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...great Madison's words, "If chief executives were angels, no corporate governance would be necessary." Yet if anything is clear about corporate governance during the recent era, it is that chief executives, like the rest of us, are not angels. I am referring not only to the headliners--convicted felons such as Enron's Ken Lay and Jeffrey Skilling, WorldCom's Bernard Ebbers, Tyco's Dennis Kozlowski, and Adelphia's John Rigas--but to a far larger cohort of chief executives who stretched generally accepted accounting principles to their very limit, and even beyond, in order to create accounting earnings that measured up to the guidance they had provided the professional security analysts of powerful Wall Street investment banking firms (the 'sell side,' promoting stocks to money managers) and the giant institutional investing firms (the 'buy side,' purchasing those stocks).
This accounting gimmickry was too often performed right under the knowing eye of public accounting firms. These firms compromised their independence by providing management-consulting services to the very companies whose financial statements they were providing attestation. In the aftermath of the 1998-2000 stock market bubble, many companies were required to restate the audited earnings figures they had reported. There have been some 6,441 restatements of earnings by publicly owned companies since 2001. These restatements have come not only from companies of marginal standing in the business community but also from some of the largest and most highly regarded corporations in the United States, including General Motors, General Electric, Fannie Mae, Xerox, Bristol-Meyers Squibb, Citigroup, and Marsh & McClennan.
Restating earnings is not a crime. But it is a symptom of the 'financial engineering' methodology of our corporate managers. What is more, other ways of artificially enhancing earnings do not even require restatement. It is, for example, in no way inconsistent with accepted accounting standards for a corporation to raise the assumed future return of its pension plan with nothing more than a guess, usually fortified by a statement that its financial officers and actuaries have said grace over the increase. Such a change can easily convert a company's annual loss into a stunning profit. In 2001, Verizon Communications incurred a loss of some $1.4 billion on its operations. However, when it increased the assumed future return of its pension plan from 9.0 percent to 9.25 percent, it created $1.8 billion of phantom income, resulting in a reported net income of nearly $400 million, (1) and enabling the firm to pay executive bonuses that would otherwise have been eliminated.
Verizon was hardly atypical in this action. In 1981, the assumed returns for the pension plan of the typical U.S. corporation were 6.0 percent. But by 2000, the assumed returns had risen to 9.0 percent, even though the outlook for prospective returns for stocks and bonds had sharply deteriorated. (For example, the yield of the benchmark ten-year Treasury note--a highly accurate indicator of the note's return over the subsequent decade--was 13.9 percent at the start of the period, but only 5 percent at the end.)
But even with all that financial engineering, from 1980 through 2004 corporate earnings had grown, not at the annual rate of 11.5 percent that our corporate leaders had projected (over five-year increments) but at a rate of just 6 percent. That rate of growth failed to match even the 6.2 percent growth rate of the American economy during the same period. So while stock prices soared by almost 800 percent during this era, roughly 500 percentage points of that total were the result not of corporate accomplishment but of an increase in the valuation of stocks, with prices on balance soaring from nine to twenty-one times earnings.
Reflecting, then, not extraordinary business achievement but an upward revaluation of stocks of a once-in-a-life-time dimension, the compensation of the average CEO rose from $625,000 to $9,840,000, a 12.2 percent annual rate of increase. This rate is double the earnings growth rate achieved by the firms themselves, which, as I pointed out, was below the growth rate of the economy at large--a fact that is surely more indicative of the failure of our CEOs in the aggregate than of their success.
Of course, the compensation of the average worker also grew--more than doubling from $14,900 to $35,100--but at a rate of only 3.6 percent per year, less than one-third of the pace of the CEO's increase. When we translate these figures into real dollars, reflecting their 1980 spending power, the gap is far more striking. CEO pay rose more than sevenfold to $4,500,000 in real terms, while the real annual pay of the average worker rose from $14,900 to $15,900, only 0.3 percent per year.
Through the contrast in these increases, the CEO implicitly sends this message: "I am the powerful emperor who created the entire increase in the value of the corporation. All of you, our dedicated and loyal employees, contributed virtually nothing." (2) One can only recall the dictum of King Louis XIV: "L'etat cest moi."
These excesses in executive compensation, and the directly related machinations of financial statements, reflected the erosion in the conduct and values of our business leaders during the recent era, when something went wrong with American capitalism. The system--which had served us well for so long--changed, one more aberration in the long course of capitalism. While each of its earlier failures was followed by safeguards put in place as defenses against future abuses, none of them contemplated the next sort of scandal that, perhaps almost inevitably, would follow.
The central ethic of the system of...
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