The illegal and unethical behaviour of some business executives over the past few decades suggests something is seriously out of whack in the corporate world.
The reputation of corporate executives has taken a pounding lately. Within an eight-year period we’ve witnessed three massive scandals involving hundreds of executives each: the accounting scandal (2001-2); the options backdating scandal (2005-6) and the sub-prime mortgage scandal (2008-9). No surprise then, that in a Gallup poll rating of the perceived ethical standards of people in different professions, conducted in late 2009, business executives ranked just a few notches above car salesmen and below lawyers. Just 12% of respondents rated the honesty and ethical standards of business executives as high or very high; by contrast nurses were well regarded by 83% of respondents.
The illegal and unethical behaviour of some business executives over the past few decades suggests something is seriously out of whack in the corporate world. Assuming that people would rather be ethical than unethical, how did we wind up with such pervasive unethical and illegal behaviour? How is it that executives have come to act in way that is so much at odds with what we would expect of them, and of what they should expect of themselves? They have fallen down the proverbial slippery slope, pushed by perverse incentives to behave in ways that are more and more unethical, less and less authentic.
The community in which executives operate is an unhealthy one that encourages and produces bad behaviour. Community is incredibly important in our lives. At our core, we are all social creatures who derive pleasure from the company, love and recognition of others. We strive to make our mark on the world and to feel that our lives are worthwhile. The work we do is a critical component of our legacy. If we believe that our work has meaning and that we are valued by others for what we do, we are encouraged and motivated. We persevere. Even when humans engage in profoundly anti-social activities, we often do so in tightly knit social groups, whether they happen to be called Crips, Yakuza or Al Qaeda. As social creatures, much of our happiness is derived from our relationship with a community – however that community is defined. We want to be members of a community that we and others see as worthwhile.
In an ideal world, we can find communities that value us for who we are, and so enable 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. So what constitutes a healthy community? While there are many ways to describe it, most would agree that a healthy community would:
• believe in long-term relationships rather than one-off transactions
• seek reciprocity rather than exploitation
• protect its weakest members rather than gouging them
• worry about the externalities that it creates rather than turning a blind eye to them
• discourage member actions that endanger the community rather than encouraging them
Before the advent of shareholder value theory (the belief that the sole purpose of a company is to maximise the financial return to its shareholders), the community around CEOs was relatively healthy. Customers, employees, the home city of his company and his long-term shareholders loomed large in the typical CEO community of the 1950s and 1960s. The intimacy of these
relationships was aided by the scale of the enterprises of the day. GM, the only real behemoth of 1960, pulled in revenues that, even when converted to today’s dollars (approximately $66 billion), would be dwarfed by Wal-Mart’s $408 billion and would barely rank in the top 100 companies by revenues.
This smaller scale meant that customers tended to be concentrated in a company’s home region (or, for the largest companies, home country). So, it was relatively easy for a CEO to get to know customers, figure out how to serve them, and continuously improve products or services with those customers in mind. It was also possible to connect directly with employees, because there weren’t all that many of them and they mainly lived nearby, with roots in the same home city. The executive typically lived in and had a network of friends in that city too, creating a deep link between his corporate role and his personal life. That is to say, 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 very short-term results, because shareholders planned to be around for the long-term too. The relationship between corporation and shareholder was like a marriage – a partnership not without it bumps, but one in which both parties were willing to commit for the long haul.
Picture an executive of Boeing Corporation in post-war America. He would, by dint if his status and rewards, feel that he was a valuable member of the Boeing senior management team. Since Boeing was a highly successful corporation that had materially helped the Allies win World War II, he would feel pride at being part of that team. He would bask in the glory of Americans writ large feeling that Boeing was a great company, a technology leader and one of the country’s biggest exporters. He would likely be a pillar of the Seattle community. And even though William Boeing, the beloved founder, had sold his stake in 1934, the executive still would likely feel a sense of community with the longstanding shareholders of Boeing. When he went to work, he could feel pride in doing a great job for his team, his city, his customers and his shareholders – together, these stakeholders created a community of which he could genuinely feel a part.
While not perfect, this structure enabled the executive to live a reasonably authentic life; the way he wanted to live personally was largely aligned with his corporate responsibilities. He wanted to make the 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 his company and his family. And he wanted to make his shareholders happy, because he knew that those shareholders had placed a long-term bet on his company. If he worked hard on all those aspects of his community, he could be successful and happy, and the corporation 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 more dispersed (and anonymous) and the home city is far less central – even expendable. With the rise of institutional investors and mutual fund companies, a veil has been placed between the company and its shareholders. CEOs don’t even know, generally, who their shareholders really are; they see only the entity that is investing the shareholders’ money. All of this has weakened the bonds between the traditional community and the CEO.
Moreover, the rise of shareholder capitalism has pushed another community to the fore – players concerned with expectations market, the rise and fall of stock prices. Institutional investors, equity analysts, investment bankers, hedge funds and the financial press have emerged as the central figures in the CEO’s community. Unlike the traditional, positively reinforcing community of yore, this new is community rife with transactional relationships, exploitation and distrust. Its members prey upon one another, ignoring the ill effects of their actions and encouraging each other’s bad behaviour.
The modern institutional investor is a rational, cold-hearted (and even computerised) beast, in and out of a given stock at a whim. Yes, some investors still engage in ‘relationship investing,’ but not in the main. No, institutional investors can and do sell without warning or explanation, looking for short-term advantage and maximum profits right now. 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 create a convergence between their estimates and company performance. They and all the others involved know that if they were capable of discerning whether a stock is overvalued or undervalued even 51% of the time, they would be principal investors, not equity analysts, and they would be wildly rich. Instead, most analysts merely attempt to avoid looking bad, relying closely on company guidance and rewarding those companies that make them look good by meeting the agreed-upon predictions. They coo with approval when companies put shareholder value first and spank them when they don’t. They dance a dance, whereby they set expectations high at the beginning of a quarter and then lower them later in the quarter under pressure from the company and in a desire not to look silly. It is all a game.
Wall Street investment bankers, ever on the hunt for fees, tout ‘value-accretive merger & acquisition ideas’ sure to ‘enhance shareholder value’. Yet don’t share in the outcome of these transactions. 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 huge $350 billion deal. Meant to create an integrated new-media powerhouse, the merger went downhill almost immediately. A decade later, the unmerged companies are now worth just one-seventh of their pre-merger selves. Yet investment firms Salomon Smith Barney and Morgan Stanley, each collected $60 million in fees just the same.
Then there are the hedge funds, which work to exploit volatility – and will actually 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. In late 2008, the SEC went as far as to ban short selling on some 800 financial products companies after claims were made than hedge funds and other market makers were targeting the firms (and others have claimed that naked short selling may have accelerated the declines of Bear Sterns and Lehman Brothers).
And the final member of the expectations community is the financial press. Ultimately, the financial press wants a good story. So, they will pump executives for details and quotes, eager to fill inches of column space. This can create a sinister compact – preferential access for positive coverage – in which the media serves an accessory to the executives, spewing the party line to pump up or minimise expectations as the firm requires. But the relationship can have a dramatic downside for executives as well. Just as executives are able to exploit the financial media for their own ends, the media can turn on a company quickly and savagely, gleefully tearing down icons and highlighting stories of unmet expectations. Dashed hopes make excellent stories; they are full of angst and anguish – and sell lots of papers. Witness the feeding frenzies around former media darlings like Lehman’s Dick Fuld (once one of Barron’s Top 30 CEOs) and HP’s Mark Hurd (one of Fortune’s Power 25).
To be a valued member of this community, a CEO has to give guidance to analysts on things he can’t actually predict — and then make the predictions come true; he must undertake transactions that provide the investment bankers with fees but return little to the firm; he must provide arbitrage opportunities for the hedge funds and offer stories for the financial press, all the while keeping shareholder value rising perpetually for institutional investors. Little of this produces anything good for the company, and most CEOs know it. That the community causes them to act without authenticity is unfortunate, but the allure of belonging to a community, even an unhealthy one, is strong indeed.
The modern CEO has been told in no uncertain terms that increasing shareholder value is his core purpose. But, other than himself and his executive team, those shareholders are faceless, nameless people represented by fiduciary institutions, like Fidelity and CalPERS, who can and will terminate the relationship for any reason, at any time, without warning or explanation. Are these the people to whom the CEO really wants to dedicate his life? It means spending the majority of each day attempting to maximise the wealth of anonymous people with whom he has the shallowest of possible relationships. It is hardly deeply motivating. In fact, it is alienating.
So too is game-playing with analysts. In the current structure, the CEO spends oodles of time trying to talk analysts’ expectations into line with what the company can really do, instead of talking to customers in the real market. The task is painful, time-consuming and difficult, made more so because it has to be accomplished without contravening Regulation Fair Disclosure; every analyst, no matter how idiosyncratic his or her viewpoint, must be told the same things as everyone else. And, in the end, the task may be fruitless anyway. No matter how persuasive the CEO is with analysts, he always runs the risk that the market will run far ahead of reality anyway. Expectations swing wildly – far more so than real returns.
The CEO’s compensation package is chock full of stock-based incentive compensation, so he has clear reasons to do all he can to increase the stock price. Yet he understands just as clearly that he can’t do so forever – especially in the face of market overreactions. He has been set up to play a game he can’t win, in concert with players he can’t trust or doesn’t really know. So, no wonder he games the game. He maximises his own self-interest because it is a meaningful goal he can accomplish and because maximising an anonymous shareholder’s interests is both impossible over the long term and ultimately meaningless. In the midst of an unhealthy community, the CEO leads an inauthentic life, doing whatever it takes to feed the expectations beast – sacrificing once healthy relationships with customers, employees, hometowns and long-term investors along the way.
He behaves, in other words, as Philip Condit, former CEO of Boeing, did. In 2001, in the interest of maximising value for his multitude of anonymous owners, Condit essentially put the location of Boeing’s headquarters out to tender. He announced that Boeing would leave its longtime headquarters in Seattle for whichever city could deliver the best package of incentives and credits. Chicago won, offering the biggest municipal bribe (or rather, “incentive”). Boeing forsook Seattle, its home for 85 years, for an offer from the highest bidder. But even that mercenary move wasn’t enough for the expectations beast. Short-term shareholders kept pressuring Boeing for higher and higher earnings increases. In its efforts to satisfy them, Boeing engaged in procurement corruption and industrial espionage, which resulted in huge fines, jail terms and the forced resignation of Condit (and, in due course, of his successor as well).
Undoubtedly, there is no one reason for the fall of Boeing. But certainly a contributing factor was the replacement of a community of real, long-term investors with anonymous, short-term, shareholders, and a shift in the purpose of the firm from producing great products and great jobs to producing shareholder value. As a result of these changes, longtime Seattle jobs could be destroyed to create shareholder-value-friendly jobs in Chicago. Rules could be bent – or broken outright – to increase earnings for a community of transitory shareholders.
Boeing was an iconic, great American firm, a stalwart of the Pacific Northwest. That it fell prey to the siren call of shareholder value so dramatically, leading to corruption and espionage, is heartbreaking. So, too, is the pervasiveness of the flat-out fraud of options backdating, and the dangerous expansion of ‘NINJA’ (i.e. no-income, no-job, no-assets) mortgages, repackaged in elegant slices and sold to hopelessly naïve investors. In each case, values and ethics fell by the wayside.
Such behaviour saps the moral authority of the business community and causes many talented young people to avoid it in order to retain their own authenticity. For that reason, for the future of business itself, it is imperative that we improve the health and authenticity of our business community and its leaders.
The straightforward answer is to simply tell CEOs to ignore the expectations market. The problem with admonishing CEOs to ignore the expectations market is that it means asking them to be insubordinate. Incentive compensation systems are designed with a purpose: to encourage the person covered by the incentive plan to produce the outcomes targeted by the incentive structure. If a saleswoman is given an incentive structure with a substantial bonus for achieving a specified sales quota, and she makes no attempt to achieve the quota and earn the bonus, she is being insubordinate. The incentive was put in place to encourage the behaviour desired. When a board gives its CEO stock-based incentive compensation, whether stock options, stock or phantom stock, it is issuing an incentive to do one thing and one thing only: raise expectations from the current level to a higher level. If expectations are not raised from the current level, incentive compensation will not be earned. If the CEO doesn’t attempt to raise expectations, he is showing no regard for the incentive structure that was put in place. He is being insubordinate. We can’t expect CEOs en masse to be fundamentally insubordinate in order to follow our admonitions to ignore Wall Street.
The only way to restore the focus of the executive on the fundamentals of his business 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. If an executive wants to buy stock, as some sort of bonding with the shareholders or for whatever other reasons, that is just fine. However, they should be prevented from selling any stock, for any reason, while serving as an executive – and indeed for several years after ceasing to be an executive.
While this may seem radical, let’s remember, 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 1% of that was earned through stock-based compensation. By 2000, CEOs averaged $14 million in compensation, with 50% coming from stock options. And shareholders actually did better in the earlier period (a 7.6% compound annual return on the S&P500 before 1976, versus 6.4% since). Stock-based compensation is a very recent phenomenon, one associated with lower shareholder returns, bubbles and crashes, and huge corporate scandals. It is time that came to an end.
The article is adapted from the author’s latest book: FIXING THE GAME: Bubbles, Crashes, and What Capitalism Can Learn from the NFL (Harvard Business Review Press, 2011)
About the author
Roger Martin has served as Dean of the Rotman School of Management, University of Toronto since 1998. He is an advisor on strategy to the CEO’s of several major global corporations. He writes extensively on design and has published several books, including: FIXING THE GAME (2011), The Design of Business: Why Design Thinking is the Next Competitive Advantage (2009) and Dia-Minds (with Moldoveanu, 2010).
In 2009, Roger Martin was named one of the top 50 management thinkers in the world by The Times of London.