The road has been rocky for business leaders of late. A well known opinion poll company, Gallup Inc., in its 2010 rating of the perceived ethical standards of people in different professions, executives polled just a few notches above car salesmen and beneath lawyers.
Just 15% of respondents rated their honesty and ethical standards as ‘high’ or ‘very high.’ Of course, this hardly comes as a surprise. In just the past decade, we have witnessed three massive, blowout scandals: the accounting corruption that ensnared Enron, WorldCom and others (2001-2002); the options backdating scandal that included scores of Silicon Valley firms (2005-2006) and the subprime mortgage scandal that devastated both Wall Street and Main Street (2008-2009).
In Nigeria, the Cadbury scandal in 2007 relating to book running by the executives is still a reference point. Executives and top managers of financial institutions have been convicted and some are still being prosecuted for ethical lapses following the Nigerian banking crisis of 2009.
This ongoing display of illegal and unethical behaviour suggests that something is seriously out of whack in the corporate world. Of course, not all executives should be blamed for the misdeeds of a few, or even a few hundred. But many executives do engage in dangerous and little-discussed practices that come very close to the line of illegality, one that betrays the spirit of securities laws and accounting regulation –earnings management.
Executives and Earnings Targets
Executives have plenty of incentive to meet earnings targets. In a 2002 article in the Journal of Accounting and Economics, Eli Bartov, Dan Givoly and Carla Hayn showed that, regardless of the level of performance, a company’s stock performs better if the firm meets or beats analyst earnings expectations. That is, a company is likely to see its stock perform better if it earns $1.10 per share when its consensus estimate was $1.08 per share than if it earns $1.12 per share when the consensus estimate was $1.15 per share. It’s more important to outperform expectations relatively (+2¢ versus -3¢) than to deliver better absolute performance ($1.12 versus $1.10), and as a result, executives have increasingly turned to earnings management to satisfy the market, tailoring returns to meet market expectations rather than to reflect actual performance.
According to Trivet Business Review (Issue 2, 2011), as executives became more aware of stock price dynamics, they became increasingly proficient at meeting the numbers. In the period from 1983 to 1993, companies met or beat earnings expectations 50% of the time. But by the 1994-2007 periods, companies were able to meet or exceed expectations almost 70% of the time –a dramatic improvement and the outcome of extreme determination, greater skill in earnings manipulation, or both.
Regulators have attempted to decrease the ability of companies to use games (especially accounting games) to manage earnings through legislation, including Sarbanes-Oxley. And, indeed when John Graham, Campbell Harvey and Shiva Rajgopal (again in the Journal of Accounting and Economics) explored how 400 financial executives from major American public companies operated in the newly-tightened environment, they found that the executives had become loath to use accounting measures to smooth earnings. However, they also made the following worrisome discovery: “The majority of managers would avoid initiating a positive NPV (net present value) project if it meant falling short of the current quarter’s consensus earnings. Similarly, more than three quarters of the surveyed executives would give up economic value in exchange for smooth earnings.”
That is to say, these executives would damage the future prospects of their company—to the clear detriment of shareholders—in order to please those same shareholders by ensuring that the company unfailingly met or beat analyst expectations. Not only have executives used accounting manipulations and talked down their own stock to meet expectations, they will sacrifice the long-term financial performance in the real market in order to satisfy the vagaries of the stock market in the short term.
Far too many of our leaders are now using their talents and corporate resources to smooth earnings rather than to build their companies. This has become a significant feature of the unhealthy society in which our Chief Executives Offices (CEOs) now live –a society that causes executives to lead bogus lives.
Authenticity, Where Art Thou?
Authenticity can be defined as “the degree to which one stays true to one’s own character and morals while dealing with external forces.” In an ideal world, we would find communities that value us for who we are, thus allowing us to act authentically and honestly within them. And, where we interact with a number of communities at once, those communities would ideally be mutually reinforcing rather than at odds with one another, enabling us to be true to ourselves and consistent across contexts.
Before the obsession with shareholder’s value-maximisation began to emerge, the CEO community was relatively healthy. Customers, employees, the company’s home city and long-term shareholders loomed large in the mindscape of the 1950s and 1960s CEO, and the intimacy of these relationships was aided by the scale of the enterprises of the day. A smaller scale meant that customers tended to be concentrated in a company’s home region, making it relatively easy for the CEO to get to know customers, figure out how to serve them, and continuously improve products or services with customers in mind. It was also possible to connect directly with employees, because there weren’t that many of them and most lived nearby, with roots in the area.
The chief executive typically lived in and had a network of friends in the city too, creating a deep link between his corporate role and personal life. As a result, doing things to benefit the city made sense both corporately and personally. On top of that, shareholders were likely to encourage, or at least tolerate, long-term planning as opposed to short-term results –because shareholders planned to be around for the long term, too. In short, the relationship between corporation and shareholder was much like a marriage: a partnership not without its bumps, but one in which both parties were willing to commit for the long haul.
This structure enabled a male executive, for instance, live a reasonably authentic life, because the way he lived personally was largely aligned with his corporate responsibilities: he wanted to make customers –whom he was likely to know personally –happy. He wanted to support the well-being of his employees –many of whom he and his family knew well. He wanted to be a respected figure in the city –a city that was important to both his company and his family; and he wanted to make his shareholders happy because he knew that they had placed a long-term bet behind his company. If he worked hard on each of these aspects of his community, he could be successful and happy, and his company was likely to continue to prosper, too.
Since the 1970s, as companies have ballooned in size, the CEO’s traditional community has become far more impersonal and distant. Customers and employees are now more dispersed (and anonymous), and the company’s ‘home city’ is far less central. With the rise of institutional investors and mutual fund companies, a veil has been placed between the company and its shareholders. Generally, CEOs don’t even know who their shareholders really are. This combination of factors has weakened the bonds between the traditional community and the CEO.
Moreover, the rise of ‘shareholder capitalism’ has pushed another community to the fore: the capital markets. Institutional investors, equity analysts, investment bankers and hedge funds have emerged as the central figures in the CEO’s community, which has become a community rife with transactional relationships, exploitation and distrust, whose members prey on one another, ignoring the ill effects of their actions and encouraging each other’s bad behaviour. The modern institutional investor is a rational, coldhearted (even computerised) beast who is often in and out of a given stock on a whim. Yes, some investors still engage in relationship investing, but it is no longer the norm; instead, institutional investors can and do sell without warning or explanation, looking for short-term advantage and maximum profits. Rather than a healthy marriage, the investor-company relationship is now more akin to anonymous sex.
Equity analysts are paid to play the game of helping to create convergence between their estimates and company performance; but they and everybody else involved know that if they were capable of discerning whether a stock is overvalued or undervalued even 51 per cent of the time, they would be principal investors, not equity analysts (and wildly rich, to boot.) Instead, most analysts merely attempt to avoid looking bad, relying closely on company guidance and rewarding those who make them look good by meeting the agreed-on predictions. They effectively dance the dance described by Bartov, Givoly and Hayn, whereby they set expectations high at the beginning of a quarter and then lower them later under pressure from the company in an effort to not look silly.
Wall Street investment bankers – ever on the hunt for fees – tout ‘value-accretive merger and acquisition ideas’ sure to ‘enhance shareholder value.’ Yet, they don’t share in the outcome of these mergers –instead, they take an upfront fee and walk away, unaffected by the success or failure of the enterprise. It turns out that most mergers and acquisitions destroy real value. In the year 2000 for instance, AOL merged with Time Warner in a $350 billion deal intended to create an integrated new-media powerhouse. While the merger went downhill almost immediately –a decade later, the unmerged companies are worth just one-seventh of their pre-merger selves –investment firms Salomon Smith Barney and Morgan Stanley each collected millions in fees, just the same.
Then there are the hedge funds, which work to exploit volatility—and will work to produce it, if necessary—seeking to arbitrage any weakness they see. In essence, these fund managers attempt to find the most naive fiduciary institution to gouge, regardless of what the gouging will do to the beneficiaries of that pension fund or charitable cause. And they will continue to arbitrage merrily away, even if such actions help to bring the whole market to the edge of destruction, as they did in the 2008–2009 financial crisis.
Restoring Health and Authenticity
The good news is that the inauthentic behaviour described herein is not inevitable. If we can refocus CEOs on communities that are both healthy and meaningful, we have a hope of returning authenticity to the C-suite. The simplistic answer would be to simply tell CEOs to ignore the capital markets; but that would be about as effective as admonishing frat boys to stop chasing girls. Investors, analysts and hedge funds are all creatures of the expectations market and they continue to reward firms that meet expectations and punish those that do not. As Bartov, Givoly and Hayn demonstrated empirically, there are clear consequences to failing to meet or beat expectations. In the current environment, to simply ignore the expectations market is to court disaster.
The better answer is to rethink the way in which we compensate people. Currently, executives are granted stock-based incentives, like options. The fundamental problem with stock-based incentives is that they direct the recipient to try to raise expectations from the current expectation level. If one is clever and determined, one can do so for a long time, but it can’t be done forever. In our view, the only way to restore the focus of the executive on the real market and on an authentic life is to eliminate the use of stock-based compensation as an incentive. This doesn’t mean that executives shouldn’t own shares, but they should be prevented from selling any stock – for any reason – while serving in that capacity, and indeed for several years after leaving their post.
While this may seem radical, let’s remember that it worked very well for the majority of the history of modern business. As late as the early 1970s, stock-based compensation was rare and made up a minuscule fraction of the compensation for CEOs of S&P 500 firms. In 1970, CEOs earned an average of $850,000 (in constant dollars), a tidy sum at the time, and less than one per cent of that was earned through stock-based compensation. By 2000, CEOs averaged $14 million in compensation, with 50% coming from stock options. Shareholders actually did better in the earlier scenario: in the period immediately before the increase in stock-based compensation, 1934-1976, the inflation adjusted annual returns for the S&P 500 were 7.6%. For the period from 1977-2010, returns were 6.6%.
Stock-based compensation is a very recent phenomenon that is associated with lower shareholder returns, bubbles and crashes, and huge corporate scandals. It is time to bring an end to it and find a better, more dependable approach that will enable both the corporate world and its stakeholders to thrive.