Celebrity CEOs Share the Blame for Street Scandals

By Robert Shiller

Move over Martha, here comes WorldCom. This week, just days after news that Rite Aid fraudulently overstated earnings by $1.6 billion, WorldCom entered the scandal roster with the announcement that it had overstated earnings by $3.8 billion. If accurate, this represents the largest accounting fraud in history.

Does this degree of corporate fraud have the potential to really upset investor confidence? Indeed it does if it changes fundamental beliefs about management's ability to promote long-term earnings growth. Our response to Wall Street's depressing list of scandals, therefore, should be a reexamination of management's ability to promote earnings growth, in contrast to the short-term share-price boondoggles of the 1990s. The best way to prevent too sharp a drop in investor confidence is to take meaningful steps to fix the management problems--not just accounting problems--that stand revealed.

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At least until now, it appears that investors have not been as worried as one might think. The Dow is still not much different than it was (around 9200) in mid-October just before Enron executives announced that they were under in- vestigation by the Securities and Exchange Commission. Moreover, the Yale School of Management Stock Market Confidence Indexes have been holding up very well since then, for both individual and institutional investors.

Investor confidence isn't the same thing as affection and respect for CEOs, accountants and financial advisors. People may well feel that some of these professionals are nasty and selfish, some even a little crooked, but stock- market investors may be undaunted, so long as they feel that genuine profits are rolling in. We have seen financial scandals in history before. Investors know that we emerged stronger from these experiences, with new government controls placed on the companies, new initiatives from self-regulatory organizations. Investors see a rational set of responses being proposed, from, the SEC, the New York Stock Exchange and Congress.

Investor confidence isn't just an emotion, and it is partly driven by objective facts like reported earnings. It's no coincidence that S&P 500 reported earnings fell by 51% between 2000 and 2001 (the biggest year-to-year drop since 1920-21), and the S&P 500 index itself fell by 39% from peak to trough between those two years (the biggest peak-to-trough drop within two calendar years since 1973-74).

The expert consensus is for a return of earnings to nearly-2000 levels in 2003. But if that earnings outlook is not fulfilled, and there is not evidence of better growth down the road, the market could slip much further. Indeed, there is a risk that the experts are presenting too optimistic a picture and that earnings outlook will disappoint in future years for reasons related to the scandals at Enron and now WorldCom-namely, how the "new paradigm" thinking and bubble mentality of the last decade has affected corporate management.

The bubble years preceding the market peak in 2000 were a period when the nature of management changed fundamentally. We moved, in the words of Harvard Business School professor Rakesh Khurana, from "managerial capitalism to investor capitalism." Control over corporations shifted away from teams of managers who worked together over long periods of time and towards charismatic visionaries, often recruited from outside the corporation, who focused on increasing the share price over all else. The recruitment process of these "corporate saviors" developed its own celebrity culture, restricting the group of suitable candidates to a small number of people with the star quality to impress the market and boost share price.

Not only have corporate leaders been increasingly selected for their impact on the market, but they've also been given strong incentives to focus their attention on the market. Mr. Khurana documents that unsatisfactory stock-market performance increasingly became grounds for dismissal of CEOs, and the rate of their dismissal soared in the 1990s. They were also increasingly given incentive options: For instance, the grant value of top-management stock options as a fraction of their salaries and bonuses more than trebled over the '90s.

This selection and incentive method for top management is a grand social experiment that often turned managers into market manipulators, shifting their focus toward acting out phony new-paradigm fantasies, boosting the market price at the expense of real fundamental value, and even occasionally fudging earnings.

Unfortunately, the recent high-profile scandals may be just the tip of the iceberg. Since earnings are a residual--the difference between revenues and expenses of a firm--it doesn't take much of a tilt away from long-term fundamental thinking to cause a major disruption in profits years down the road. For example, a CEO may have fundamental doubts that a proposed new product line will really work well for consumers--or suspicions that it is likely to be seriously challenged by foreign competition in coming years--but decide to go ahead with launching it because of pressure from the market. With such distorted judgment at play, sales may well turn out to be at least a little bit below the break-even level. Future earnings may thus disappoint even if the accounting is impeccable.

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Proposals to fix the investor confidence problem mostly involve accounting-regime changes and CEO responsibility for accounting, insider trading and analyst incentives. It is important that some of these proposals be implemented. But it may be more fundamental for the long term to respond to the recent Wall Street crises by changing how we select and incentivize top corporate managers.

Our selection process for managers needs to put more weight on their experience with and loyalty to the firm, and less on their charisma and celebrity status. Incentive schemes should put far less weight on stock-market performance, and more on peer evaluation of the consistency of the managers' own performance. We will then be left with managers not only less likely to manipulate the books, but also more likely to bring in the real profits that can ultimately support investor confidence.

Mr. Shiller is professor of economics at Yale's International Center for Finance and author of "Irrational Exuberance" (Princeton, 2000).