Business "Reforms" Should Not Ignore Incentives and Competition

The New York Times, "Economic Scene" , July 18, 2002

In a recent interview with Wired magazine, the technology pundit George Gilder reflected on how he had gone from the world's best stock picker for several years to the worst in 2001. Most telecommunications companies he promoted have lost almost all their value.

Newsletter readers who bought and held the stocks he recommended lost big, as did Mr. Gilder himself. He's now broke.

When prices got high, why didn't he suggest selling?

"In retrospect, it's obvious that I should've subtly said, 'Hey, things have gotten out of hand at JDS Uniphase, and it's not worth what you'd have to pay for it,' " he told Wired. But he didn't, for fear that his influence would make the stock price crash.

His newsletter's picks moved prices up. Presumably, his advice would also move them down.

"If I had said, 'Hey, this is a top, you should all sell,' it would've been a cataclysmic event," he said, adding, "Half of my subscribers would have been eternally grateful, but the other half -- the new ones -- would've been enraged because they had just come in."

There, in a nutshell, is the fundamental problem of a market bubble: Everyone who owns stock wants prices to stay high.

When reality finally breaks the bubble, stockholders cry that they weren't warned. But when prices are high, it seems almost irresponsible to deliver bad news. If influential analysts or executives tell people to sell, they can cost current shareholders millions.

Hence the pressures to keep earnings high, leading some companies to adopt devious or fraudulent accounting practices. Stockholders weren't just the victims of such shady practices. They were also, in many cases, the beneficiaries.

Making executives look out for shareholder value is, after all, why companies skewed their compensation systems toward stock options and other equity compensation.

The goal was to give decision makers a strong incentive to keep the stock price high. They would then act in the owners' interests rather than pursuing less-profitable pet projects, avoiding painful spending cuts, or lavishing money on their personal perks.

In some cases, that incentive worked all too well. Stock prices grew, executives became rich, and so did shareholders. But for some companies, the earnings supporting those prices weren't real.

Fraud didn't cause the bubble, but the bubble encouraged fraud.

Cooking the books -- or, legally but problematically, always making judgment calls in the direction of higher earnings -- helped support otherwise insupportable stock values. If it's the job of management to represent the interest of current shareholders, arguably that's what aggressive accounting did.

Like Mr. Gilder's newer subscribers, current shareholders are hurt by bad news. In the short term at least, they're better off with cheerful lies.

The fundamental problem is that the interest of current shareholders is not the same as the interest of a well-functioning market.

The policies Congress is rushing through to demonstrate Washington's concern with corporate shenanigans won't do much to address this problem. Some will actually make things worse.

Take the idea, pushed by Senator John McCain, the Arizona Republican, and others, that executives shouldn't be able to sell their stock until they've left the company.

Rather than encourage sound management that builds good companies, that would actually punish long-term commitments. Executives who devoted their careers to a single business would be financial fools, never able to diversify their personal portfolios.

Managers who really did build value would need to move on after a few years to reap the rewards of their tenure. Corporate America would increasingly be run by job-hopping generalists, not long-term chief executives with deep knowledge of their particular business. And in exchange for assuming more financial risk, top managers would demand even higher salaries.

At start-ups, which have more promise than cash for salaries, the effect would be devastating. Someone like Margaret C. Whitman, who brought management experience at an early stage to eBay, would probably decline to head a start-up altogether or would leave and cash out her stake as soon as possible. Before it went public, eBay lured Ms. Whitman with options to buy 14.4 million shares for 3.5 cents each.

Successful founders would have to retire early to cash out their equity. There'd be no more long careers like the ones that built Intel, Federal Express, Microsoft or Southwest Airlines.

Such a strong financial incentive for executives to change jobs would mean growing companies suffer constant turnover in their management. Neither current nor future shareholders, or a healthy marketplace, would be served by that.

But what about the problem of fly-by-night chief executives and the shareholders who benefit from inflated results? If the shareowners themselves don't have an interest in truthful financial reporting, who guards the corporate guardians?

One possibility is the stock exchange. While artificially high earnings may help a company, accurate results serve the market as a whole. An exchange that independently monitored its listed companies' results would benefit from investor confidence at the expense of laxer competitors.

If auditors were hired by the exchange, rather than the company, and given a forensic mandate, they would enjoy both more freedom and more prestige. Indeed, turning audits into independent investigations might help solve one of accounting's biggest problems: Auditing is too boring to attract and keep the best accountants.

Even now, the mob waving pitchforks and torches finds the details of accounting, compensation and corporate governance too tedious to take seriously. But "reforms" that ignore the role of incentives and competition will turn out to be monsters themselves.