Marketplace, March 3, 2004
The "rotten apple" theory of corporate misbehavior is getting aboost.Members of the Rigas family, who ran Adelphia, have just gone to trial.Ex-World Com CEO Bernard Ebbers has been indicted. Jeffrey Skilling,erstwhile chief executive of Enron, was formally arrested and charged withfraud and insider trading.
The "rotten apples" theory assumes that what we've been witnessing inboardrooms and on Wall Street is the work of a very few people who abused theirauthority - and that if we deal with these rotten apples the rest of thebushel will remain perfectly healthy.
It's not all that difficult for prosecutors to find evidence that a fewhigher-ups have looted their companies or profited from insider trading orcooked the company books. These prosecutions reassure the public that ahandful of corporate crooks may be headed for jail.
But the rotten apples theory distracts public attention from the broadpattern of malfeasance that's still endemic in corporate board rooms. And ittakes the pressure off to come up with systemic reforms.
It's an open secret that many companies pumped up their balance sheets overthe past few years. In the last two years, a large percentage has had torestate their earnings, a strong sign that some numbers have been fudged.Most of the troubles on Wall Street have involved CEOs who pumped up balancesheets and then dumped their own shares before the market learned of theextent of the pumping. Pumping and dumping it's called - and the incentivesto pump and dump are still there.
It's fine to require CEOs to sign off on their audits, and to demand thatmore company directors be independent. And headline prosecutions of a fewexecutives may serve as a useful deterrent. But none of this gets at thebasic problem. The incentive to pump and dump comes from executive stockoptions. As long as top executives can sell them in the short term,executives are going to use whatever gimmick they can find to pump up theshare price before the sale.
I'm not suggesting we do away with stock options. They're a good means ofencouraging executives to act in the interests of shareholders and do whatthey can to raise share prices. But stock options have to be designed insuch way that they don't encourage executives to cheat. IBM recently took astep in the right direction by telling its top executives they could cash instock options only if their shares rose at least 10 percent. But even thisisn't enough to reduce the incentive to pump and dump. They just pump up by10 percent.
The real answer: Prevent executives from selling shares in theircompanies for at least five years from the time they acquire them. This way,they have an incentive to take a longer-term view. And that means, they'remore likely to act for the benefit of their shareholders.
