Have We Carried the Concept of Alignment Too Far?

by James Heskett

Summing Up

Don't throw out alignment while fighting greed and ignorance in corporate governance

Respondents to this month's column have spoken: The cause of investor mistrust of management is not the concept of alignment; it is, among other things, ways in which the concept is misused or subverted.

As John Apen points out, "Alignment works only if CEOs and boards have the same time perspective as the other two groups (investors and employees)... top managers' and Wall Street goals were all short term.…" C. J. Cullinane adds, "Alignment and buy-in were abused by those who should have insured and enforced fairness and honest reporting."

Many questions were raised about the level and form of compensation afforded U.S. business leaders today. Allen Roberts comments, "In sustainable, successful organizations, levels of pay come well down the list (of employee desires) ... Why should it be any different for the high-flyers? If they are truly good, is it really necessary to pay them more than they can ever hope to spend?" As Stever Robbins says, "Alignment is still a great idea. We've not seen alignment with recent stock option grants... We'll see little change in behavior until we guarantee that those who destroy value and betray the public trust don't profit from it handsomely..."

These matters have become embarrassing for Americans living overseas. Tammy Doty reports that "As an American living in Asia, I most definitely have egg on my face, especially considering that during the last five years the U.S. has lectured Asia on ending collusion and cronyism."

There is a general tone in responses to this month's column that there are few antidotes, including alignment, to greedy leaders and ignorant board members short of restoring common sense to compensation schemes and holding officers and directors responsible for their actions. All of which implies greater transparency in information, education for non-officer directors, and stiffer penalties for willful abusers.

This leaves us with several questions: (1) How much of the remedy can be legislated? (2) What's the likelihood that vigorous new enforcement of new regulations will make it increasingly difficult to find qualified and independent directors? (3) If the latter occurs, will investors' interests really be better served? What do you think?

Original Article

In the past several weeks we have been treated to vastly restated earnings, the conviction of an entire accounting firm, and the baiting by congressional committees of witnesses drawn from the ranks of corporate managers. We are faced with the prospect of new SEC regulations, a revamped Financial and Accounting Standards Board, new New York Stock Exchange rulings regarding board composition and other matters, and a Corporate and Auditing Accountability, Responsibility, and Transparency Act (CAARTA) by Congress. A misguided overreaction? Possibly. But even Goldman Sachs chairman Henry Paulson said last month, "I cannot think of a time when business overall has been held in less repute."

Regardless of the facts and the appropriateness of the responses, it now appears that actions based on perceptions will not be trivial. Investors, both U.S. and more significantly foreign, are voting with their feet. This hardly provides a stimulus for corporate investment. Executives are confronted with options so far underwater that they may not surface in the span of a management career. And employees are disillusioned by what they read repeatedly about the alleged self-dealing of a relatively small number of high profile leaders. Even my publisher informed me this week that at least one major retail book chain will not promote a book on management unless it is an exposé. Can a wholesale decline in interest in management as a career be far behind?

Executives are confronted with options so far underwater that they may not surface in the span of a management career.
— James Heskett

Is it possible that one culprit is a highly appealing concept universally taught in business schools in the 90s, the importance of aligning the interests of employees and management with shareholders? An important vehicle for achieving alignment was the stock option grant. The bigger the better. This made the potential payoff huge, especially to top executives. It created an incentive to push aggressive accounting to the limits. The practice benefited everyone in the ranks of the aligned—shareholders, employees, top executives, those associated with the capital markets, and anyone desiring a "healthy" economy. Those not joining in risked enormous erosion of value. Accountants could hardly be expected to be more than a weak reed in the hurricane fed by policies of alignment.

Among the proposals for legislation and oversight, one relatively simple one has been set forth by the SEC and supported by the administration to provide checks on what might be regarded by some as the excesses of alignment. It involves holding CEOs and chief financial officers personally responsible for the accuracy of financial reports. Others might include directors among those held responsible, with at least the confiscation of all incentive pay gained as a result of deliberate inaccuracies.

How did we get into this mess? Did an overemphasis on alignment have anything to do with it? What kinds of checks and balances are needed in the future? What do you think?

    • Anonymous

    The problem is not alignment but a lack of board participation in the fundamentals of a business. Boards are not intimate enough with their company's operation and do not spend enough time evaluating their company's fundamental strategy and resulting execution. It is the strategy and the execution that are not always aligned.

    In the case of Enron, the board obviously did not recognize that the fundamentals associated with Enron's investments in things such as power plants in India were poor and that those investments would not even earn Enron's cost of capital. Allowing a tremendous amount of capital—in relationship to the company's size—to be deployed in these types of investments was irresponsible on the board's part.

    • John Apen
    • Editor, Manheim Auto Auctions

    The "law of unintended consequences" bites again. Alignment implies congruent goals. As has been demonstrated, top managers and Wall Street goals were all short term: Make the numbers and get out. At the other end were employees locked into long-term 401K and pension plans. Caught in the middle were investors with mid-term goals. Both of the latter groups were badly hurt when the focus of short-term results by management led to "aggressive" accounting with the resulting short-term spurts and long-term disasters. Alignment works only if CEOs and boards have the same time perspective as the other two groups.

    Why were Enron board members allowed to sell stock obtained from options while sitting on the board? Why are CEOs' and CFOs' stock options not locked in for 5 years or more? There never was "alignment" in the way stock options were granted. The assumption that top management was in for the long haul, like other "owners," such as employees and investors, and would respond accordingly, was only a bad joke.

    • C. J. Cullinane
    • VP/GM, Everbrite

    It may be simplistic but plain old greed triggered this mess! Alignment and buy-in were abused by those who should have insured and enforced fairness and honest reporting.

    CEOs and CFOs should be held responsible for the accuracy of any report they generate; it is their job! A small (hopefully) group of executives has done all business leaders a disservice. A CEO is not only responsible for profits on the bottom line but also the integrity of that bottom line.

    • Allen Roberts
    • General Manager, Agri Chain Solutions, Ltd.

    It has been clear for some time, not just with the benefit of hindsight, that the huge incentive to bend the rules—offered by the presence of a bag of gold—was going to be taken up by some in a position to do the bending.

    In every organizational review I have been involved in, there has been an objective to provide a work environment where individuals want to come to work, contribute, and make a difference. For that effort, they can reasonably expect to be compensated financially and emotionally. In sustainable, successful organizations, levels of pay come well down the list [of employee desires] after security, recognition, opportunity to organize their own "workspace," and often a few others.

    Why should it be any different for the high-flyers? If they are truly good, is it really necessary to pay them more than they can ever hope to spend?

    • Anonymous

    The current rash of corporate disasters including Enron, WorldCom, and HIH here in Australia is [the result of a] lack of business transparency, not a result of alignment. Alignment in and of itself is a good thing. But if the regulatory environment surrounding business allows companies to be opaque about their "true" performance, then, of course, the temptation will exist for those who are potentially exposed to a conflict of interest—between their personal interests and corporate responsibilities—to muddy the waters.

    The temptations [inherent in] conflicts of interest will never be removed (as remuneration will always follow results). Instead, the opportunity for such misleading opacity should be removed. This should be done through stronger regulation, enabling better standards of internal and external audits, and through more transparency in how businesses are required to report a true and fair view of the their results.

    • Shaun Greene

    Alignment is fine. Just throw those who abuse the system in jail and throw away the key...

    • Stever Robbins
    • President, VentureCoach, Inc.

    Alignment is still a great idea. We've not seen alignment with recent stock option grants. A $100 million grant doesn't align a CEO with shareholders. As a holder of $10,000 worth of WorldCom stock, I care much more about share price than a $100 million CEO would. A 90 percent drop in value wipes me out, while only taking the $100 million owner down to a "paltry" $10 million. (Still quite enough to retire in style forever, even in 4 percent T-bills.)

    The problem may be much deeper: We assume that the sum of everyone acting in their own best interest leads to the best interest for all. In any case where shared resources can be plundered, however ("tragedy of the commons" or "prisoner's dilemma" scenarios), that just isn't true.

    The Enron/Xerox/WorldCom/Global Crossing/Anderson executives may have tanked their companies, but in most cases they still took hundreds of thousands—millions in many cases—of dollars out before the companies came crashing down. Even if there are jail sentences (and none will be as bad as a jail sentence for sidewalk purse snatching), the individuals involved will be walking off with "endgame" nest eggs. We'll see little change in behavior until we guarantee that those who destroy value and betray the public trust don't profit from it handsomely when all is said and done.

    • Tammy Doty
    • Business Development Manager, Poelmann Chan Group (Hong Kong)

    "Alignment" in big business seems to have mutated into a synonym for collusion when it ought to mean a balance between profits and ethics.

    As an American living in Asia, I most definitely have egg on my face, especially considering that during the last five years the U.S. has lectured Asia on ending collusion and cronyism. If it's good for the gander, ain't it good for the goose?

    • Anonymous

    There is no doubt that recent events, such as the WorldCom affair, have prompted a rethink about corporate governance and, more specifically, the accounting and auditing standards that are supposed to ensure a "true and fair" picture of a firm's financial position. It is, needless to say, a complex matter that highlights issues ranging from stock options for corporate executives to the state of auditing and accounting standards in general.

    Alignment, in the form of stock option grants, for example, is probably a contributing factor to giving executives the green light to pursue higher and higher profits, even when it amounts to some tricky accounting work to produce the right figures for shareholders and investors.

    Surely, though, any reforms need to address the regulatory framework. Auditing and accounting standards must be reviewed to prevent over-inflated profitability and potential corporate collapses. Indeed, the Bush Administration has been quick to acknowledge the need for such reform that, we all hope, will prevent further cases from emerging out of the woodwork.

    • Dr B. V. Krishnamurthy
    • Professor, M. P. Birla Institute of Management, India

    The present mess may perhaps be attributed to our overlooking a basic premise of business—that directors and executives are merely trustees of public wealth. The concept of stock option plans and indeed, of any form of performance-related compensation plan, became popular because of a perceived notion that these would be the best means to motivate executives to be intrapreneurs, and to retain talented employees.

    It is important to remember that many of the breakthrough concepts in management are double-edged swords. Used judiciously, they could be valuable tools in enhancing performance. However, when personal greed gets the better of the public good, the same tool could prove to be disastrous for the enterprise.

    I do not believe that changing the law or making it more stringent would have the desired effect. It is the classic "cops and robbers" syndrome. For every law enacted with the avowed objective of reducing crime, those who want to break the law invariably find a way of circumventing it.

    The only way out of this sorry state is accountability at the personal level—listening to one's inner voice. This may sound utopian but any other alternative would have the same effect as the laws have had till now—smart professionals always looking for a way out.

    It is time that we took a hard look at the process of creating wealth—the means are as important as the ends. This might involve more emphasis on values in education. This might also require, in the short term, the social ostracism of people found to have abused the trust reposed in them. If this sounds too drastic, let us remember that tumors often require surgery. Enron, WorldCom, Xerox: Is it possible to restore public confidence without wielding the scalpel?

    • Anonymous

    I'm an MBA '73 whose entire career in professional services and advising senior executives confirms that the reaction is not too great. It is not isolated, but rather an epidemic caused by the corporate culture we chose to create over the past twenty-five years. Corporate culture in this country encourages and causes these abuses. As anyone at the top will tell you, to rise you have to "make your numbers." Doing the right thing is no way to advance in corporate America.

    Without checks and balances, power corrupts. Sadly the idea shapers of the past twenty years were so enamored of the "free market" that they forgot about this. I also blame the politicians who pervert the potentially balancing regulatory bodies, the Ph.D. economists with whom I have worked side-by-side in mergers and acquisitions, regulatory policy, and other "inside-the-beltway" activities for the past thirty years; and the business school where you teach game and negotiation theory (remember Raiffa) without teaching ethics. And I'll even throw in Harvard who as John Shad once said, "I gave them money to set up an ethics course at HBS and instead they built a gym. I knew they would spend my money however they pleased after I was dead, but that they did it while I was alive surprised me."

    • Herb Smith, Ph.D.
    • Professor and Head of Marketing, Organization: Yang-En University, People's Republic of China

    The reality is that America's elite managerial class has become a den of thieves. Alignment, my aunt Suzy!

    These people have behaved deceptively in every area of corporate endeavor to assure their survival and the continuation of their absurdly huge paychecks. American managers have run companies into the ground because they have forgotten the basics of management, if they ever really knew them.

    The effective word is greed, pure and simple. The recent Enron-Andersen debacle had nothing to do with so-called advanced management techniques; it was greed, nothing less.

    America's primary problem is the business community and its efforts to control society in virtually every facet. The educational system is in shambles because of the business community. The welfare system is now really bollixed because of the business community. There isn't an area of American life where the business community has not intruded and screwed up.

    The business of business is business, not government, not education, not welfare, or any other sociopolitical endeavor. The sooner business "gurus" start touting that, the sooner the American nation will get well again.

    • Anonymous

    I was an audit partner in an international accounting firm. I have worked in three countries spanning across Europe, U.S., and Asia.

    I left the profession for several reasons, some of which may address the questions that you are raising.

    International accounting firms' structure is a recipe for disaster. Trainees or people with, at best, three to five years' experience, are assigned to substantially scrutinize company records. In a complex environment, these young auditors have little hope in discovering irregularities that may be deliberately concealed by dishonest management.

    Fee structure and clients' pressure to contain fees to a minimum (most clients see audit as a necessary evil and are reluctant to pay) may result in managers and partners spending less than desirable amount of time on the job.

    Eager to gain market shares, most accounting firms accept new assignments regardless of whether they have adequate resources to handle all assignments

    In boom years, accountants typically leave audit firms prematurely, say after two to three years of limited experience. They then assume high title positions in various organizations, including dot-com companies. Most who spent less than seven to eight years in an international accounting firm will not be fully equipped to handle the accounting issues of complex organizations. As auditors, the risk of missing erroneous accounting entries is significantly increased when the client is staffed with incompetent accountants/CFOs. I have raised concerns regarding the competency of a client's accounting staff and have on several occasions incurred the wrath of the client.

    Few organization's top management truly understand what is going on. Most don't understand finance. They are good at forming strategies to make money but typically have no clue as to what is proper accounting, corporate governance, internal controls, risk management, etc. Dealing with clients who are running the company blind is an occupational hazard.

    I have much more to tell. What is happening around the world is of great concern and hence I have written more than I have ever told anyone before. However, I realize that I am getting carried away and you may find this absolutely boring and irrelevant. So I shall stop writing now and wish you all the best in your research.