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Greed Is BadNew York Times by Paul Krugman June 5, 2002
(6/4/02) - The point is, ladies and gentlemen, greed is good. Greed works, greed is right. . . . and greed, mark my words, will save not only Teldar Paper but the other malfunctioning corporation called the U.S.A."
Gordon Gekko, the corporate raider who gave that speech in the 1987 movie "Wall Street," got his comeuppance; but in real life his philosophy came to dominate corporate practice. And that is the backstory of the wave of scandal now engulfing American business.
Let me be clear: I'm not talking about morality, I'm talking about management theory. As people, corporate leaders are no worse (and no better) than they've always been. What changed were the incentives.
Twenty-five years ago, American corporations bore little resemblance to today's hard-nosed institutions. Indeed, by modern standards they were Socialist republics. C.E.O. salaries were tiny compared with today's lavish packages. Executives didn't focus single-mindedly on maximizing stock prices; they thought of themselves as serving multiple constituencies, including their employees. The quintessential pre-Gekko corporation was known internally as Generous Motors.
These days we are so steeped in greed-is-good ideology that it's hard to imagine that such a system ever worked. In fact, during the generation that followed World War II the nation's standard of living doubled. But then, growth faltered and the corporate raiders arrived.
The raiders claimed usually correctly that they could increase profits, and hence stock prices, by inducing companies to get leaner and meaner. By replacing much of a company's stock with debt, they forced management to shape up or go bankrupt. At the same time, by giving executives a large personal stake in the company's stock price, they induced them to do whatever it took to drive that price higher.
All of this made sense to professors of corporate finance. Gekko's speech was practically a textbook exposition of "principal-agent" theory, which says that managers' pay should depend strongly on stock prices: "Today management has no stake in the company. Together the men sitting here [the top executives] own less than 3 percent of the company."
And in the 1990's corporations put that theory into practice. The predators faded from the scene, because they were no longer needed; corporate America embraced its inner Gekko. Or as Steven Kaplan of the University of Chicago's business school put it approvingly in 1998: "We are all Henry Kravis now." The new tough-mindedness was enforced, above all, with executive pay packages that offered princely rewards if stock prices rose.
And until just a few months ago we thought it was working.
Now, as each day seems to bring a new business scandal, we can see the theory's fatal flaw: a system that lavishly rewards executives for success tempts those executives, who control much of the information available to outsiders, to fabricate the appearance of success. Aggressive accounting, fictitious transactions that inflate sales, whatever it takes.
It's true that in the long run reality catches up with you. But a few years of illusory achievement can leave an executive immensely wealthy. Ken Lay, Gary Winnick, Chuck Watson, Dennis Kozlowski all will be consoled in their early retirement by nine-figure nest eggs. Unless you go to jail and does anyone think any of our modern malefactors of great wealth will actually do time? dishonesty is, hands down, the best policy.
And no, we're not talking about a few bad apples. Statistics for the last five years show a dramatic divergence between the profits companies reported to investors and other measures of profit growth; this is clear evidence that many, perhaps most, large companies were fudging their numbers.
Now, distrust of corporations threatens our still-tentative economic recovery; it turns out greed is bad, after all. But what will reform our system? Washington seems determined to validate the judgment of the quite apolitical Web site of Corporate Governance (corpgov.net), which matter-of-factly remarks, "Given the power of corporate lobbyists, government control often equates to de facto corporate control anyway."
Perhaps corporations will reform themselves, but so far they show no signs of changing their ways. And you have to wonder: Who will save that malfunctioning corporation called the U.S.A.?
Another Sell-Off; Another SuicideAssociated Press by Amy Baldwin June 3, 2002
NEW YORK (AP) - Skeptical about corporate accounting practices and worried about conflicts overseas, investors dumped stocks Monday, sending the Nasdaq composite index to its lowest level in eight months and the Dow Jones industrials skidding more than 200 points.
Investors still nervous about companies' books following Enron's collapse were upset by news that Tyco's CEO had resigned and that Microsoft had agreed to settle charges that it misrepresented its finances. The market disregarded two positive economic reports in the process.
"It makes it very difficult for people to invest in the market when they don't have a clue what a company's revenues and profits are," said Al Mirman, strategist at V Finance in Sarasota, Fla. "Companies are reporting profits that are not real. They are restating results. People just don't have confidence in companies."
The Dow closed down 215.46, or 2.2 percent, at 9,709.79. The last time the Dow finished lower was Feb. 7, when it stood at 9,625.44. The blue-chip index hasn't had a bigger one-day point drop since Feb. 4 when it lost 220.17.
Broader stock indicators also tumbled. The Nasdaq composite index fell 53.17, or 3.3 percent, to 1,562.56, its lowest close since Oct. 2 when it stood at 1,492.33. The last time the Nasdaq suffered a bigger one-day point loss was April 2 when it sank 58.22.
The Standard & Poor's 500 index dropped 26.46, or 2.5 percent, to 1,040.68.
The sell-off accelerated in the final hour of trading, which analysts attributed to the Dow having broken below the 9,800 level and triggering programmed selling. Institutional investors often select a certain level at which to sell blocks of stocks.
"And, no one is around to buy. No one is interested. I throw good economic news at them, and they say, `So what?,'" said Larry Wachtel, market analyst at Prudential Securities.
The market has not enjoyed a positive day since May 23, six sessions ago and the last time that the three major indexes ended in positive territory. Since then, the Dow has slid 509.29, or 5.0 percent. The Nasdaq has lost 135.07, or 8.0 percent, and the S&P 500 has retreated 45.34, or 4.2 percent.
Tyco slid $5.90, or nearly 27 percent, to $16.05 on news CEO L. Dennis Kozlowski had unexpectedly resigned following reports that he is being investigated for possibly avoiding paying New York state sales taxes. Analysts said the news raises concerns about how he ran the company, which has faced questions about its complex bookkeeping.
Microsoft fell $1.49 to $49.42 after agreeing to refrain from accounting violations as part of a settlement with the Securities and Exchange Commission of charges that Microsoft misstated results. Under the settlement, Microsoft did not admit or deny wrongdoing.
Energy company El Paso dropped $3.70 to $21.95 following news that senior vice president and treasurer Charles Dana Rice was found dead Sunday in what police said was a suicide. Last week, El Paso said it would overhaul its accounting practices to make them easier to understand. However, there was no information to immediately connect Rice's death with El Paso's announcement, and industry executives said Rice was known to have long-term health problems
"Investors are saying, `I just don't want any more pain. I am willing to cut my losses,'" said Thomas F. Lydon Jr., president of Global Trends Investments in Newport Beach, Calif
Shareholder Activist Gets Post-Enron BoostCBS MarketWatch by Ted Griffith May 23, 2002
(5/22/02) - BOSTON (CBS.MW) -- A year ago, shareholder activist Timothy Smith was a lonely crusader.
Smith, who works for Walden Asset Management in Boston, hoped to get EMC shareholders to agree to a study on the ethnic diversity of the company's work force. But his proposal never made it onto the agenda for the 2001 shareholders' annual meeting.
In post-Enron 2002, Smith was back. At the data storage giant's annual meeting on May 8, EMC shareholders approved a nonbinding resolution -- backed by Smith and other activists -- that calls for the company to put more independent directors on its board.
How did Smith, in the space of a year, go from barely making a ripple to winning the support of so many shareholders?
He credits heightened concern about corporate governance in the wake of Enron's collapse.
"The lessons of Enron cry out for effective checks and balances," Smith, the director of "socially responsive investing" at Walden, said during the annual meeting.
He said institutional investors have long embraced the principle of having a board that's independent of management, but he said Enron has increased the "intensity" of that feeling and prompted shareholders to take action.
Smith, whose firm holds 130,000 EMC shares, said the disappointing recent performance of the company's stock may have also contributed to shareholders' willingness to challenge management. EMC's stock, like the stocks of many high-tech firms, is sitting at a multiyear low as the company's sales have declined sharply and profits have disappeared.
The board has been dominated by relatives of co-founder Richard Egan, the "E" in EMC. Egan has given up his spot to become U.S. ambassador to Ireland, but his son and another family member hold two of the seven board seats.
The independent-director proposal captured 56 percent of the vote and was widely interpreted as a rebuke to management, which, according to Smith, spent hundreds of thousands of dollars to oppose the initiative. EMC sought unsuccessfully to get permission from the Securities and Exchange Commission to exclude the measure from the company's proxy statement, which serves as the agenda for the annual meeting.
The win seemed to surprise even Smith. In an interview with CBS.MarketWatch.com the day before the annual meeting, Smith downplayed expectations, noting that EMC's management controlled a large number of shares.
Another initiative, calling on EMC to increase the ethnic and gender diversity of its white, male board, did go down to defeat. But the activists won more than a third of the votes cast.
Smith said he was pleased with the outcome, especially because of the difficulties inherent in pushing a proposal opposed by management. This was the first time EMC shareholders approved a resolution not endorsed by the top executives.
What happens next?
This year's independent board proposal won backing from some investment heavy-hitters, including CalPERS -- the California Public Employees' Retirement System. The resolution was also recommended by Institutional Shareholder Services, the organization that boosted the Hewlett-Packard acquisition of Compaq with its approval. Officials representing Connecticut's public employee pension funds actively supported both of this year's shareholder resolutions.
The backing of such prominent investors helped Smith and other activists score a victory, but the practical effect of that victory isn't clear yet.
The resolutions were not binding on EMC. Supporters said they opted for nonbinding resolutions because their top priority was to communicate a message to EMC management and they wanted to avoid the legal difficulties inherent in a binding vote.
EMC spokesman Mark Fredrickson said the passage of the independent board initiative does nothing to change the view of Chairman Michael Ruettgers because Ruettgers already supports the idea of adding outside directors.
During the meeting, Ruettgers said he opposed the specifics of the resolution, not its intent. He said the shareholder proposal was simply too restrictive because it discouraged the company from having customers on its board. Given that most major companies, academic institutions and government agencies are customers, EMC would have been greatly limited in its pool of director candidates, Ruettgers said.
Board to grow
The chairman said EMC previously planned to expand its board to nine members so it could increase the number of independent directors. But he said the company has run into difficulty finding appropriate candidates who can devote enough time to the positions. With so much post-Enron scrutiny of accounting practices, it's especially challenging to find people willing to serve on the board's audit committee, he said.
Ruettgers said the company is now focusing its board search on retired chief financial officers.
For his part, Smith seems optimistic that the initiative will lead to real change at EMC. The one-time divinity student noted that most companies are responsive when a large number of shareholders express their wishes.
"It's been an uphill climb, but we're encouraged," Smith said.
Shareholders Strike BackCBS MarketWatch by Matt Andrejczak May 22, 2002
(5/21/02) - WASHINGTON (CBS.MW) - Walter Hewlett may have lost his battle. But he helped start a war that has spread to every boardroom in corporate America.
Coming during the biggest crisis of confidence in Wall Street since The Great Depression, Hewlett's solo battle to scuttle the merger of Hewlett-Packard and Compaq Computer this spring underscored a level of shareholder outrage against company directors and executives that experts say has created the best opportunity in a generation to reform how companies are managed.
The Enron scandal, the Wall Street analyst scandal, and the almost daily parade of accounting time bombs that have savaged stock prices this year have left shareholders demanding change in how the companies they own pieces of are run. Some changes have already been made, but experts predict it will still be an uphill battle.
"We got so full of ourselves during the bull market," said Philip Livingston, president of Financial Executives International. "Boards and accountants got too relaxed. We need some quick action to restore investor confidence."
Indeed, shareholder activism took a back seat during the stock market bubble of the 1990s. Then the market plummeted, one-time high-flyers Enron and Global Crossing went belly up, disillusioned investors began to point accusatory fingers and testy lawmakers scolded executives at numerous congressional hearings.
Despite the clamor for change, shareholder activists still predict that it will be slow going trying to convince entrenched managements and "old-boy" boardrooms to be more transparent to their stockholders, even with all of the bad publicity right now.
"We don't expect wildly dramatic changes this year," concedes Ann Yerger, director of research services at the Council of Institutional Investors, a trade group representing some 250 pension funds and investment firms.
A scorecard of annual meetings and corporate governance announcements this spring illustrates the mixed results.
While Mentor Graphics shareholders won a proposal to approve all executive stock option plans, Adobe Systems and Cadence Design thwarted attempts to let stockholders vote on similar measures.
E-Trade Chairman and Chief Executive Christos Cotsakos agreed to forfeit one-fourth of his $80 million paycheck after investors went ballistic. But that won't solve the core problem. E-Trade resisted making changes to its compensation committee.
And so much for banishing Enron directors from board rooms across America. Lockheed Martin and Qualcomm both backed Frank Savage, who won re-election over the objections of shareholder activists and labor unions.
While results so far have been mixed, Enron's collapse has fueled a renewed call for corporate governance reforms. Shareholder activists, Congress, the Securities and Exchange Commission and the stock exchanges are all looking at new ways to force more accountability from corporate boards and board members.
"This is beginning of a renaissance for boards," predicts Roger Raber, president of the National Association of Corporate Directors, a non-profit group devoted to improving corporate board performance. "All the issues are out the barn door."
Many corporate governance experts argue the burden of reform lies squarely on the shoulders of company boards because congressional action will be minimal. Walt Disney and Cendant are among a small group of companies considering and implementing wholesale changes.
But the New York Stock Exchange and Nasdaq could still force companies to meet certain standards through yet-to-be-finalized regulations. The exchanges - at the urging of the SEC - recently unveiled initial recommendations but there is no deadline to implement them.
"There are some serious signs of change," said Damon Silvers, associate general counsel of the AFL-CIO, the nation's top labor organization. "But it is unclear what we're going to see."
One thing is certain: mutual funds could produce a sea change in bolstering corporate governance at U.S. companies - if they choose to. Critics charge that fund mangers are unwilling to bark at corporate executives to improve their performance.
"Mutual funds have failed to exercise their corporate citizenship," contends Jack Bogle, the retired founder of the Vanguard Group, the No. 2 U.S. fund family. "All we have to do is get those institutions to stand up."
During his rousing speech to the Council of Institutional Investors in late March, Hewlett said the problem with corporate governance is the lack of democracy in the boardroom.
Hewlett, who had just lost his campaign to derail the $18.6 billion merger of H-P and Compaq, said: "Boards must be pried loose from the grip of management and their hired hands."
One translation: board members are too afraid to ask tough questions - something that critics charge sparked Enron's demise.
One reason is that too often CEOs handpick the directors, in turn creating a backroom, cigar-smoking atmosphere. "Boards don't have the incentive to rock the boat," remarked Mark Latham, who runs the Corporate Monitoring Project.
But the problems go far beyond that.
Audit committees are not independent enough. They don't have the power to fire or hire auditors or approve non-audit work, leaving them with few options but to rubber stamp what management tells them.
What's more, board members can be subject to conflicts-of-interest that can impair decision making, ranging from consulting contracts with the company to the charities or businesses they run, according to corporate governance experts.
Back to E-Trade: all three members of its compensation committee help run companies that do business with the on-line brokerage. What you see is CEOs practically "negotiating their pay packages with themselves," Silvers commented.
There is no shortage of proposed solutions to fix corporate governance practices.
They include creating an independent office of the chairman to restrict CEOs from wielding too much influence; banning directors from selling stock while serving on the board; formal nominating committees to select directors; and mandatory boardroom peer-reviews.
What investors are likely to see is a tighter definition of independent directors, compensation committees run by directors unaffiliated with the company, a greater number of outside directors sitting on boards, and continuing education requirements for boards.
More controversial regulatory reforms -- such as stockholder approval of all stock option plans and limiting the influence of CEOs on boards -- will be more difficult to get accepted, corporate governance experts predict.
Don't expect a flood of reform. Corporate governance is an evolutionary process. When threatened, boards tend to entrench themselves. But this time around there is more incentive to be receptive. No one wants to be the next Enron.
Boards are to Represent ShareholdersNew York Times by Steve Lohr May 21, 2002
(5/6/02) The Hewlett-Packard proxy fight was seen as a rare example of shareholder democracy in action, of corporate life imitating the rough-and-tumble of politics.
It ended last week when a Delaware judge dismissed the suit brought by Walter B. Hewlett, who had accused Hewlett-Packard's management of rigging the shareholder vote that narrowly approved the company's purchase of Compaq Computer. After a proxy contest that was costly, acrimonious and personal often resembling a presidential campaign in tone and tactics the court challenge in Delaware was the business equivalent of the Bush-Gore fight in Florida after the 2000 election.
But back to the issue of corporate democracy. Why does it seem so rarely in evidence? And why do the checks and balances in corporate governing not work more effectively to prevent abuses like Enron's or astronomical pay for executives at companies whose fortunes, and stock prices, have declined?
Mr. Hewlett, an heir of William Hewlett, a Hewlett-Packard co-founder, is no grass-roots populist. He is to corporate democracy what Mayor Michael R. Bloomberg of New York is to political democracy testimony to what money and a brand name can do. And as a director, Mr. Hewlett, according to his own testimony in court, missed the board meeting when strategy behind the Compaq merger was explained in detail, and he never asked to hear that strategic assessment. Listening to any promerger arguments did not seem to be a priority for Mr. Hewlett.
Yet Mr. Hewlett's campaign of opposition to the merger very nearly won for two reasons. First, many Hewlett-Packard stockholders shared his "grave concern" that the Compaq merger was a bad idea, reasonably enough, given the poor track record of big mergers in the computer business. Second, his dissent was bound to get a thorough, sympathetic hearing because having a board member publicly object to a management-backed deal is so unusual. And Mr. Hewlett did so in the shadow of the Enron scandal, a cautionary tale of the perils of a board that did not stand up to management.
Time and events will determine whether Mr. Hewlett was right or wrong about the Compaq merger. But his arguments on the need for more open, democratic governing practices in corporate America resonated well beyond the computer industry.
Mr. Hewlett made his case most eloquently after the proxy contest was over, in a speech before the Council of Institutional Investors in Washington. "Despite more than 200 years of political practice in the United States, democracy remains an ideology strangely alien to many corporate boardrooms," he told his audience. "And too many corporate executives still fail to distinguish dissent from disloyalty."
"At the very least," he said, "boards must be pried loose from the grip of management and its hired hands."
Experts in corporate governance say that directors are too often selected by chief executives, who tend to choose people likely to be agreeable for one reason or another. The so-called outside directors may in fact be other members of the chief executive club, or they may be suppliers, customers or consultants who do business with the company.
"You want governance to act as an insurance policy against abuses," said Patrick S. McGurn, a vice president at Institutional Shareholder Services, which advises large shareholders on corporate governance matters. "And having truly independent directors who are really doing their best to serve the interests of shareholders is the best safeguard."
A corporate board can be thought of as a parliamentary form of government. The shareholders are the citizen-owners who elect the board members as their representatives. And the board members then select, monitor, compensate and, if necessary, fire the chief executive. That is the theory anyway, but in practice the board too often merely ratifies management's proposals instead of serving the shareholders.
The complaint is not a new one. In 1868, a popular magazine, Hours at Home, wrote, "Stockholders' rights are no more considered by the managers of some of our colossal railway corporations than the squeezed rind of the lemon whose juice has given a passing flavor to the fluid which stands in the directors' private room."
Colleen A. Dunlavy, a business historian at the University of Wisconsin, argues that the road to the present predicament began in the 1850's with the shift in corporate governance from one vote for each person to one vote for each share. "This signaled the demise of the shareholder as citizen of the corporation," Ms. Dunlavy wrote in a recent academic paper.
But organized shareholder rights activism is a relatively recent phenomenon. Many of today's corporate governance professionals and shareholder advocates really had their start in the 1980's. With their stock holdings increasing steadily, pension funds found themselves owning a significant slice of corporate America, and the Labor Department ruled that in the interests of the workers and retirees the funds represented, they had to vote their shares actively.
The biggest pension funds also held sizable stakes in most major companies, so they could not easily register dissatisfaction by trading in and out of companies. They were the modern buy-and-hold investors. Some of the pension funds, led by the nation's largest, the California Public Employees' Retirement System, or Calpers, started pressuring poorly performing companies and pushing for governance reforms, like independent boards.
Executive pay was high on the list of changes advocated by some pension funds and shareholder rights groups. The goal was to align the interests of managers more closely with those of shareholders, and the perceived way to do that was to compensate them more with stock to give executives an economic incentive to behave like owners.
The idea was sound, but it opened the door to the abuse of stock options in recent years. Executives reap huge gains in good years, but are often bailed out in bad years by having their options repriced or by being issued new options that can be exercised at a far lower price.
Once again, boards that are beholden to management are to blame, investor groups say. "Executive compensation is a barometer to show that at large publicly traded companies, markets are not working efficiently," said Sarah Teslik, executive director of the Council of Institutional Investors, an organization of large pension funds. "And the basic problem is simple. When fifth-graders pick their teachers, fifth-graders get A's."
So what steps can be done to move toward greater board independence? One step favored by corporate governance experts is to have all board members selected by a nominating committee of nonmanagement directors. That is at best an evolutionary step, though, if the current members of the nominating committee owe their board seats to the chief executive. Another suggestion is that the board should have its own financial and legal advisers not the management's team when a company is weighing a major strategic step, like a merger.
Michael C. Jensen, a corporate finance and governance expert, argues that the single most effective reform would be to "effectively remove the chief executive as chairman of the board, to have a nonmanagement chairman who sets the agenda."
The advantage, says Mr. Jensen, a former professor at the Harvard Business School who is a managing director of the Monitor Group, would be to make sure there is a certain balance of power in the boardroom.
Mr. Jensen points to measures like auditing, the process of formulating and ratifying strategy, and evaluating and compensating senior management as "functions that are best separate from the chief executive."
How Shareholder Votes Are Legally RiggedBusinessWeek by Louis Lavelle May 20, 2002
Most shareholders would have given up a long time ago, but not Evelyn Y. Davis. Every year since 1985, the corporate gadfly from Washington, D.C., has asked Bristol-Myers Squibb Co. shareholders to approve a proposal that would force the company to eliminate staggered board elections and elect its entire board of directors annually. Designed to increase accountability, the proposal has passed by a majority of votes cast at the annual meeting for six consecutive years, garnering 69% on May 7. Yet nothing has changed. "It's ridiculous how they ignore the wishes of stockholders," says Davis. "You just keep trying and hope that some day they'll see the light."
Don't count on it, Evelyn. Every year, dozens of U.S. companies engage in a great corporate rite of spring: ignoring shareholder resolutions that won a majority of votes cast. Despite "winning" the election, shareholders end up losing because many companies require a supermajority vote. Most states, including Delaware, require only a simple majority of votes cast to change bylaws, but some companies set the bar well above that, at a near impossible 80% of shares outstanding. Indeed, while Davis won the majority of votes cast, she only captured 46% of Bristol's outstanding shares. Says company spokesman Robert F. Laverty: "We have to be responsive to what shareholders say. We have to look at this very, very carefully."
With management accountability a front-page issue, it's time to lower the hurdle. A supermajority of 60% of shares voted is more like it. And if resolutions fall short, management should consider compromise action to address investor concerns. It's time to make it easier for shareholders to have a hand in how their companies are governed.
At one time they did. In the early 1990s, it was not uncommon for two-thirds of shareholder resolutions garnering a simple majority of shares voted to trigger company action, according to the Investor Responsibility Research Center. Today, more resolutions are winning, but far fewer--just 17%--are prodding companies into action. Says Alan P. Cleveland, special counsel to the New Hampshire Retirement System: "Is it arrogant? Sure it is. It shows a disregard of the company's shareholders."
Many companies have a different view. They say that without the higher hurdle, a company could, in a low-turnout year, find itself bowing to the dictates of a small minority of shareholders. Electronic Data Systems Corp. spokesman Jeff Baum says the supermajority rule is in fact pro-stockholder: "It enables us to act in the shareholders' best interest."
Other companies argue that the tough voting rules are fair, since both shareholders and management are held to the same standards when it comes to making changes to the bylaws. In fact, though, when management wants a change, it is only too happy to do away with supermajorities. That's because not all resolutions involve bylaw changes. Consider stock options. When management is seeking shareholder approval for new executive option grants, which dilute the value of existing shares, most companies require only a majority of shares voted at the annual meeting. Such rules make it easy for shareholders to enrich managers but difficult for shareholders to rein them in.
Not all companies are so insensitive. At Cendant Corp. (CD ) and Home Depot Inc. (HD ), shareholders have floated proposals that did not garner supermajorities, prompting management to put them to a vote at the annual meetings--this time as management proposals. Cendant Vice-Chairman James E. Buckman says: "It gives it the best opportunity for passage that it can have."
Companies with high hurdles for shareholder resolutions could learn a thing or two from Cendant and Home Depot. Shareholders deserve a say in how their company is governed--and right now they have no such thing.
America's Poor Accounting StandardsNew York Times by Paul Krugman May 18, 2002
(5/17/02) - On Tuesday Standard & Poor's, the private bond rating agency, announced that it would do something unprecedented: It will try to impose accounting standards substantially stricter than those required by the federal government. Instead of taking corporate reports at face value, S.& P. will correct the numbers to eliminate what it considers the inappropriate treatment of "one-time" expenses, pension fund earnings and, above all, stock options a major part of executive compensation that, according to federal standards, somehow isn't a business expense. S.& P.'s estimate of "core earnings" for the 500 largest companies slashes reported profits by an astonishing 25 percent.
Why does S.& P. along with Warren Buffett, Alan Greenspan and just about every serious financial economist think that current accounting standards require a drastic overhaul? And if such an overhaul is needed, why doesn't the government do it? Why does S.& P. think that it must do the job itself?
To see the absurdity of the current rules, consider stock options. An executive is given the right to purchase shares of the company's stock, at a fixed price, some time in the future. If the stock rises, he buys at bargain prices. If the stock falls, he doesn't exercise the option. At worst, he loses nothing; at best, he makes a lot of money. Nice work if you can get it.
Yet according to federal accounting standards, such deals don't cost employers anything, as long as the guaranteed price isn't below the market price on the day the option is granted. Of course, this ignores the "heads I win, tails you lose" aspect: executives get a share of investors' gains if things go well, but don't share the losses if things go badly. In fact, companies literally apply a double standard: they deduct the cost of options from taxable income, even while denying that they cost anything in their profit statements.
So how could it possibly make sense not to count options as a cost? Defenders of the current system argue that stock options align the interests of executives with those of investors. Even if that were true, however, it wouldn't justify ignoring the cost no more than it would make sense to deny that wages, which provide incentives to workers, are a business expense. Furthermore, it's now clear that stock options, far from reliably inducing executives to serve shareholders, often create perverse incentives. At worst, they handsomely reward managers who run their companies as pump-and-dump schemes; executives at Enron and many other companies got rich thanks to stock prices that soared before they collapsed.
Options are only part of an accounting system in deep trouble. As David Blitzer, S.& P.'s chief investment strategist, recently wrote, "Financial markets are as much a social contract as is democratic government." Yet there is a growing sense that this contract is being broken, undermining the trust that is so essential to the operation of financial markets. Clearly, major reforms are needed. And bear in mind that this isn't a left-right issue; it's about protecting investors middle-class and wealthy alike from exploitation by self-dealing insiders. So who could possibly be opposed? You'd be surprised.
Harvey Pitt, the accounting-industry lawyer who heads the Securities and Exchange Commission, has clearly been dragging his feet on reform. And his boss, George W. Bush, has declared himself opposed to treating stock options as a business expense. Wouldn't it be nice, just once, to see the Bush administration oppose the interests of a privileged elite?
But the administration is not alone in its foot-dragging. In fact, perhaps the biggest foot-dragger of all is Senator Joseph Lieberman. Way back in 1994 Mr. Lieberman gave crucial aid to lobbyists trying to head off new accounting standards, which would have forced companies to recognize the cost of options; now he is once again defending the status quo, urging his colleagues to go slow.
Some politicians do see the problem; John McCain and Carl Levin have introduced legislation to reform America's accounting standards. But it seems unlikely that government will fix our dysfunctional accounting rules anytime soon.
Mr. Blitzer of S.& P. points out that in previous periods of corporate scandal, "legislators and prosecutors took the lead in tackling public concerns over the market." It is a sad commentary on our leadership that this time he feels that he must do the job himself.
Shareholders Win Resolutions!Wall Street Journal by Jerry Guidera May 12, 2002
In a sign of increased shareholder activism following widespread corporate accounting scandals and concern over outsized executive pay, investors in two companies -- EMC Corp. and Mentor Graphics Corp. -- approved shareholder resolutions opposed by management.
Typically, such measures are defeated, often by a wide margin. However, EMC shareholders handed management a surprising defeat, with 56% of the votes cast in favor of a nonbinding resolution promoting a majority of independent directors on the board of the big data-storage firm, according to a preliminary tally at EMC's shareholder meeting Wednesday.
And Mentor Graphics said 56.7% of shareholders voting at its annual meeting on Tuesday backed a nonbinding resolution asking that all significant stock-option plans be submitted to the software company's shareholders for approval.
The votes could provide encouragement to advocates of corporate good governance, which has been getting increased attention as a result of numerous disclosures of questionable practices and the sharp slide in many stocks in the past year, especially technology issues. Indeed, Peter Clapman, senior vice president and chief counsel for corporate governance at TIAA-CREF, a big institutional investor that sponsored the Mentor Graphics resolution, said the vote on the stock-option measure sends a "clarion call" for action by regulators.
The EMC resolution approved by shareholders also recommends that the audit and compensation committees of the board -- two panels with power to rein in any management accounting trickery or excessive pay packages -- and the director- nominating committee also be composed solely of independent directors.
EMC management had opposed the proposal, saying it would limit the company's flexibility in selecting board candidates. Although the resolution is nonbinding, management said after the vote that it would comply with its terms - - though EMC's definition of what constitutes "independent" may not square with corporate good-governance advocates.
EMC's board was for many years dominated by its founding Egan family, friends and company employees.
Shareholder activists have argued that a more independent board might have prodded the company into actions that may have prevented the recent collapse in its business fortunes and stock price. EMC stuck doggedly to a storage-only, hardware-dominated strategy while newcomers began chipping away at its franchise via storage software and bundled package sales of many technology products.
EMC shares, the best performers on the New York Stock Exchange in the 1990s, lost 80% last year. As of 4 p.m. in broadly higher New York Stock Exchange composite trading Wednesday, EMC shares were up 61 cents, or 7.9%, to $8.30.
Shareholder activists and corporate-governance experts were pleased by the support for the resolution. Carol Bowie, director of governance-research services for Investor Responsibility Research Center, a research organization in Washington , D.C ., said the support was "remarkable." She noted that only three out of some 50 similar proposals calling for an independent board won the support of shareholders between 1996 and 2001.
EMC is the first company this year to lose a shareholder fight over the independence of its board. But shareholders have won some 16 other fights so far, according to proxy service IIRC, mostly dealing with the timing of directors' terms. Shareholder resolutions favoring election of all directors at the same time -- a schedule that makes it easier to unseat incumbents than does staggered elections -- succeeded this year at Airborne Inc., Goodyear Tire & Rubber Co ., Occidental Petroleum Corp. and Morgan Stanley, among others.
Bill Patterson, who heads the office of investment for one of the proposal's backers, the AFL-CIO, said he wasn't expecting to win this vote, even though EMC is one of the 26 companies the labor federation is targeting through its vast holdings in pension funds. Other shareholders supporting the resolution included the Connecticut Retirement Plans & Trust Funds, Walden Asset Management, Friends Ivory & Sime, Trillium Asset Management, Calvert Group, Green Century Equity Fund, Trinity Health and the General Board of Pensions and Benefits of the United Methodist Church.
EMC sought to downplay the impact of the vote. EMC Chairman Michael Ruettgers, in an interview, said the company's board already has a majority of independents, which some of the resolution's supporters would dispute. But he disclosed that EMC picked an executive-search firm to fill two board positions that have been vacant since last September with independent candidates. He said they would be nominated by the end of the year. He also affirmed that the audit, compensation and nominating committees would be independent by then. EMC will have to establish a nominating committee to meet the resolution's recommendation; until now, it has made nominations via an "ad hoc" internal group, Mr. Ruettgers said.
Don Clark contributed to this article.
Buffett Blasts Corporate America's CrooksIndependent.co.uk by Chris Hughes May 6, 2002
Warren Buffett, the legendary US investor, has launched a blistering attack on sloppy accounting, corporate greed and Wall Street investment banks, while warning that coming years will see poorer investment returns.
The chairman of Berkshire Hathaway, aged 71, supported by his deputy and long-standing business partner Charlie Munger, told the US investment group's annual meeting in Omaha that fraud was rife in US businesses.
The actions of Enron were "grotesque" Mr Buffett said, with Mr Munger, describing the collapsed US energy trader as "the most disgusting example of a business culture gone wrong".
Wall Street and the accountancy profession should share in the blame, the pair went on. Investment banks had no concern for investors, and the only question they asked when dealing with stocks and shares was "can it be sold?". Auditors had been too pliant to their clients' demands, and had succumbed to "dubious accounting".
"Many of the crooks look like crooks," said Mr Buffett. "Wall Street loves them as long as they are pushing out securities." Mr Buffett, known affectionately as the Sage of Omaha, said a good way to spot possible frauds was to keep a close eye on those companies that reported results using Ebitda (earnings before interest, tax, depreciation and amortisation).
Mr Munger, 78, also sounded a warning over companies involved in derivatives, saying. "To say derivative accounting in America is in the sewer is an insult to sewage," he fumed.
Mr Buffett also backed a call made last week by Alan Greenspan, the chairman of the US Federal Reserve Board, to clamp down on the "shameful" way that companies inflated their profits by excluding employee share options from the main body of their accounts.
He did not expect regulators to heed Mr Greenspan's call, however, because chief executives were lobbying hard in Washington and "get what they want every year".
Despite his displeasure with corporate America, Mr Buffett said he could not recall ever having had more fun than he was at the present time.
The pair took questions for six hours after completing the formal business in 15 minutes. One investor among the 14,000 gathered called Mr Buffett "a hero", a sentiment echoed in the auditorium's applause.
Some shareholders were less adoring. Two questioned whether Berkshire's continuing investment in Coca-Cola one of its largest holdings alongside American Express and Gillette was sensible, given stiffening competition from Pepsi. Mr Buffett countered that he would be surprised if Coca-Cola surrendered market share in the next five or 10 years.
Mr Buffett admitted the performance of Berkshire's core insurance operations during 2001 had suffered due to the mispricing of policies for terrorist attacks, but he expected the group to benefit from strengthening premiums hereon. He warned that it was hard to find suitable investment opportunities. In the present low interest-rate environment, investors should not expect returns to exceed 6 or 7 per cent.
Areas of interest were companies bankrupted by asbestos claims, but only if it was possible to insulate Berkshire Hathaway from all liabilities.
Truth in Stock OptionsAssociated Press May 5, 2002
WASHINGTON (AP) - The lucrative stock options that showered millions of dollars of wealth on top corporate executives over the past decade need to be treated as a business expense even though that accounting change could significantly reduce a corporation's reported profits, Federal Reserve Chairman Alan Greenspan said Friday.
Greenspan, in remarks to a financial markets conference in Sea Island, Ga., continued his campaign to get accounting regulators to force a change in the way companies deal with options on their books. His proposal represents a rare break with the Bush administration, which has sided with corporate executives in opposing the accounting change.
Greenspan's proposal is the major recommendation he has made in response to the collapse of Enron Corp., whose top executives made millions of dollars in profits by cashing in their stock options before the company's stock collapsed, wiping out the retirement benefits of thousands of the company's rank-and-file workers.
Greenspan said under the current practice, which does not require companies to reflect the true cost of options in their annual reports, investors will continue to receive inaccurate information on the financial status of a company.
``The failure to expense stock option grants has introduced a significant distortion in reported earnings and one that has grown with the increasing prevalence of this form of compensation,'' Greenspan said in a speech to a financial markets conference convened by the Federal Reserve Bank of Atlanta.
In his remarks, Greenspan expanded on arguments he made in late March that the current practice of not counting stock options as a business expense was inflating corporate profits and giving investors a false impression of the true value of the company.
His campaign for changes is at odds with the administration. President Bush, in an April newspaper interview, said ``while I hate to get in a debate'' with Greenspan, he did not believe stock options should be treated as a business expense.
That puts the administration in line with the views of corporate executives, who are lining up in force to fight legislation sponsored by Sen. Carl Levin, D-Mich., which would make such a change.
The change would have a huge impact on U.S. companies. The Fed has estimated that annual corporate earnings growth between 1995 and 2000 was 2.5 percentage points higher for big companies because they did not have to count options as expense subtracting from their earnings.
Stock options give employees the right to buy a company's stock, in the future, at a predetermined price. The more the company's stock price rises, the more valuable the stock option becomes.
Greenspan said in Friday's speech that the failure to treat the options as a business expense was depriving investors of a true picture of the claims outstanding against a company.
``The seemingly narrow accounting matter of option expensing is, in fact, critically import for the accurate representation of corporate performance,'' he said. ``And accurate accounting, in turn, is central to the functioning of free-market capitalism -- the system that has brought such high prosperity to our country.'' Greenspan said he would prefer that this change be accomplished through decisions of the regulatory groups that set standards for the accounting industry rather than legislation in Congress.
Greenspan also argued that companies should change the way they grant options to tie their value not just to how the company's stock price is doing but to some measurement of how the company is performing relative to its competitors.
He said such a change would limit the temptation of executives to make questionable business judgments simply to drive up the price of the company's stock, an allegation that has been made against former top Enron executives.
Greenspan, who delivered his speech by satellite to the conference sponsored by the Atlanta Federal Reserve Bank, said nothing about the current status of the economy or the future direction of interest rates in his remarks, which were made available in Washington.