Asymmetrical Information

"First, good corporate governance—of the sort mandated by post-bubble regulations—may have done little to prevent fraud. Enron's board, for instance, was rated among the nation's five best-governed in 2000."

Why shouldn't the conclusion have been that whoever rates the nation's boards doesn't know what they're doing?

The part about attention from the press is interesting. I guess it shouldn't be a surprise that celebrity CEOs would be driven primarily by external validation/recognition and would be terrified of being seen as a "failure." Therefore they would be the likeliest type of CEO to cook the books so as to present at least the appearance of success to the market.

I'll take a CEO driven by challenge, lust for power, or family ties to the business over an external validator any day.

So based on the above, which (publically-traded) firms are most likely heading for a fall now?

I notice that the study, or at least the report of the study, left out that fraud firms were most likely to be in the most highly-regulated aspects of the economy.

I haven't read it, but this could tie in fairly well with David Callahan's "The Cheating Culture."

He argues that extremely high incomes for top performers encourages cheating, from the corporate suite to MLB (I know, those players were taking substances that weren't illegal or banned at the time). The argument makes intuitive sense, just from the standpoint of a simple risk-reward analysis.

With regard to the Atlantic article, I wonder if the study accounted for the possibility that the most successful firms are more likely to get caught in fraud because everyone wants to give the king of the hill a good push.

denise: "He argues that extremely high incomes for top performers encourages cheating, from the corporate suite to MLB"

Which would suggest that a 90% income tax for compensation above some limit -- $10M per annum? -- should pretty much take care of the problem. Why cheat unless the rewards are commensurate with the risk?

Academic research seems to confirm the idea that having a greater percentage of "independent" boards does little to control accounting manipulation. However, there are a couple of studies that indicate there's at at least one factor that helps to constrain this behavior. Agarwal and Chadha (mentioned in a recent post in my blog) found that firms with independent directors that had financial expertise on their boards were significantly less likely to restate earnings.

There's another recent study by Xie, Davidson, and DaDalt (in the Journal of Corporate Finance). It found that firms with these same types of directors had significantly less aggressive accounting policies.

So, the requirement that firms must have financially adept outside directors on their audit committees could very well end up constraining firms from engaging in at least some questionable behaviour.

Congrats on the weight loss - I've still got about 15 pounds of winter suet that won't depart until I break out the bike.

First, good corporate governance—of the sort mandated by post-bubble regulations—may have done little to prevent fraud. Enron's board, for instance, was rated among the nation's five best-governed in 2000. Second, while crooked execs may have fooled analysts, the media, and the public, the market sniffed them out. The median fraud firm lost 40 percent of its value in the year before its actions came to light.

Following this line of reasoning, one could also say that government regulation (aka law) does little to prevent murder. Even in the most strictly regulated areas, murder still happens.

Perhaps you'll correct me if I'm mistaken, but are you advocating for no government regulation of business because it doesn't catch everybody?

"Which would suggest that a 90% income tax for compensation above some limit -- $10M per annum? -- should pretty much take care of the problem. Why cheat unless the rewards are commensurate with the risk?"

That would increase the rewards (and thus likelihood) of tax cheating.

Corporate governance regulation is concerned with structure and procedure. If the board is structurally sound and its established procedures are consistent with standard norms, it will be considered "well-governed", without regard to whether or not its members are competent and vigilant to keep a rein on bad management and cooked books (not to mention honest enough to _want_ to do so).

Structure and procedure are important, of course. But for exchange-listed companies most of the important issues of structure and procedure were settled way before the bust by rules established in the listing standards of the stock exchanges. What was left was incompetence and greed...and structural/procedural regulations aren't going to stamp out either incompetence or greed.

Has anyone here read The Smartest Guys in the Room, concerning Enron? I'm slogging through it ever so slowly because it depresses the heck out of me. It seems to me that most of the players (not all - Fastow looked like a crook from the get-go in the book's treatment, anyway) never intended to go so wrong; they wanted to make lots & lots of money, yes, way more than they could spend (though they tried), so greed is a big factor - but more importantly, it seems that they really did buy into the whole "New Economy" "all bets are off" rhetoric of the time. They really did think they were the smartest guys in any room, then that they were reinventing business (well, in some ways they actually did), then that marking to market but never truing up your revenues was OK... and down the primrose path they went.

A terribly depressing book. Makes me wonder what primrose paths I can be led down. Makes me want to reemphasize the importance of basic moral tenets in teaching my kids - forget the flash cards, tell me what you do if you find a dollar on the sidewalk.

Does the author not look at fraud firms in the past? Is the "post-1996" set substantially different from the past? Could an investor who studied the past have been unable to recognize the bad guys 'this time'(after 1996.)

There was no New Economy, no significantly different ploys this time, no increased stupidity or evil. The themes, and their relative significance, were somewhat different. One of the authors about Enron seemed to make sense, when he said that if the company had been twice as crooked and half as inept/cocky, things would have turned out less poorly for the stockholders and employees. The Enron board of directors was a joke - - so what else is new.

Comments are Closed.