Greed, Fear, and The System Hinder Corporate Reform

Enforcers of regulatory laws are making some headway, particularly since the passage last summer of the Sarbanes-Oxley Act, but their work as a whole needs more teeth, according to panelists at the session on regulation and enforcement. The session was led by Harvard Business School professor Rakesh Khurana.

Here are some of the challenges:

Basic greed. Wayne M. Carlin, northeast regional director of the Securities and Exchange Commission, who clarified that he was speaking for himself and not on behalf of his organization, wondered whether greed could overcome compliance laws as long as people were willing to be tempted.

Basic fear. Barry R. Goldsmith, executive vice president of enforcement for the National Association of Securities Dealers, who has worked in enforcement for eighteen years, suggested that enforcement by its nature is reactive. It kicks in only after investors have already lost money. Enforcement may work as a deterrent, but in the long run, he suggested, it is difficult to know whether deterrence instills investor confidence. The key is to let everyone know that regulators are out there, he said. "It is a challenge."

Basic existing corporate governance. According to Grace Hinchman, senior vice president for public affairs at Financial Executives International, chief financial officers need to become more responsive to a smarter audit committee, and shareholders have a responsibility, too. "Regulation is not the magic bullet," she agreed.

There's been an incredible diffusion of what some people are calling the stealth-wealth pay system.
— Rakesh Khurana

One of the key points to remember in fixing the system, according to Khurana, is that most of the attempts to bypass the regulations were not just done by the CEOs themselves. There are entire industries that have been created to help avoid paying taxes and find creative ways around compensating people, he said.

"There's a lot of aiding and abetting that goes on in this kind of environment and I think it's important to think about how regulation can help in that kind of environment."

Much-touted self-regulation has its problems, he said, and it is not clear that self-regulation is actually working. According to the latest data, and putting aside improvements at either end of the curve, the median CEO pay is continuing to rise, he said.

"Despite a 20-plus percent decline in Standard & Poor's last year, the median CEO pay is up 14 percent this year. Moreover, there's been an incredible diffusion of what some people are calling the stealth-wealth pay system. This was evident, for example, in American Airlines and Delta Airlines: the adoption of supplemental executive retirement plans, in which up to 100 percent of one's compensation can be deferred into a non-taxable account that gets a guaranteed return that's much higher than, say, the State Treasury fund rate—it's often 9, 10 percent—and it's paid for by the shareholders."

For Khurana, this begged the question of whether, in such an environment, self-regulation could stand a chance if boards such as those at American or Delta were willing to approve such compensation packages. Could self-regulation function in a context in which median CEO pay continues to go up and the shareholders have lost an "enormous" amount of wealth?

Designing regulatory systems is very tricky and could result in the "unintended consequences" of slippery CEO pay efforts, he observed.

"I think society pays a price when we give individuals the right to have access to and control of enormous amounts of resources. We expect something in return," Khurana told the audience. "We expect fiduciary responsibility; we expect them to behave like professionals. In other words, there's an implicitly moral and social contract that's necessary for the economy to work."

"And what's happened in recent years, I think, really violates that social and moral contract. ... Our society really depends, at some level, on having trust in the system, having trust in the information that's produced, having trust that people are doing what they're saying."

One of the difficult challenges ahead, he said, will be persuading people around the world that their trust in the private sector, rather than the government, could be well placed.

"It becomes a lot more difficult when internal documents show that analysts were recommending stocks that really had no chance of ever making money and that executives were regularly manipulating earnings," he said. Khurana concluded his remarks by reciting the lyrics to a ditty posted on the Internet by disgruntled workers.

The Restoring Confidence in American Business conference was co-sponsored by the Harvard Business School Association of Boston and the Boston Security Analysts Society.