A System of Problems

Investors are reeling from corporate scandals. Regulators are investigating and promising that they will take action against these white- collar criminals. Politicians appear on TV talk shows. They show their anger over the problems and promise tougher laws and more regulation. President Bush even talks about ethics in corporate America. Certainly, the criminals need to be punished. We also need laws that make it easier to prosecute offenders in the future. Also, some new laws and policies need to be put in place to change the incentives of the people in the business system.

However, the system is integrated and complicated. The incentives for executives, auditors , boards , banks, etc., to misbehave are tied together. By focusing on one part of the system, politicians and regulators are not likely to fix anything in the long run. Consider the diagram of corporate participants in Figure 2-2. The arrows show the relationships that occur between the groups. These relationships are interrelated.

Figure 2-2. Corporate participants and the various interlinking relationships.

For example, analysts talk to the management members of a firm to try to gauge the prospects of the firm. Managers want to paint a rosy picture so that the analysts will recommend a "buy" rating and the stock price will rise. However, this causes the analysts to predict a high profit forecast for the company, and the managers may struggle to meet the high forecast. If the business activities of the firm do not merit the high profit forecast, managers pressure their accounting department to help. In some cases, consultants are hired who recommend aggressive accounting techniques to give the appearance of increased profits.

The public auditors for the firm have had a long and fruitful relationship with the company. They have audited the books for many years and are proud to have a prestigious corporation as a client. They do not want to end this long relationship and do not press too hard on limiting the aggressive accounting methods used. This is especially true if the consultants who recommended those methods are from their own accounting and auditing firm.

Why are managers so obsessed with pushing hard for smooth and increasing profits, and with gaining analysts' favor? It is because they have been awarded stock and stock options by the board. If they can increase the price of the stock, they can cash in their options and stock and become rich. These incentives were awarded by a board that is largely picked by the managers.

We also rely on regulators to monitor corporate behavior. However, regulators often come from this very system. They often have experience as partners in consulting firms, auditing firms, or law firms that are an integral part of the system. By participating in the corporate system, they know how it works. However, they may also have conflicts of interest. The former director of the SEC, Harvey Pitt, has been accused of just this sort of conflict of interest. His career before joining the SEC was in securities law, which means that he had major companies and accounting firms as clients .