The bottom line: the limits of corporate regulation

How do we make sense of the stream of corporate scandals that now include WorldCom, Enron, Global Crossing, Tyco International, Adelphia Communications, Qwest, RiteAid, and even Xerox? One place to start is to recognize that gross misbehavior by those who control great concentrations of corporate wealth has been around as long as large corporations themselves. Past scandals, it is also helpful to remember, have often resulted in beneficial reforms. The antics of the railroad robber barons in the mid-nineteenth century led to creation of the Interstate Commerce Commission, the first federal regulatory agency. Late nineteenth-century monopolies in oil and other trusts provoked enactment of the Sherman Act, the first federal antitrust legislation. The debacle of the securities markets following the Crash of 1929 produced the Securities and Exchange Commission, and the Savings and Loan crisis of the 1980s led to significant regulatory change. There is thus reason to believe that today's problems are not unique, and that a positive outcome is possible. Witness passage of the corporate-fraud bill of 2002.

But maybe we should keep worrying. Today's problems are not just another predictable eruption of corporate greed, but the result of the collapse of the bulwarks against greed. The four basic control mechanisms so painstakingly constructed in the last century to protect investors and limit managerial fraud have begun to fail catastrophically:

The failure of transparency. The federal securities laws enacted in the 1930s require large corporations to disseminate publicly huge amounts of financial and other information. Because of the resulting transparency, American companies were able to raise large amounts of capital, both domestically and from foreign investors. Of course, the mandatory disclosure system was never perfect: there has always been plenty of securities fraud. But the constant flow of usually reliable information ensured the flow of investment. Today's scandals, however, indicate that too many public corporations have been gaming the disclosure system, either subtly (Enron), or brazenly (WorldCom). Suddenly, American securities markets are remarkable not for transparency, but for unreliability.

The failure of monitors. Also crucial to the integrity of public corporations and securities markets has been the auditing, mandated by the federal securities laws, of corporate financial statements. The legal requirement for certification by independent auditors was a counterbalance to management's tendency to puff or dissemble. Similarly, independent securities analysts made a business of publishing critical, dispassionate analysis about companies under their scrutiny. Their job was to tell when the emperor had no clothes. Recent events have shown that too many accounting firms and securities analysts have been corrupted by conflicts of interest that compromised their independence. Some accounting firms found that a compliant approach not only generated more auditing business, but protected their lucrative consulting relationships with clients. Analysts got soft when they found their compensation tied to the investment banking business generated for their firms by the companies they were supposed to scrutinize.

The failure of stock option compensation. The practice of compensating corporate managers with stock options, which today seems so disastrous, was actually intended to align the interests of managers with those of shareholders. When managers are compensated purely by salary, they do not share in the increase in shareholder wealth created when the stock price rises. Rational salaried managers thus tend to be too risk-averse because they do not benefit from the upside of risk. Economists call this conflict of interest between shareholders and managers the problem of "agency costs." Stock option compensation seemed to be a brilliant, nonregulatory solution to the problem. If managers would benefit directly from pushing the stock price above their option price, they would have an incentive to manage in a way that would benefit themselves and the shareholders simultaneously. But it hasn't worked out that way. In fact, stock option compensation has created a moral hazard. Managers are tempted to pump up stock prices by illicit means, such as inflating earnings and hiding losses, or to take excessive risks, because they know they can use their inside knowledge to exercise their options and liquidate their investments before the bad news becomes public and shareholders are left to absorb the loss.

The failure of SEC enforcement. The enforcement of SEC law takes money--lots of it. Revealingly, all living former SEC chairmen, an ideologically disparate group, have insisted that the agency simply does not have the resources to enforce the laws vigorously.

There are remedies for all these failures: more stringent SEC disclosure standards; greater board and CEO responsibility for financial disclosures; heavier criminal liabilities for senior officers; tougher accounting standards; stricter regulation of the accounting industry; sharp separation of auditing and consulting functions; tax treatment of options as expenses; a shift from compensation with options to compensation with stock; greater restrictions on managers' rights to exercise their options and liquidate their positions; and substantially increased funding of SEC enforcement. All of these solutions were proposed after Enron, but the political will to adopt them waned until this summer. The stock market's slide has had a clarifying effect, resulting in President George W. Bush's signing of corporate reform legislation on July 30, 2002. That legislation contains many of the much-needed remedies.

But are those reforms enough? They represent a strengthening and refocusing of the existing network of rules. But they do not change anything fundamental about the nature of public corporations and how the people who manage them should behave. What has been eroded in the last six months is not just investor confidence but belief in the legitimacy of the corporate enterprise itself. That is the most serious loss, and it requires a rethinking of what large public corporations are and what they are for.

The dominant legal and economic theory is that the corporation is simply a nexus of contracts among providers of capital, labor, and managerial services. Implicit in the contract with managers is a generalized fiduciary obligation, which requires them to maximize the value of the assets they manage for the benefit of the shareholders, not themselves. This is not, however, a system of ethical obligation; it is only a set of legally enforceable contractual obligations. In an ethical vacuum, unethical behavior flourishes, and the law plays a constant catch-up game.

There is, of course, a different vision of what a corporation should be, one suggested in Catholic social thought. This vision was expressed in Centesimus annus, where Pope John Paul II wrote that "the purpose of a business firm is not simply to make a profit, but is to be found in its very existence as a community of persons who in various ways are endeavoring to satisfy their basic needs, and who form a particular group at the service of the whole of society."

Description of a public corporation as a "community of persons" may seem naive. The "persons" involved in the entity are transient, as well as largely unknown to each other. The "shareholders" are a fluid group of investors who move in and out of ownership with rapidity in highly liquid securities markets. Managers come and go, and even ordinary employees have few expectations of long-term employment. How can this be described as a "community"? Does it make sense to describe the corporation as being "at the service of the whole of society," if that service is essentially nothing more than providing particular goods or services for a materialistic consumer society?

The pope's vision thus is not an accurate description of large public corporations, but it is not supposed to be. It is a prescription, not a description. It is an aspiration, grounded in a moral and social tradition that insists on economic organizations recognizing the dignity of each person involved in or affected by the organization. If the managers of large corporations conceived of themselves as stewards of the wealth they control for the benefit of the infinitely valuable persons whose lives they touch, this would provide the ethical framework missing from the dominant theory of the firm.

A naive hope? Maybe. Yet a crisis of legitimacy allows prophetic voices to be heard. Perhaps even in Congress. Perhaps even on Wall Street.

Mark A. Sargent is dean of Villanova University School of Law.

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