A RETROSPECTIVE ON 2002'S CORPORATE SCANDALS:
Responses Have So Far Failed To Target The Crucial Problem of Executive "In-Groups"

By JAMES FANTO

Thursday, Jan. 09, 2003

In the beginning of this new year, it makes sense to take stock of the likely effectiveness of the legislative and regulatory responses to the corporate scandals that emerged in 2002. The responses, of course, are ongoing. For example, federal and state securities regulators continue to probe the behavior of securities analysts who touted stocks of companies despite their negative views on the companies' prospects.

Unfortunately, the responses that have been undertaken so far, at the state and federal levels, are likely to have limited success. That is because they fail to address adequately and imaginatively the socio-psychological phenomenon at the base of the scandals: The tendency of executives, board members and their advisors, like all individuals, to form strong inward-focused groups.

These groups concentrate on the group's survival and its members' well-being - as opposed to the well-being of those perceived as outsiders, including shareholders and potential shareholders. As a result, shareholders' interests are given short shrift, while insiders' interests are elevated far beyond what is appropriate.

Tunnel Vision: The Down Side of Corporate In-Group Psychology

By now, the corporate scandals are so familiar, they are even becoming subjects of made-for-television movies. A few salient characteristics that the scandals share come easily to mind.

Certainly, there is the greed - typified by the excesses of Enron's executives, as amusingly documented in Robert Bryce's Pipe Dreams, and the baronial misbehavior of Tyco's former CEO, Dennis Kozlowski. Remember the $2.1 million Italian birthday party Kozlowski gave for his trophy wife?

But a less obvious, and still major characteristic of the scandals is the formation of tight-knit executive and board groups. The ostensible purpose of creating such a group in the first place was to foster a unified corporate strategy. That was all well and good, but the creation of these insiders' groups also had a cost. The groups' members tended to mesh together all too well - adopting a kind of tunnel vision that focused on the welfare of fellow group members, to the exclusion of that of the company and its shareholders.

Accompanying this in-group focus was a vicious resistance to any criticism of the group or its members. Think here of Xerox's abiding hostility towards a former executive who became a whistleblower with respect to its accounting problems.

How The In-Group Psychology Helps Explain 2002's Scandals

This socio-psychological picture helps explain the corporate scandals. For instance, Enron's disintegration owed much to several related groups, composed of board members, executives and corporate advisors, who pursued both misguided strategies and the goals of collective self-enrichment.

Similarly, although Kozlowski took the lion's share of the spoils at Tyco, other top executives also participated with him in secret compensation deals. Their similar interests and investment in the group they had formed thus gave them an incentive not to become whistleblowers themselves.

Perhaps even worse, these groups extended beyond the executive suite and the board room to include corporate advisors as members. As a result, any check on in-groups' self-serving behavior was gone; supposedly independent advisors became part of the in-group instead.

Advisors, Too, Became Insiders Who Could Not Effectively Oversee and Police

Consider, for instance, the recent settlement between JP Morgan Chase and its insurers over liabilities to some of Enron's special purpose entities. Had the bankers properly policed Enron's deception, they probably would have fought the case.

Unfortunately, advisors were more likely to play the role of partner, than that of police officer. The Arthur Andersen trial showed, for example, how outside accountants and lawyers of prominent law firms became so much a part of executive in-groups that they were unable to advise and monitor firms as outside professionals. They, too, had been transformed into insiders.

Other scandal-related trials are likely to illustrate the same point - with advisors shown to be so thoroughly co-opted into being insiders that they either participated or, at best, turned a blind eye to corporate wrongdoing.

Reforms Aimed at Inhibiting the Formation of In-Groups

These points bring us to the heart of the retrospective: Are the reforms introduced to stop 2002's scandals from repeating themselves likely to succeed? The answer for many of the measures, I fear, is no.

One way of looking at the legislative and regulatory reforms addressing the corporate scandals is to consider them efforts to inhibit the formation of executive in-groups. And few of the reforms do so effectively.

Some reforms introduce an oppositional group within the firm that can become the in-group's competitor or even adversary. For example, the New York Stock Exchange's and the NASD's rules increase the number of independent directors on the board, and enhance the role of these directors on key board committees. The idea is that the independent directors will not simply be a part of a board dominated by top executives, but an independent check on it. When the board acts together - or even through key committees - it must be accountable to them.

Similarly, the Sarbanes-Oxley Act's provisions to strengthen the audit committee also seek to provide an entity separate from the in-group. This type of committee ought to serve as a counterweight to the executive in-group, since its duty is to investigate the company, not serve the in-group's interests.

In addition, the reforms addressing corporate advisors may be seen as an attempt to prevent them from rejoining executive in-groups. The reforms make accountants responsible to the audit committee, not the executive in-group. Pursuant to proposed SEC rules, lawyers are to follow a chain of reporting authority in a firm that does not make them beholden to the CEO (and, implicitly, to the executive in-group).

Finally, the reforms also try to insulate the most "professional" side of investment banking, investment research analysts, from in-group influence. The idea is to stop them from feeling pressure to achieve good ratings from their investment banker colleagues and the bank's clients.

The Reforms' Success is Likely To Be Limited

All these reforms may sound like good ideas, and to some extent, they might be. But in-group pressure exerts a tremendous power on individuals. After all, evolutionary biologists tell us that the formation of groups and a focus on group members' welfare were the traits that allowed human beings, as a species, to survive over our centuries of development. One cannot therefore be too hopeful about the likely success of reforms that are attempting to counter a fundamental human characteristic.

Unfortunately, independent board members have been only too ready to join executive in-groups, and to become blind or passive to the worst of corporate abuses. There is no reason to think that increasing their number, or giving some of them enhanced responsibility, will adequately counter the power of executive in-groups.

Moreover, some reforms simply don't go far enough. For one thing, they don't stand a chance of preventing accountants from joining executive in-groups. Truly achieving that goal would demand, at the very least, that an accounting firm be rotated off of a particular corporate client after a set number of years.

Only that remedy would break completely the insidious formation of in-groups of executives and accountants: Knowing its work would be short-term, the accounting firm would tend to focus more on its responsibilities than its insider relationships. But accounting firms were able to block that crucial reform (now only an engagement partner, not the entire firm, needs to be rotated).

Meanwhile, lawyers continue to contest enhanced reporting responsibilities that might enable them individually to resist the enticement of executive in-groups. While there are problems - such as confidentiality and attorney-client privilege - with forcing lawyers to report, there are also serious problems that occur when lawyers effectively collude in wrongdoing.

For the time being, many securities analysts remain employed in investment banks, with only an enhanced "Chinese wall" keeping them from investment banker and company influence. Such "Chinese walls" prevent particular employees from communicating, but do not prevent a corporate culture - and in-group mentality - from being shared.

The Return of Corporate Scandals: Expect It To Happen

Because the effectiveness of these reforms will be very limited, it is only a matter of time - although it may be some time, given the current shaky stock market - before a new speculative bubble emerges, with its accompanying corporate scandals. And when the scandals become public, one suspects that it will be revealed that executive in-groups, with their corporate advisor members, were again behind the misbehavior.

A hue and cry will then go up as to why the reforms didn't work - why didn't we learn from 2002? But the answer is already obvious: The reforms are too weak to fight human nature.

So how can we effectively prevent executive in-groups from considering publicly-traded companies as troughs from which they can feed with relative impunity? The answer to that question demands considerable imagination and innovative efforts. And it demands going far beyond the heart of the current reforms.

The reforms are promising, but they are only the first tentative steps in addressing a perennial problem in large firms. Unless other steps are taken, we may soon have a repeat of the scandals of 2002.


James Fanto is a Professor at Brooklyn Law School.

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