01 Dec 2002
Bad Times for Business
Trouble in Corporate Americaby Garry Emmons
With corporate America rocked by revelations of conflict of interest, malfeasance,
negligence, and greed, a group of HBS professors recently gathered to review the
current crisis. Is it a case of dé jà vu or an unprecedented, systemic failure? This roundtable discussion, moderated
by Professor Krishna Palepu, sought answers and suggested some corrective
measures. Highlights of the conversation follow.
Krishna Palepu: Let's start with some background
on these matters as they relate to your areas of interest and
expertise. Then we'll discuss some of the challenges they pose.
Brian, what about the issue of top-management compensation?Brian Hall
: As you all know, stock options were intended
to give executives incentives to get share prices to rise, which in
theory would create value for shareholders and society alike. That
worked in many cases.
But some executives who were loaded up with stock options
succumbed to the temptation to game a financial-markets inefficiency,
inefficiencies caused by inadequate disclosure rules.
Those executives essentially misled investors, falsified information,
and pretended to create value when value hadn't really
been created. If inadequate disclosure rules were cracks in the
financial infrastructure, options were the rocket fuel that blew
the cracks wide open, with some disastrous results.
Nancy Koehn: As a historian, I would note that this
is not the first time that Americans have gone through intense
questioning about the system and the conduct of its actors. For
example, in the latter part of the 19th century, the railroad, the
telegraph, and a host of other innovations related to them —
along with the rise of powerful business figures, such as John
D. Rockefeller — gave many observers pause. The reaction
was increased oversight and antibig business sentiment.
I think such moments are part of something very important in
the U.S. system. There is extraordinary freedom for business and
other actors to race ahead, while at the same time, a range of
stakeholders can question, claim their share, or put up guardrails
around that headlong rush toward change. I think all the attention
being paid to the current problems — particularly by business
itself — will help keep our system of capitalism democratic and in
sync with the larger interests of the nation.
Paul Healy: We may have been through these experiences
before, but it's shocking where we have ended up, given all the
advances in technology and improvements in governance. In spite
of all the checks and balances, failures occurred with boards of
directors, auditors, regulators, financial analysts, and professional
investors and money managers.
We thought we had a pretty good system, one the rest of the
world looked to as a capital market that effectively allocated
resources in the economy. I still think that our approach is a good
one, but maybe not as good as we thought. Hopefully, we'll better
understand the conflicts of interest, improve the system, and have
more awareness of the risks of investing.
Rosabeth Moss Kanter: If a few rotten apples
can spoil the barrel, I think we have to look at the nature of the
barrel, not just the apples. Organizational design, structure, and
culture do play a role and almost always have in corporate scandals.
Companies that get into trouble often do so because of minimal
internal connections between many parts of the organization. With
deficient information and knowledge, you can't put all the pieces
together or understand when something might be going wrong.
Jay Lorsch: There was a cycle of greed throughout the
system, and boards, for their part, allowed it to go unchecked.
Some audit committees and compensation committees didn't
do their jobs responsibly.
But boards can only do so much — their members, after all,
are part-timers. And while they're expected to be independent,
they have to rely heavily on managers and auditors for information.
One problem in all this was that the boards weren't getting
appropriate information and that was compounded by directors'
complacency because everything seemed to be going well.
Palepu: Mention of compensation committees brings
to mind the issue of dramatic escalations in executive pay.
What's behind these big increases?
Hall: One element was the rising stock market. Another was
the use of stock options — because options are so complex, they
can obscure the amount of pay actually being given to executives.
In most cases where we see big excesses, it has to do with compensation
committees not holding the line, as Jay noted. They
granted packages that ensured their executives would receive
above-average pay even though all executives can't be above
average. The market for executives is not one in which there
are strong competitive pressures to keep compensation down;
so, in the end, it's the boards that must resist the pressure to
Healy: To put it in context, we live in a society in which the
stars — entertainers, professional athletes, the top performers in
any industry — make all the money. That includes the executive
market as well.
The irony about pay-for-performance is that pay packages
had no built-in control for the general rise in all stock prices.
Executives benefited from the run-up in the stock market, rather
than for taking their companies to the next level.
Kanter: There's a danger, however, in focusing only on
boards and compensation and not on organizational performance
writ large. If we don't concentrate on the entire organizational
system — in short, the shape of the barrel — we may not find
remedies. We may have a flurry of new regulations here and there,
but we won't have genuine solutions for these problems that are
not only causing scandals but are also hurting the performance of
Koehn: Board performance and the culture of organizations
as factors affecting a firm's integrity have been issues in American
business since the rise of the corporation more than two centuries
ago. So why this cycle of greed, why this eruption now? I think it
goes deeper than just the rising stock market in the 1990s and the
possibilities that presented to all kinds of people.
Perhaps we're in the midst of a larger technological and information-
driven transformation, a rare inflection point in industrial
capitalism, in which there's been widespread exuberance and
some bad bets made to this point, but in which a range of more
positive outcomes are on the way.
Lorsch: To me, the trouble began in Silicon Valley and
spread from there. Everybody was going to get rich! And that created
a tone for much of corporate America throughout the 1990s.
When that bubble burst, we suddenly discovered a lot had been
hidden by the fact that everybody was doing well — nobody was
being critical of what was transpiring. The question is, How did
we get started, and what were the norms that led to this disregard
for traditional verities?
Kanter: The two big messages of the 1990s were The old
rules don't hold and There are no new rules, and if there are,
you should break them. I think that leads to a particular kind of
culture where people start feeling foolish if they're not participating
in these perceived changes.
Getting Down to Business
Palepu: How can we begin to fix some of these problems?
Hall: On the issue of executive compensation, clawback —
forcing executives to pay back ill-gotten gains from option exercises
that preceded accounting restatements — and longer vesting
would be great.
Another significant step would be to expense stock options,
which would make their costs more evident and more transparent.
Expensing would likely result in fewer excesses and would
encourage moves toward moderation in equity-based pay
packages, such as the use of indexing.
Palepu: With costs more apparent, might board compensation
committees also gain a better understanding of what
they're actually giving up?
Hall: Absolutely. Because stock options aren't expensed,
compensation committees have focused on them without thinking
hard about alternatives. Expensing, I think, would actually
liberate companies by enabling them to choose among a variety
of compensation methods they've heretofore been ignoring
because they involved expensing.
Lorsch: People talk about curbing the power of CEOs,
but I frame the issue in terms of enhancing the power of boards.
Over the last decade, I think there's been a lot of progress made
in boardrooms. Problems remain, of course, but cronyism has
diminished, the principle of independence is becoming well
established, and board members are trying to do the right thing.
How do we make boards even stronger? Some good ideas I've
heard recently call for getting the independent directors to meet
alone without management and having somebody other than the
CEO lead the board, at least in its independent deliberations.
Boards need to think more carefully about how they manage and
Palepu: Paul, you spoke about the breakdown of checks
and balances in the system generally. Can you elaborate?
Healy: One thing that strikes me is the enormous pressure
for short-term performance in the capital market. Analysts and
money managers are mostly worried about quarterly performance.
That filters all the way back to management, which feels pressure
to deliver good numbers for the next quarter's performance. And
if that pressure gets too intense, some managers are going to do
things that we'd rather they didn't.
Ironically, all this is driven by things that we prize and value:
competition, with its pressure to perform well, and freedom, as in
the ability to move our money around. Unpalatable as it may be,
perhaps we need to impose some costs or incentives that would
help get us away from this short-term fixation.
Palepu: Through tax deferments on pension money, society
is giving tax breaks so that people can save and invest for the long
term. And so one idea that has been proposed is that, because the
government is giving a tax break, it should be able to put some
restrictions on the short-term movement of that money.
Kanter: When that kind of intervention takes place, however,
we hear cries that the tax system is being used for social
engineering. But I certainly have the sense now that without some
degree of public and social engineering, we're not necessarily
going to solve these problems.
Palepu: Rosabeth, you mentioned the structure and
design of the organization as possibly contributing to the
current problems. What improvements can be made?
Kanter: We need more external information — both financial
and nonfinancial — about the total, multidimensional performance
of the organization. But external information should be
reported less often, so that we ease the pressure to meet shortterm
Internally, we need more disclosure. The board must be wired
into all systems so that it can get the information, too. More
frequent internal reporting will not only encourage cross-fertilization
and the exchange of ideas, but will also help catch problems,
flaws, and weaknesses before they multiply.
Koehn: From the standpoint of organizations, it strikes me
that what we have is an opportunity for companies that run a
clean shop — culturally, organizationally, and financially — to educate
their employees, their communities, the financial community,
and the public, as to what they stand for and what they're really
about. Make it not only a touchstone for how a particular company
conducts its operations but, more broadly, the standard by which
business is done — the cool way to run an organization.
A Role for HBS
Palepu: Is there anything in the curriculum or classroom
we can do that might enhance some of the changes we've
Lorsch: I think we can teach students more about what we
mean by professional management and give them opportunities
to test out their own values against what's expected of them as
responsible professionals. We don't teach them about the dysfunctional
aspects that we've been discussing here, and we should.
As someone who's interested in corporate governance issues, I
believe we can do more to reach out to the director community —
through Executive Education programs — and help them think
about some of these questions.
Kanter: Suppose we took some of these issues we've been
discussing — CEO compensation, for example — and asked students
to think of themselves as problem solvers. Suppose we
asked them to think about how they might want to change the
rules of the game to get to outcomes that are good. I'll bet they'd
come up with lots of great ideas. They would go out into the field
and grapple with these difficult questions, and it would give them
a solid foundation for thinking about larger issues and the consequences
of their actions.
Koehn: We should ask ourselves, How do we incite the best
in our students? How do we help them learn that they're responsible
for other people?
One expectation our students have when they come here is
that HBS will transform who they are as a person and who they
will be as a professional. So we should think long and hard about
that developmental aspect, across disciplines and courses.
As Jay noted, How do we teach and educate them to help them
as professionals make sound decisions with great integrity? That's
a complicated task, but it has been part of our mission — indeed,
our imperative — for 94 years.
Hall: I teach a compensation course, and yet I always begin
it with the idea that organizations exist to create value for society.
I want to try to center things around the core reason we're here.
Compensation — how we share in the value creation — is only one
tool toward the larger purpose of motivating value creation.
Healy: One of the things that strikes me is we have a whole
set of alumni who are really outstanding people with excellent
values. We have so many graduates who are powerful role models
— at every opportunity, we ought to get those people on campus
to meet with our students. That kind of interaction would make a
deep and valuable impression.
Hall: We need to show our students how incremental errors
of judgment can lead down a slippery slope to a whole heap of
trouble. In addition to having successful careers, our students
want to be part of something great, to be inspired by what is great
and noble in business. We can do more to tap into this desire.
Palepu: We could keep going for several more hours, but
unfortunately, we're out of time. I'd just like to observe that, over
the last twenty years, American financial markets have been the
envy of the world for their ability to minimize transaction costs,
maximize liquidity and access, and fund a lot of very innovative
and complex businesses.
Unfortunately, the same forces that made markets so liquid
may have made market institutions weaker. As a result, all the
traditional checks in the corporate governance system — management-
incentive systems, corporate boards, external auditors,
analysts, and professional investing institutions — seem to need
some reengineering to deal with these new market realities.
I'm sure you and our other HBS colleagues will have plenty of
ideas for dealing with this new set of challenges. Thank you all