How Hands-On Do Corporate Leaders Need to Be?

By: Richard Willing

PRINTER FRIENDLY VERSION

For John T. Ryan III (ND ’65), it has become something of a ritual. His Hertz rental car bill comes each month, and the chairman and CEO of the Mine Safety Appliances Company (MSA) of Pittsburgh, Pa., goes through it line by line.

He carefully weeds out his personal trips—here’s a visit to Notre Dame to see a football game, there’s a family weekend tacked on after a business trip—before sending the record on to accounting to have his corporate expenses reimbursed.

For the leader of a 4,600-employee company with $853 million in 2004 sales, this may seem like micro-managing. These days, Ryan doesn’t think so. “Keeping expenses accurate is just the right thing to do, and when you can say that about any business practice, well, that’s really all that needs to be said,” Ryan says.

“Besides, it sends an important message (to all employees): ‘if the guy at the top is playing it perfectly straight, then you’d better, too.’

“In the current environment, you really need to have that message come across.”

Welcome to the world of corporate governance, 2005.

Three years from the accounting and ethics meltdown that sank Enron and other major companies, three years since Congress passed a comprehensive reform bill aimed at restoring confidence in America’s publicly traded corporations, how businesses police themselves remains a work in progress.

Students of corporate governance and investors say that old-fashioned management styles such as Ryan’s have come back into fashion.

“It’s like your father told you as a kid growing up— if you remember to do the right thing you’ll be okay,” says Gary E. Gigot (ND ’72), general partner at Frazier Technology Ventures, a Seattle-based venture capital firm, and a member of Notre Dame’s Business Advisory Council. “(Investors) are looking for companies run by leaders with that attitude.”

Changes in corporate accounting rules and a renewed emphasis on ethics appear to have accomplished one of reform’s key goals—restoring investor confidence.

“The stock market has risen 50 percent since the depths of Enron and WorldCom,” says Matthew J. Barrett (ND ’82, JD ’85), a law professor who teaches accounting for lawyers and federal income taxation at Notre Dame Law School. “That’s very important right there.”

Enrollment in accounting courses is up, and sales of a textbook on accounting for lawyers that Barrett co-authored are brisk. Incoming students at the Mendoza College of Business no longer ask professors, as they did a few years ago, if new hires at an American corporation can afford to be ethical if they wish to climb the corporate ladder.

“There was always this question ‘maybe it’s alright for the person at the top, but are you sure this (ethical behavior) is something that’s good when you’re at the bottom and have to fight for oxygen?’” says Carolyn Woo, dean of the college.

“Students don’t ask that now.”

On the other hand, debate continues to rage among academics, investors, and business leaders over whether the Sarbanes-Oxley Act, the 2002 corporate reform law, is worth its very high costs. Bloomberg estimates that audit fees for Fortune 1000 companies rose 66 percent from 2003 to 2004. Bruce Bartlett, senior fellow with the National Center For Policy Analysis in Dallas, believes increased accounting charges cost corporations $15 billion a year, or $1 million per $1 billion of sales. It is difficult, he notes, to reckon the law’s “distraction costs” as executives and financial officers are required to focus on compliance rather than on capital acquisition or new business opportunities.

SOX, as Sarbanes-Oxley has come to be called, and the corporate reform movement generally have made it less likely for qualified persons to serve on corporate boards, its critics charge. “That’s just the opposite of what needs to happen,” says MSA’s Ryan. Others suggest the trend deters unqualified candidates.

Additionally, determining how to instill ethical values in a corporation—by regulation, prosecution, voluntary guidelines—remains an open question.

Patrick F. McCartan (ND ’56, JD ’59), chairman of Notre Dame’s Board of Trustees and senior partner at Jones Day, the international law firm based in Cleveland, is a

longtime specialist in the law of corporate governance. He says the ongoing discussion needed to happen.

“The potential has been there,” McCartan says. “All you needed was an Enron or an Adelphia or a Tyco to ignite the blaze.”

A Wave of Corporate Scandals

And quite a blaze it was. Beginning with Enron, whose stock fell from over $80 a share to under $1 through November 2001, Americans were treated to a seemingly continuous wave of corporate immolations. First Enron, the Houston-based energy and e-commerce giant, collapsed into bankruptcy under the weight of overstated profit and revenue statements bucked up by dubious accounting. Thousands of employees lost their life savings, which company executives had encouraged them to invest in shares of the company’s declining stock, even as the executives quietly dumped theirs.

Then Adelphia and WorldCom, both telecommunications conglomerates, went down, done in by accounting irregularities and executives’ penchant for high living at company expense. Later in 2002, executives of Tyco International were charged in a lawsuit filed by shareholders with inflating the company’s value by as much as $90 billion to increase their own compensation which was tied to stock performance. Resolution of the suit is pending.

Because of poor investment outcomes, accounting fraud, and resulting bankruptcies, the bull market of the 1990s that produced over $18 trillion in gains was suddenly reversed. From 1999 through 2002, more than $5 trillion of investment value was lost from worldwide equity markets.

“This clearly was the worst we’ve ever seen,” says Thomas Frecka, Vincent and Rose Lizzadro Professor of Accountancy at Notre Dame’s Mendoza College of Business. Frecka teaches a course on accounting fraud.

“There have always been greedy, self-interested people, but never have the consequences been so great. The two largest bankruptcies in our history, Enron and WorldCom, occurred within months of each other, and fraud, at the highest levels of both companies, contributed to their downfall.” When the smoke cleared, it was found that executives, sometimes abetted by their companies’ outside auditors, had connived to inflate revenue figures and to hide liabilities.

At Enron, audits failed to disclose side deals and other exotic loan arrangements to top executives that, if revealed, would have cast a shadow on profitability. At WorldCom, a report prepared for the board of directors by outside attorney William McLucas stated that chief executive Bernard Ebbers had been aware “at a minimum” that the company was meeting revenue expectations “through financial gimmickry.”

The collapse of Enron, Notre Dame’s Frecka notes, typified the way other corporations fell.

“They felt they needed to hide a bunch of debt by keeping it off the balance sheet,” he says.

The Arthur Andersen accounting firm, which abetted Enron’s downfall by failing to fully account for the company’s debt, fell too. Although the Supreme Court reversed Andersen’s conviction for obstruction of justice earlier this year, the firm had already ceased auditing and terminated most operations.

But the corporate collapses also revealed that some executives were living near-Neronian lifestyles at company expense.

Ebbers took loans from the company to buy a huge cattle ranch and a minor league hockey team. Tyco executive Dennis Kozlowski spent $15,000 on an umbrella stand and $6,000 for a shower curtain. The Rigas family used Adelphia funds to invest in a golf course and to buy a condo for a niece. Corporate jets were used to ferry specially chosen Christmas trees to family homes.

Investor confidence, already battered by the corporate accounting scandals, was further demoralized by these tales of executive excess.

Landmark Legislation

Enter SOX.

The bill, backed by Republicans and Democrats, was assembled in record time and passed in July 2002 while the corporate scandals were still unfolding. It aimed to restore investor confidence by eliminating conflicts of interest, such as outside accounting firms that also had consulting contracts with the corporations they audited.

SOX, which applies to publicly held companies, ended that practice. It also established a federal accounting oversight board and mandated that a company’s audit committee be composed entirely of independent outsiders. SOX outlawed loans to executives and granted special protections to whistle blowers who report fraud.

SOX’s most controversial provision by far is its section 404, which requires management to report on the quality of internal controls over financial reporting and the company’s independent auditor to attest to, and report on, management’s assessment. These reports must disclose any “material weaknesses.” Other controversial provisions require company executives to personally certify the correctness of its books or face criminal prosecution.

SOX provides for stiff criminal penalties for executives who fail to disclose such weaknesses or sign otherwise faulty statements that detail their companies’ finances. It is these provisions, executives and scholars say, that have caused the large new auditing bills as nervous executives bend over backwards to get their paperwork right.

Section 404 was phased in gradually and has still not taken full effect. To date, there have been no criminal convictions under its “material weakness” provisions, Law Professor Barrett says.

Up-sides

SOX has plenty of fans.

Improved financial controls and higher quality financial reporting ushered in by SOX have slowed corporate wrongdoing, though accounting fraud cases still arise, says Barrett.

In the years before Enron collapsed, Accounting Professor Frecka often assigned students the task of estimating the firm’s value from information in its public filings. Given the complexity of its operations and the lack of clarity and completeness in its disclosures, students found the task daunting, he says. The firm’s questionable mark-to-market accounting and off-balance-sheet debt made it nearly impossible for students to measure financial performance.

“Hopefully, as a result of SOX and new accounting standards, financial statements have improved and that’s not the case any longer,” Frecka says.

Eliminating consulting work by outside auditors has prevented the kind of conflict of interest that could make it difficult for accounting firms to question procedures, such as changing the basis for booking revenue, that can overstate a corporation’s profits.

“Accounting firms can no longer use auditing as a loss leader,” says Dean Woo. “That’s good for everybody.”

SOX has had what Law Professor Barrett calls an “educative value” as well. He notes that “worry” about running afoul of SOX’s reporting provisions caused the chief financial officer at the HealthSouth Corp. to question what he believed were past irregularities in corporate accounting. That led to the prosecution of Richard Scrushy, HealthSouth’s founder, on 36 counts of conspiracy, fraud, money laundering, and issuing a false corporate report—the first prosecution under the Sarbanes-Oxley Act.

Scrushy was acquitted of all charges in June 2005. But the company has voluntarily undertaken a series of reforms aimed at improving controls.

SOX has also brought intangible benefits. The public, especially small investors who form the backbone of the mutual fund industry, have had their confidence restored, says Office Depot Chief Executive Officer Steve Odland (ND ’80).

“There was a recognition that to re-establish trust, we needed to lead on corporate governance,” says Odland, who holds a bachelor’s degree in business administration from Mendoza and is a member of Notre Dame’s Business Advisory Council.

“Corporate governance has undergone dramatic and lasting reforms….Change is good.”

Down-sides

The reform legislation has its detractors, too. Some executives view the costs as exorbitant. James G. Berges (ND ’69), who retired as president of Emerson Electric Co. in November 2005, says SOX compliance cost his firm, which booked $15.6 billion in sales in 2004, about $4.5 million in added accounting fees last year alone.

Despite predictions that costs will fall in ensuing years, Roxanne M. Martino (ND ’77), president of Harris Partners LLC of Chicago, doesn’t believe it.

“I believe that (such) fees are a one-way street,” says Martino, whose firm chooses investment managers on a global basis. She is also a member of Notre Dame’s Business Advisory Council.

SOX carries costs beyond the new accounting bills, scholars and business leaders say. Some private firms have shelved plans to go public because of the increased accounting costs. Dean Woo notes that Quality Dining Inc., a Mishawaka, Ind.-based company that owns about 180 franchise restaurants, took itself private earlier this year in part to eliminate the expense of SOX compliance. Executives, she adds, are obliged to devote more time than ever to how their corporation tracks and reports its finances. This, she says, burns up time that ordinarily would have been spent developing the business.

“It’s impossible to say what the costs are (in this area) but you have to believe they are there,” she says.

Others say the legislation’s punitive measures miss the target.

“If people in your accounting department didn’t sign an expense report, or someone didn’t change a password after 30 days, well, SOX is going to make sure you catch that,” says Emerson Electric’s Berges, a member of Notre Dame’s Business Advisory Council.

“But if the officers of a large company and the CEO want to cook the books, SOX reviews aren’t going to stop them.”

Ryan, of MSA, analogizes SOX to the Transportation Security Administration’s policy of broadly screening all airlines passengers in the hope of deterring terrorists.

“SOX is the equivalent of strip-searching grandmothers, when they really need to be looking for the guy with the surface-to-air-missile who actually might shoot down a plane. It’s overkill.”

The Mendoza College’s Woo argues that complying with SOX can lull a corporation into a false sense of security about its governance practices.

“There’s this dangerous mindset that because we’re checking off all the correct boxes we must be better,” Woo says.

No one interviewed expects SOX to be repealed, or even seriously modified.

“It’s here to stay and I think that’s generally accepted,” says Office Depot’s Odland. “What we’re asking for now is ‘don’t give us any more rules until we’ve absorbed this.’”

So how can corporate governance be policed, SOX’s shortcomings notwithstanding?

Some say that tools that were in place long before SOX was brought into existence—criminal prosecutions, SEC sanctions—need to be used more effectively.

“Regulation has its place, but seeing Bernie Ebbers marched off to prison for 25 years really makes the point that this is serious,” says Accounting Professor Frecka. “A lot of resources will be needed to fight the war against fraud.”

Changing The Nature of Boards

Others take the position that another of SOX’s goals—increasing the independence and oversight responsibilities of corporate boards—is a critical piece of the new governance picture.

“In cases of serious governance issues you’ll find boards are extremely weak,” Berges says. “WorldCom had explosive growth with relatively weak oversight. Some people with relatively tough-minded management skills would have challenged a Tyco.

“There wasn’t a CEO on one of those boards.”

Students of corporate governance as well as present and former board members say that the nature of board service is changing.

There is less emphasis, they say, on creating “boutique boards” made up of celebrities, activists, and other high profile types whose faces might dress up an annual report but whose backgrounds made it unlikely that they would successfully challenge management.

“Traditionally, non-confrontational individuals were often chosen for board membership,” says Barrett, the Notre Dame law professor. Says Woo, who began serving on corporate boards in the mid-1980s: “In the old days you weren’t expected (as a board member) even to know how to read an annual report.”

That has changed. Venture capital investor Gigot says he is seeing more examples of board members who are recruited because they possess “core values, vigilance, and a bias for action,” and “fluency” in law, accounting, or other basic languages of their company’s business.

“Look at Tyco, where the board said they had no idea what went wrong,” Gigot says. “But you know what? Warren Buffett would have found the numbers…You need a board that’s not just active but knowledgeable.”

The legislation’s emphasis on recruiting board members with “fluency” counters complaints of cronyism. While board members may know each other, they must demonstrate ability, says Berges, retired president of Emerson Electric.

“High-performance people tend to hang around together but that doesn’t mean they can’t be tough,” he says.

“You want to have a board with experience…in this environment you really have to.”

Ironically, the new SOX-driven emphasis on professionalism may have made board service unattractive.

Board members now can expect meetings to last longer and to take place more frequently, especially if they serve on audit, compensation, or governance committees. Courts have not yet made clear whether board members can be held personally liable under SOX for faulty decisions or errors. But corporate attorney McCartan says the potential to be hit with a “devastating” legal judgment has “raised the pressure significantly” in today’s boardroom.

Looking Ahead

Where to from here? Students of corporate governance as well as working executives have a wide variety of suggestions for keeping the post-Enron spirit alive.

Joseph T. Wells, a CPA and former FBI agent, argues for a federal “executive transparency” law that would require company insiders to have their tax returns and financial statements monitored by independent auditors. Such a law, says Wells, would have detected WorldCom-style corporate looting before it got off the ground.

Wells is founder and chairman of the Association of Certified Fraud Examiners in Austin, Tex.

McCartan, the corporate attorney, would take aim at conflicts of interest that are especially likely to occur in start-up situations. Directors who are beholden to third parties, or who may be anxious to run up share prices so they can cash out their equity, pose ongoing problems, he says.

McCartan would have the boards of publicly held companies create permanent conflict of interest committees to regularly review director “loyalty.”

And Martino, who recruits investment managers, would pressure corporations to drop the “quarter to quarter mentality” that has made short-term profit and stock price appreciation the major measure of a company’s success.

The need to meet Wall Street’s quarterly expectations, she believes, helped create the environment in which corporations such as Enron, WorldCom, and Tyco hid debt or resorted to accounting gimmicks to overstate operating revenue.

A new mindset, she continues, might help create a more “sober market” among small investors. She notes that in the Adelphia case, for instance, questionable loans to family members were disclosed in the company’s public filings but that investors continued to buy the stock. “It was going up,” she says.

Meanwhile, the heightened sensitivity to ethical issues continues to register across the corporate landscape in great and small ways.

In Pittsburgh, John T. Ryan III regularly reviews anonymous summaries of MSA’s employee telephone hot line for tips on wrongdoing.

“It’s still about 99 percent human resources complaints—you know, ‘I didn’t get promoted when I should have,’ that kind of thing which we look into,” Ryan says. “But when we get (an ethical complaint), we pursue the matter very thoroughly.”

In St. Louis, James G. Berges regularly scans newspapers and trade journals and clips out articles that detail ethically shaky conduct at other businesses. He sends the stories to senior executives at Emerson Electric with the appropriate questions attached:

“We don’t have off-the-books debt, do we?”

“We don’t do these kinds of exotic derivatives they’re talking about, right?”

In Delray Beach, Fla., Steve Odland continues to carve some time from his schedule at Office Depot to work on ethical issues for the Business Roundtable, an association of CEOs, where he chairs the corporate governance task force.

But the more he thinks about it, the more it seems clear to Odland that task forces and the guidelines they produce will only solve part of the problem.

“People (who work for a corporation) need and want leadership,” Odland says. “I’m obligated to stand up and say ‘this is what’s right and what’s wrong.’ They need a standard, and they need to see a standard being set (by the CEO himself).

“People can argue that that’s stuff that should have been learned in kindergarten. But in today’s society people may have learned all kinds of things. We certainly seem to have found that out.”

 


Richard Willing covers justice issues for USA Today from Washington, D.C.

Illustrations by Jon Krause

 
 
Copyright © 2006 University of Notre Dame All Rights Reserved Last Updated on: December 6, 2005