add the mystique of the hedge-fund wizard.

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.

Clive Crook is a senior editor of The Atlantic.
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