The subject of business ethics looms large in contemporary thinking – and for many good reasons: the politely named “accounting irregularities” of WorldCom, Metromedia Fiber Network and Warnaco; the alleged outright thievery at Tyco, Adelphia and Rite Aid; and Accounting ruses involving Enron, Arthur Anderson, Cendant and HealthSouth, to name a few.
Happily, there are thousands of business leaders who refuse to step over the line, who hold themselves and their subordinates to very high standards. They don’t make the headlines, but they are running most of the country’s 15,000 public companies and 20 million private companies, attempting to do what’s right for customers and employees. The power of example at the top is not to be underestimated. An organization’s culture is primarily an extension of the values of its leaders.
Business ethics is about making business decisions that factor in oneís own morality and sense of responsibility to all stakeholders. Albert Schweitzer had it right when he wrote 54 years ago: “A man is truly ethical when he obeys the compulsion to help all life which he is able to assist, and shrinks from injuring anything that lives.” Accordingly, if we perceive a business ethics crisis, we may well be looking at a societal ethics crisis.
There are so many facets to this subject that are applicable not just to business – ranging from the quality of public education, the weakening of the family, a promiscuous culture, the weaknesses of public education, the sidelining of religion in the public sphere, the greed of the 1990s – to mention just a few.
I’d like here to address one line of thought related to “systemic’ causes of the current excesses in business. “Management systems” affect individual and corporate behavior in ways many executives don’t fully appreciate. By management systems, I mean simply what is measured and what is rewarded. Most folks want to do what’s expected of them. And what’s expected of them is not very hard to discern. “How am I being measured?” “What do I do that gets positive feedback from the bosses?”
What, then, are the expectations of senior managers running America’s public companies? Where do their pressures come from? What behaviors follow from those pressures?
I’m speaking of day-in, day-out operating pressures that have too often led to exaggerated efforts that border on, or actually become, fraud.
In my judgment, the key variable – one that did not exist a generation ago – is the concentration of stock ownership in the hands of institutions. Forty years ago, only 10 percent of the publicly traded stock in the United States was held by institutions like pension funds, mutual funds and others. Today, fully two-thirds of the country’s public stock is owned by institutions. In l968, there were only 100 mutual funds in the United States. Today, there are 8,800 funds serving 54 million households with $7 trillion of assets. That growth was driven by the invested wealth of the aging baby boomers.
Individual investors have little influence over how the funds are managed. The individual investor’s voice is represented by professional fund managers. The fund managers analyze the companies, select the stocks, talk with executives and vote the shares.
What, then, is the goal of the fund manager, whose responsibility is to maximize his or her fund’s value? The answer: stock price appreciation. Given that U.S. tax law had, until recently, discouraged the payment of dividends, the only way to realize a return on stock had been through an increase in share prices. Little else mattered.
Generating ever-increasing share prices is usually helped if a company can produce smooth earnings from quarter to quarter. So all companies try to meet those expectations by employing every available accounting method to smooth what otherwise would be naturally erratic earnings. It’s what weíve come to know as earnings management.
Failure to meet short-term earnings expectations can be disastrous for stock prices and terminal for CEOs. A number of other academic studies identify, specifically, “short-term failure” as the major contributing factor to the shrinking tenure of CEOs.
After a decade of emphasis on earnings management, it is sadly predictable that a few now highly visible executives would move beyond legal accounting schemes to gray areas or even unlawful steps in an effort to “satisfy investors” – or to save their own skins.
Given the nation’s demographic patterns, institutional investors will continue to expand their share of ownership, their influence on management and their focus on near-term stock price appreciation. How then can the systemic incentives be altered to produce a better societal result? One positive step would have been the total elimination of double taxation on dividends.
Until recently, the tax code heavily favored debt financing over equity financing because the cost of debt – namely interest – is fully deductible as a business expense. The cost of equity – namely dividends – was not deductible at all. So earnings were taxed once at the corporate level and again as income to the individuals receiving dividends.
The recent change from treating dividends as ordinary income to taxing dividends at a 15 percent rate (the same as capital gains) was certainly a step in the right direction. But like most political decisions, it was not nearly as clean a change as the average American investor deserved.
If U.S. tax law treated dividends exactly like interest, there would be an inherent incentive for companies to pay or increase dividends. And for most sound companies with decent balance sheets, dividends need not fluctuate even in periodic weak-performing quarters. Consistent dividend flow from quarter to quarter depends more on the strength of the balance sheet (cash and liquidity) than on any specific quarter’s earnings.
That stream of dividends would form a more concrete basis for valuing a company’s stock by computing the present value of the dividend stream. Stock valuations would be somewhat more predictable and less lottery-like. And stock prices would move up or down as companies increased – or decreased – dividends, or when the future prospects seemed strong or weak.
But so long as dividends are tax inefficient – that is, taxed twice – any rational institutional investor would understandably discourage the paying of dividends.
Since the May 2003 tax law change making dividends less tax inefficient, about 500 companies have initiated or increased dividends thus far this year. I think that will be good news for investors and for corporate behavior who should experience less stock-price volatility.
Management attention could then be focused more on the long-term health of the firm. That would encourage increased spending on research and development and capital investment in plant and equipment. Those long-term investments create new jobs and serve to improve a firm’s global competitiveness. The incentive for earnings management would be moderated as would the temptation to push accounting rules to (and beyond) the limit. CEOs would be rewarded more by long-term performance and solid balance sheets. Dampening the shareholders’ obsessive focus on quarterly earnings would do a lot to change management behavior – and perceived ethics.
There will always be criminals, in business and elsewhere. Closer audits might catch the thieves more frequently, and tighter internal controls can certainly discourage abuse. More rigorous board oversight, now being implemented, will also be helpful. But I don’t think we will ever pass enough laws to prevent future corporate misconduct. Families, schools and churches need to address causes. Legislation can only address symptoms.
Business leaders need to be exemplars in the lives of those around them. We may not be able to change the whole world, but each of us can certainly impact the portion of the world we touch.
Louis E. Lataif is dean of the School of Management.
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