Two versions of post-Enron reality

Today’s WaPo discusses the effects of post-Enron corporate governance reform, linked by Law Blog. While it fairly presents both sides, its presentation of the pro-SOX side makes me wonder what these folks have been smoking. So let me contrast their statements with another version of reality.

The grades suggest that the greatest improvement has been in the regulation of the behavior of accountants who serve as gatekeepers to the markets. New York Attorney General Eliot L. Spitzer said the profession has been "scared straight" by fallout from the scandals, which included the death of accounting firm Arthur Andersen LLP . . . .

The AA prosecution is a funny poster child for reform – its conviction was for destroying documents, not bad accounting, and in any event was recently reversed, closing one of the most embarrassing disasters in corporate crime prosecutions. The rest of the industry has been “punished” by reaping a massive windfall in new Sarbox compliance business.

Corporate boards get fair marks for meeting more often and paying more attention to the work of auditors. Last year, longtime directors at insurer American International Group Inc. overthrew Maurice R. "Hank" Greenberg as chairman after nearly 40 years at the helm after regulators stepped up an accounting probe at the company.”

Here's another odd example of post-Enron reform success, in view of the significant questions about regulatory extortion of AIG by Spitzer's office.

As long as CEO pay is so fundamentally out of whack, we cannot say that boards are doing their job or that corporate governance reform has been accomplished," said Nell Minow, an investor advocate and co-founder of the Corporate Library.

Some companies have moved away from compensating top executives with stock options now that they are required to count them as an expense. But in numerous cases, they have simply replaced options, which pay off only if a company's stock performs well, with restricted shares, which promise a gain for executives no matter what. Critics refer to such compensation as "pay for pulse."

Ok, how is executive compensation reform going to clean up corporate fraud? Are the regulators really going to figure out how to motivate executives better than the firms themselves? Here’s another, rather different, view of the tradeoffs between stock options and restricted stock and of the perverse effect of accounting regulation on the structure of stock options.

And, of course, the only reform we're seeing is more disclosure, which, as discussed here, is aimed more at reducing total pay than at improving incentives.

Nevertheless

William J. McDonough. . . . said recent initiatives, including a drive by the SEC to beef up disclosures about executive pay, are heartening.

Oh really?  Then why does he then say this?

I don't think anybody including me has any theory of how executive compensation should be set.

Sprinkled through the article are reports from the planet Earth, where the rest of us are living.

[C]omplaints that boards and accountants spend too much time meeting meaningless criteria rather than getting to the root of more insidious problems.

Here I discuss one such complainer, also mentioned in the WaPo story.

And most importantly, what’s been the effect of all this?

[E]xperts warn that the ingredients for a similar financial disaster remain. "I just don't think we are as far along as we need to be," said former SEC chairman Harvey L. Pitt . . . Many shareholders may have been led to believe that [reforms] have cured all the problems, and we're home free. Unfortunately, that's a prescription for disaster."

The story points out that “[r]egulators can never pass laws that will force executives to act with integrity -- or force investors to do their homework before they buy stock. Little has changed to shrink the incentives for taking big risks, business as well as ethical, that can give rise to misdeeds. . . . . Businesses pay a price for missing targets by even a penny or two."

A good example of regulatory futility the story mentions is Refco, which collapsed in accounts of insider fraud only two months after it did an IPO that was subject to SOX, with a prospectus that indicated accounting problems.  Here's my account, with the implications of the fact that Refco happened after SOX.

The bottom line:

Jeffrey Stone, a former federal prosecutor who now heads the white-collar defense practice at McDermott Will & Emery, said some new rules, especially one that requires a company and its auditors to examine financial controls, impose heavy costs "that far outstrip the protections that are afforded."

The story concludes with Harvey Goldschmid pronouncing that the Enron trial outcome could have “a more profound impact on attitudes among corporate executives in the long run than the regulatory changes. Deterrence is very important, and this trial is of large consequence for that reason.”

Yeah, and as I’ve pointed out, the case could go against the government. Hopefully that would send a deterrence message to prosecutors.

Goldschmid is generally right about the importance of deterrence. But deterrence of what? The level of entrepreneurial activity (see, e.g., here)? Incentives to take risk? Expenditure of resources on productive business rather than make-work monitoring?

What this article is really about, in my view, is the yawning gap between what the promoters of SOX and corporate crime prosecutions are saying about the results of their efforts, and the reality. 

Comments

[Broc Romanek]

Two thoughts:

1. Executive compensation reform doesn't have to come from the regulators; in fact, it shouldn't. Rather, it should come from those primarily responsible - boards and their advisors.

2. Compensation reform helps stop corporate fraud because the incentives to commit fraud could be wiped away. Why do you think numbers were smoothed so much over the past decade - because option grants became a routine annual event (when they originally were never intended to be so).

Executive compensation is well-known to be at the heart of corporate governance - yet, Sarbanes-Oxley and all the other recent governance reforms didn't touch executive compensation. That time has come.

Bill McDonough may not know how to properly pay executives - but many that practice in the field do. For example, here are the four simple tools we recommend to ensure that pay is appropriate:

1. Tallying ALL Components
2. Internal Pay Equity
3. Accumulated Gains Table
4. Hold Until Retirement

Thanks, Broc Romanek
Editor, CompensationStandards.com