Implicitly Assuming that the CEO is Not a Crook Misses the Problem

By William K. Black

Gretchen Morgenson has brought a revealing study to the attention of the public in her article entitled “The CEO is My Friend, So Back Off.”  Here’s the bad news – the situation is vastly worse than the authors of the study conclude and the policy advice that experts offered Morgenson in response to the findings would fail where they were most needed.

Morgenson begins her article by describing a recent speech by the head of the SEC to an audience containing many board directors.

“Mary Jo White, the chairwoman of the Securities and Exchange Commission, [stood] in front of an audience that included a fair number of corporate directors, urging them to be more accountable.

In the speech, at the Rock Center for Corporate Governance at Stanford University, Ms. White emphasized their crucial duty to protect shareholders from abusive practices at companies they oversee.

‘Setting the standard in the boardroom that good corporate governance and rigorous compliance are essential goes a long way in engendering a strong corporate culture throughout an organization,’ Ms. White said, later adding that ‘ethics and honesty can become core corporate values when directors and senior executives embrace them.’”

White is channeling corporate ethics’ sole meme – “tone at the top.”  If the CEO and the board set an ethical tone at the top they can produce an ethical organization.  Even Alan Greenspan explicitly made the same statement.  But what Greenspan, White, and virtually all those who peddle this business ethics meme fail to do is ask themselves two logical questions if we assume for purposes of analysis that the meme is correct.

  • What can we infer from the fact that rampant fraud was the norm at our largest and most prestigious financial institutions, hundreds non-prestigious mortgage banking firms, and tens of thousands loan brokers and brokerages with terrible reputations arranging loans that the industry called (behind closed doors) “liar’s” loans?  As I have documented, we are talking about millions of cases of fraudulent loan origination and the fraudulent sale of those fraudulently originated loans to the secondary market, plus Libor, plus the epidemic of foreclosure fraud.  Under the corporate governance and ethics meme we can infer that the CEOs of these hundreds of institutions refused to “embrace … ethics and honesty” and selected board members that they believed would sallow these millions of felonies share that refusal.
  • Why would CEOs fail to set an ethical “tone at the top” and run firms that, collectively, created these millions of felonies?  There is one obvious answer to that question.  The answer has two related parts.  CEOs are made wealthy by modern executive and professional compensation if they engage in the “sure thing” of running a firm that engages in widespread fraud.  Depending on the type of “control fraud” that they lead, the fraud may enrich or “loot” the shareholders.  Accounting control frauds create fake (record) profits and real (record) losses, but other forms of control fraud enrich the shareholders as well as the CEO.

Second, when these frauds create a competitive advantage they create a “Gresham’s” dynamic that drives honest firms, professionals, CEOs, and board members from the marketplace.

These two questions and their answers are essential to understanding why we suffer recurrent, intensifying financial crises, so I am happy that the study should, logically, lead to people focusing on those questions.  Unfortunately, no one involved even asks, much less focuses, on those questions and answers.

Does anyone seriously think there is a CEO of a publicly traded company in America who is so stupid or ignorant that he had not heard of the concept of creating a culture of integrity and need to learn about it from White?  Control frauds have terrible ethics in reality because that facilitates the fraud.  Their CEOs typically provide a thin veneer of faux ethical trappings in the form of “ethical codes” that are actually designed to reduce punishment under the Sentencing Guidelines and to fool the credulous. Does anyone think that the CEOs that control firms and use them as “weapons” to defraud want to pick board members who would obstruct those frauds?  Does anyone doubt the ability of CEOs who control these frauds to select board members who will tell regulators to “back off” from criticizing the CEO?

The standard economics joke (punch line: “assume a can opener”) should be the standard business ethics joke.  Yes, CEOs can insure that corporations, even massive corporations, act in an overwhelmingly honest fashion and one of the means by which honest CEOs would do this is by choosing directors of impeccable integrity and a track record of “speaking truth to power.”  It is useless to tell CEOs running frauds that they should select great directors.  It is easy for them to find people with great resumes to serve as sycophantic directors.

The question that gets asked instead is why directors would fail to “embrace … ethics and honesty?”

Why wouldn’t board members embrace these values? Cozy board ties with the chief executive might be one reason. A recent academic study, to be published in the July-August issue of The Accounting Review, suggests that lax oversight can result when a director of a company is friendly with the chief executive overseeing it.

But the research makes a counterintuitive finding as well. The conventional wisdom holds that when you disclose personal ties, you create transparency and better governance. The experiment found that when social relationships were disclosed as part of director-independence regulations, board members didn’t toughen their oversight of their chief-executive pals. Rather, the directors went easier on the C.E.O., perhaps believing that they had done their duty by disclosing the relationship.

I don’t think their finding is counter-intuitive and I think the researchers are correct about the psychological processes involved with this form of disclosure.

But this does not explain why CEOs would select board members who failed to “embrace” integrity.

The experiment did not allow for fraud, which makes it a poor pairing with White’s speech.  The experiment is lab study that has the usual strengths and weaknesses.  It does show that simply telling the test subjects to play a role in which the CEO is their friend is associated with the subjects being willing to take actions that harm the corporation’s long term interests in order to increase the CEO’s bonus.  We should consider, of course, how vastly more powerful real friendship reinforced by mutual self-interest would likely be in the real world.  (The authors made the first point in their paper.)  But the experiment’s design removes the key elements of reality that explain why boards typically support the most fraudulent of CEOs – the ability of the CEO to select directors who are known to defer to the CEO and support extreme executive compensation, the gains to directors from modern director compensation and other mutual back-scratching arrangements, and the perverse incentives of a Greshams’s dynamic produced by control fraud.

It would help the discussion greatly if we discussed the key real world examples of the types of fraudulent practices thousands of board members signed off on routinely that drove the crisis.  Consider the extraordinary growth in the use of loan brokers, particularly those specializing in liar’s loans.  Combining these two fraud-friendly practices was sure to produce massive losses – but also record (albeit fictional) income in the near term that would maximize corporate bonuses. Here is George Akerlof and Paul Romer’s 1993 warning about loan brokers’ reputation.

“Loan brokers, who match borrowers and lenders in exchange for a commission, have a deservedly bad reputation. The incentive to match bad credits with gullible lenders and to walk away with the initial fees is very high. It can also take several years for this kind of scheme to be detected because even a bad creditor can set aside some of the initial proceeds from a loan to make several coupon or interest payments” (George Akerlof and Paul Romer 1993: 46).

Akerlof and Romer are talking about an odious reputation that was well-established by the 1980s, the time period they are discussing – three decades ago.  The typical fraudulent mortgage lender in the U.S. adopted a series of business practices that were nonsensical for honest lenders but optimized accounting control fraud.

  • Extort, by creating a Gresham’s dynamic, appraisers to inflate market values
  • Make liar’s loans known to be overwhelmingly fraudulent
  • Originate the loans through loan brokers with perverse incentive systems
  • Sell the fraudulently originated mortgages through fraudulent “reps and warranties” to the secondary market

Yes, CEOs shape their executive compensation to be so perverse that it “successfully” reduces the firm’s value through means such as cutting R&D investments.  That is very bad.  Note that the research demonstrating the harm of the perverse incentives has not led to ending those perverse incentives even though we know how to design vastly better incentives.  But the four bullet points above cause financial catastrophe and they too are driven by the criminogenic environment that the perverse executive and professional compensation systems that the CEOs design create.  The good news is that if we concentrate on the indefensible creation of criminogenic incentives through modern executive compensation the policy steps we would take to reduce fraud would also fix the CEO’s perverse incentive to under invest in R&D.

By assuming fraud out of existence, however, we end up with proposed remedies that are certain to fail.

“There are two messages in this study. One is for regulators: Simply disclosing a conflict or friendship does not eliminate its potential to create problems.

The other is for investors.

‘Shareholders should take a more active role in finding out what kinds of relationships their boards and C.E.O.s have,’ Mr. Rose said, ‘and recognize the potential traps created by them.’”

No, there are additional and far more important “messages” that come from the combination of the study and White’s speech.  Once we realize that CEOs that “embrace” fraud will select directors to aid their frauds we realize that directors that are primarily chosen by the CEO are inherently susceptible to being suborned by CEOs and are not reliable barriers to fraud.  We can then begin to think of far more effective reforms that Rose suggests.

  • Get rid of the perverse incentives of modern executive, director, and professional compensation
  • Restore the fiduciary duty of loyalty that has been eviscerated by hostile courts
  • Forbid the elimination of the fiduciary duty of care by states such as Delaware that are engaged in a race to the bottom on corporate governance and strengthen that duty
  • More generally, end that race to the bottom
  • Do not rely on any reform that allows shareholders to remove minimum corporate governance standards
  • Spur a competition in integrity and effectiveness among directors (fyi, more female directors is associated with increased effectiveness)
  • Require publicly held firms to separate the CEO and Board Chair positions
  • One thing we know does not make sense based on behavioral finance research is to try to put the onus on tens of millions of shareholders to become more sophisticated investors in the manner that Ross proposes

7 Responses to Implicitly Assuming that the CEO is Not a Crook Misses the Problem

  1. Jerry Hamrick

    One question kept coming to mind as I read this essay: “Where do these men come from?” Are they born crooks? Are they trained by our churches or our schools? Well, actually that’s three questions.

    In your closing list of proposed remedies you tell us that female directors are associated with “increased effectiveness.” Are they also associated with increased integrity?

    Does this observation mean that female directors generally are superior to male directors? In all areas? In integrity and effectiveness only?

    • I’m all for having only female directors for all corporations. Just kidding.

      If female directors are more effective, I wonder if that is genetic or environmentally determined. Could be a combination of course. There are certainly cultural expectations for females to play more by the rules and for males to take more risks– even disastrous ones. One can see this very early in childhood– in parents’ and teachers’ reactions to the same behaviors in males vs. females.

  2. Clonal Antibody

    Jerry Hamrick
    You should look at the very good book – Snakes in Suits

    Let’s say you’re about to hire somebody for a position in your company. Your corporation wants someone who’s fearless, charismatic, and full of new ideas. Candidate X is charming, smart, and has all the right answers to your questions. Problem solved, right? Maybe not.

    We’d like to think that if we met someone who was completely without conscience — someone who was capable of doing anything at all if it served his or her purposes — we would recognize it. In popular culture, the image of the psychopath is of someone like Hannibal Lecter or the BTK Killer. But in reality, many psychopaths just want money, or power, or fame, or simply a nice car. Where do these psychopaths go? Often, it’s to the corporate world.

    Researchers Paul Babiak and Robert Hare have long studied psychopaths. Hare, the author of Without Conscience, is a world-renowned expert on psychopathy, and Babiak is an industrial-organizational psychologist. Recently the two came together to study how psychopaths operate in corporations, and the results were surprising. They found that it’s exactly the modern, open, more flexible corporate world, in which high risks can equal high profits, that attracts psychopaths. They may enter as rising stars and corporate saviors, but all too soon they’re abusing the trust of colleagues, manipulating supervisors, and leaving the workplace in shambles.

    • Jerry Hamrick

      Clonal: Thanks for the information. I will check it out. But I still hope that Professor Black, who probably has come face-to-face with many examples of those who do bad things, will give us his answer, if he has one. Your answer says to me that the problems we face in our institutions and systems of government are caused by human nature. Some people can be trusted, others cannot. If that is so, then the way we keep the bad guys from doing bad things is not regulation. We must take preemptive action, not retroactive action.

  3. What kind of pre-emptive action are you referring to? The list at the end of the article? If those actions are taken, it sounds like your belief is that regulation will not be necessary?

    • jerry hamrick

      Jill:

      I don’t have the time right now to respond fully to your question, but the actions we need to take can be understood by thinking about the two kinds of power: transformative and administrative.

      Transformative power can change people’s lives and banks have such power. If they cannot be trusted to use it wisely then they should be trusted with it. This means that banks should have administrative power only. Banking policies and procedures will be set by others. If some person, be she a banker or not, should have an idea for a product or service that would serve the common good then she can submit it to the group that sets banking policies. In this case all products would be approved in advance, in effect preemptively, and they would undergo a much thorough vetting than is now the case.

      I know that this brief exposition raises questions especially by those who love banking, but the differences between transformative power and administrative power require that they be handled differently. Right now, and ever since our nation was founded, too much power has been in the hands of too few persons, and that is a very serious problem.

  4. Jim Shannon

    Human Nature explains ALL corruption. Pay for Performance has corrupted ALL corporation! The simple truth is we are ALL greedy by nature, some more than others! Government has clearly “Green Lighted” corruption of society by the CentaMillionaire$ and Billionaire$! We have a corrupted TAX CODE to thank and the Fantansy widly held in America the the RICH are job creators!
    All economic activity, wether for profit or not, is based on meeting the needs of Consumers, a fact ignored by the those same consumers when they vote!
    CentaMillionaire$ and Billionaire$ have and continue to export the wealth they were allowed to extract from America’s Consumers and create additional personal wealth using cheaper labor elsewhere! Government allowed that to happen because of the evolution of laws, ALL designed to benefit the ULTRA HIGH NET WORTH INDIVIDUAL$!
    NO GOVERNMENT has EVER been willing to TAX real corruption out of existence! Our government is a shining exampe of what happens when GREED makes the Rule$!