How to keep corporate noses clean

Toward the end of July, Congress passed a new piece of legislation: the Sarbanes-Oxley Act, requiring chief executives, chief financial officers and other key corporate officers to certify their company's financial statements as fair, accurate and consistent with the provisions of the Security and Exchange Act of 1934.

This act, which I believe will come to symbolize a more comprehensive set of new laws and regulations arising from this era, was brought to the floor and passed overwhelmingly by a rarely unified Congress eager to demonstrate decisive leadership in the wake of the corporate financial scandals of 2002.

Was passage of this act--and the current construction of other new regulations and ground rules by regulators, politicians and professional organizations--a rational response of a society that has found wrongdoing in its midst and is acting to obliterate that cancer before it can spread further? Or is it evidence that we've moved into an age of retribution and recrimination, obsessed with finding a culprit?

Stated more simply: Will these laws by themselves prevent future abuses? If not, what else must be done?

On the table are legislative proposals so radical, they could lead back to compensation schemes that disconnect the interests of employees and shareholders.

First, let me be clear that the tremendous anger directed at those corporate officers who have been fingered for dereliction and in some cases actual fraud is both understandable and justified. At the very time many of us were losing significant fractions of our life savings, some corporate officers and others, such as Wall Street analysts, were enriching themselves--at times to astounding degrees.

I believe the anger would be justified even if there were no illegalities; the frauds, criminal acts and blatant conflicts of interest only compound that anger.

But the anger that many of us feel also is aimed--again fairly--at others. Some of these, such as financial analysts, failed in their duty to accurately assess or report the states of their respective industries and the companies they reported on with a critical, unbiased and informed eye. In many cases, there were enormous conflicts of interest.

We find, for example, that some analysts were compensated not on the basis of the accuracy, perspicacity and value of their analyses, but on the basis of the banking fees that their employers realized in underwriting the very companies they reported on--an "un-virtuous circle" of interests that provided powerful incentives for people to abuse their positions for power and enormous personal gain.

Anger is also appropriate when addressed to the auditors who failed to protect investors from egregious accounting fraud. Their excuses--"They hid the numbers from us"--reveal a lack of professional standards and competence that astounds.

Don't forget the media
And let's not forget the media, who not so long ago glorified many of the executives now being pilloried. How quickly they change from beauty contest to perp walk. The media failed us; they failed to play the role of impartial skeptics and became New Economy sycophants. Worse, they too often pandered to successful, wealthy executives and failed to ask the tough questions we expect them to ask.

What we have found is that the many of the assumptions of an efficient market--accurate information, early detection of fraud and abuse, and professional competence and standards of conduct among the many involved in the effective functioning of the market--became so distorted that investor confidence in the capital markets evaporated overnight, once the entire scope of the distortions became apparent.

Understanding what happened--how these distortions came to be--is essential to understanding how to eliminate abuses in the future, to rebuild investor confidence and to ensure that these kinds of abuses cannot happen again.

Ultimately, I believe that we need as a society to rebalance the emphasis on wealth creation on the one hand and value creation on the other.

Making it a requirement for those of us who manage companies to understand and certify as accurate those companies' financial statements strikes me as very reasonable. I believe these new certification requirements mandated by Sarbanes-Oxley will lead to exactly the kind of fiscal conservatism envisioned by the authors of the act.

Other requirements being placed on boards of directors, to maximize the independent oversight of management and to ensure that principal responsibilities are directed to shareholders rather than to management, also appear necessary and worthwhile.

But I also believe that some of the cures proposed will do more harm than good. For example, requiring companies to expense stock options is misguided in my view. Options provide the best mechanisms known for aligning shareholder, executive and employee interests. In most companies, the vast majority (in Palm's case, more than 80 percent) of options are awarded to rank-and-file employees.

Removing or seriously curtailing options from employee compensation could ultimately worsen the problem that needs to be fixed. Further, there are no good methods for valuing options fairly. Some of the proposals being considered by Congress and others could lead to accounting and financial statements even harder, not easier, to understand.

Not too many years ago, investors--and compensation consultants--were complaining about outrageous salaries and the resultant disconnects between company executives' interests and those of shareholders. Then, the cry was for a better mechanism for alignment of executives and investors--like options!

What should be done with options is to eliminate option abuse and to make more expansive the rules for and forms of disclosure. Eliminate the ability to price options below market. Eliminate the practice of issuing loans to executives to buy options to improve tax treatment on the gains. And I believe that improving the independence of compensation committees will lead naturally to increased restraint in the number of options awarded.

On the table are legislative proposals so radical, they could lead back to compensation schemes that disconnect the interests of employees and shareholders. I prefer to focus on ensuring that investors fully understand the structure and specifics of the options programs. Accurate and timely disclosure, providing better and more accurate information in general, is the best way to create efficient markets--not a blizzard of new rules and regulations that invite abuse or require us all to be CPAs to understand arcane securities laws.

We also have to remember that many dipped their hands into the till during the great Internet bubble of the last decade. At the same time that appropriate measures are being developed to curb officer and executive abuses, we should also support steps to ensure that auditors audit fairly; and that analysts analyze fairly and receive compensation based on the accuracy of their analysis, not on the fees earned by the banks that employ them.

How quickly they (media) change from beauty contest to perp walk.

And while I don't believe in tinkering too much with the media, perhaps we all should do our small part in encouraging the right behavior: the fair and accurate reporting of financial news, and insightful analyses that go beyond amplifying the blandishments of company press releases.

Ultimately, I believe that we need as a society to rebalance the emphasis on wealth creation on the one hand and value creation on the other, and to understand that in a free and efficient market, there are no risk-free investments--and no free lunches.

Here even the investment community must shoulder at least some of the blame for playing a role in contributing to the problems that we now all decry. By becoming more and more focused on short-term performance, and inventing ever more clever and complex investment instruments that increase financial leverage and therefore the volatility of capital markets, investors have unwittingly laid the groundwork for behaviors counter to their own interests.

Somehow as a society we need to learn the lesson of interdependence. What strikes me as missing from the current debates is the realization that there really are significant and causal interdependencies among the protagonists.

There are drawbacks to unrestrained shareholder activism, in other words. If, as a CEO, you know your destiny is in the hands of short-term-focused investment managers, your behavior will inevitably become more focused on short-term results--and this in turn can contribute to an attitude of "take the money and run."

What CEOs and other corporate officers should be focused on--and measured, compensated and rewarded to achieve--is the creation of great products and services, and of long-term value for shareholders, customers and employees.