Sunday, April 01, 2007


Annual General Meeting Season….

The claim for efficient control mechanisms that help shareholders to ‘get their money back’ from opportunistic and self-interested managers is at the heart of the corporate governance debate...but what if shareholders don’t care about these rights?

In recent years, in virtually all countries around the world the level of minority shareholder protection (MSP) in law and in corporate practice has significantly increased: transparency and accounting rules have become stricter, legal venues for shareholders to challenge management and/or board decisions are more numerous, the liability of board members has increased. Shareholders have hence more control instruments available to them then say twenty years ago.

However, despite the increasing possibilities for shareholders to effectively control management, a trend is perceptible which shows that shareholders tend paradoxically to become increasingly unconcerned. One indicator of this trend can be seen in the shareholder behaviour during the Annual General Meetings (AGM). In Switzerland, four signs exist which clearly show that shareholders are not very keen on exercising their control rights.

Firstly, many shareholders who buy registered shares of Swiss companies do not bother to ask the company to be registered in the stock ledger – which is necessary in order for them being able to exercise their voting rights (Boemle 2003). Thus, for up to 40% of the shares issued by Swiss companies, the company does not know who the shareholder is since she does not announce herself to the company (one speaks of Dispo-Aktien).

Secondly, those shareholders who do ask to be registered do not usually attend the AGM and do not bother to send their voting instructions to the company or their bank – which both are legally enabled to exercise the proxy right – either (Boemle 2003). The proportions of represented shares are hence very low. As an example, in 2003 of the CS Group’s 797 million exercisable votes, only 316’000 were represented during the AGM (Boemle 2003)!

Thirdly, those shareholders who do not wish to attend the AGM, but do send back the proxy card to the company so that their votes are represented send them often back without any voting instructions. For these proxies, the board of directors (BoD) can exercise the votes in their own interest (NZZ May 03, 2003).

Finally, the reform of the Stock Corporation Law of 1991 has introduced the institution of “independent representative” which is a person that the company must appoint before the AGM in order to allow shareholders to have their voting rights exercised by an independent person rather than the company’s organs (i.e. a member of the BoD) themselves. However, most shareholders chose to send their proxy to the company directly rather than to the independent voting rights representative as is shown by different studies (cf. study von der Crone in NZZ Mai 03, 2003, Boemle 2003).

Overall it appears hence that a very small proportion of shareholders take the trouble to go physically to the AGM and exercise their control rights, and even the proxy option is only to a very limited extent used in order to control the management. Besides, the main reason for those shareholders that do go to the AGM seems to be linked to sociability rather than any wish to have their say in the company’s affairs. One telling anecdote is reported by Finanz und Wirtschaft, a Swiss financial news paper which published in 1993 an article entitled “No Snack, no Candies, no Interest”. In fact, when Merkur AG (a company specialist in chocolate and candies production) announced in the invitation to the 1993 AGM that due to a share split the previous year, the number of shareholders had considerably increased and that it would therefore not be possible anymore to offer snacks after the meeting and to give a chocolate box to every shareholder, the attendance decreased from 1624 shareholders in 1992 to 703 in 1993.

So, what is all the ‘shareholder-need-more-control-fuzz’ about if they seem to be perfectly happy without these rights? Well, for one thing, one could argue that if shareholders do not use their control rights in an actively, i.e. through ‘voice’, they might just use another strategy i.e. ‘exit’. In other words, if shareholders don’t bother going to the AGM, it may be that they follow the Wall Street rule and ‘sell out if they dislike management’. The question remains, however, if this type of control over management is really efficient enough to avoid managers’ opportunistic behaviour and especially outright fraud and mismanagement.

It should be noted however that exceptions exist from the rule that shareholders are passive in Switzerland. One example is the Ethos foundation – a foundation managing the money of several pension funds – which has started to oppose actively the proposals of that the BoD submits to the AGM if they are not happy with them. As an example, the proposal of Novartis CEO Daniel Vasella to renew his double-mandate during the AGM of March 7, 2007 as well as the amount of his compensation have been fiercely contested by Ethos…without success however.

Be that as it may, it is somewhat ironic to see that all the efforts to revive the so-called “shareholder democracy” which has been debated in politics at regular intervals since at least the 1970s have not yielded fruit. Especially, one argument to explain the notorious passivity of Swiss shareholders that came up in all debates about shareholder democracy was that due to the proxy votes represented by banks – which were as a rule exercised in favour of the BoD’s proposals – it was impossible for minority groups to influence the decisions of the AGM. The absence of active shareholders was hence attributed to a feeling of powerlessness by the shareholders. At the beginning of the 21st century, proxy voting by banks has become virtually inexistent; however, the shareholders’ behaviour did not change. Obviously this argument neglected the fact that shares have become more and more a means to increase one’s personal wealth, losing more and more their concrete signification, i.e. to be a security giving right to a part of the control over the company. This is what Schumpeter meant by saying that property which is detached from the person and from matter does not generate any sentiment of loyalty. As long as the company – or rather the share price – is performing reasonably well, there is not much reason for a minority shareholder to care about the company of which she is – theoretically – a co-owner…

Saturday, February 03, 2007


Organisational Control Structures and Integrity

I think it’s useful to discuss a bit more in detail Julien’s comment on my post on whistle-blowing. In fact, his very relevant point concerning the “capturing” of external control by the controlled makes me think of Arthur Andersen or the external auditing in general. In fact, audit companies are precisely supposed to perform an external control on their clients, making sure that the accounts are right. The problem however is precisely, that “outside” does not mean “independent”, “neutral”, or “without personal interest”. Any durable social relation implies some degree of mutual dependence. This is notably true for an auditing firm and its clients: the firm is dependent on revenues that are paid by the client and the client-firm is dependent on the auditor’s favourable report. This mutual dependence can eventually lead to a situation where the interest of both conflate or at least overlap in large parts, especially when confronted with interests of actors which are not involved in this relationship. When an auditing firm like Arthur Andersen makes large parts of its profits thanks to a mandate in one particular firm, it seems very likely that they do not want to upset this valuable client and may turn a blind eye on some practices that they would otherwise consider to be problematic.

The problem lies hence in the confusion of the term “outside” and “independent” and especially in the difficulty to establish social relations between the controller and the controlled that guarantee that this relationship will allow a genuinely independent control.

I guess that’s precisely what Alain Minc meant when stating that “the independence of directors is an alibi” (thanks Julien for sending me this link). In this interview Minc – chairman of the supervisory board of the French newspaper Le Monde and business consultant – states that the idea of “independent directors” is largely an illusion. In fact, ‘independent directors’ is often synonym with ‘incompetent directors’ since they don’t know the company which they are supposed to control. The trade-off he suggests is that the more a director is “independent”, the less well she knows the company and hence the less competences she has to play her role as controller and vice versa: better knowledge of the company implies necessarily closer personal or professional relations and hence less independence.

According to Minc, the claim for independent, non-executive directors serves mainly the managers to increase their power. I made a similar point in an earlier posting when talking about “structural holes” that may appear between the board and management when too many non-executive directors sit on the board, allowing the CEO to exploit his informational advantage. Minc is right when stressing that people that sit on a board do necessarily have some kind of personal or professional ties, since they are part of the same rather small social group, the business elite. These ties are not per se a problem. Or rather, since they are inevitable, we have to deal with them. The challenge is hence to create organisational structures that allow an efficient control despite these social ties. Minc states that the solution is transparency, i.e. each director has to openly declare her ties. I don’t think that this is enough. Minc who holds seats in different companies with sometimes conflicting interests states that he does not intervene in decisions that could imply a conflict of interests. This, however, cannot be legally enforced or controlled, but depends entirely on the integrity and the business ethics of the director in question. In such a situation, transparency without enforcement mechanisms does not allow for efficient control.

Efficient control might in fact be function of different dimensions that have to be efficiently combined: internal control, external control (by state agencies for instance), and market control. One could ad the dimensions peer-control, sectoral control by associations etc. (see Arndt Sorge’s recent book “The Global and The Local” pp.190f for a listing of different dimensions). The empowered third-party control, which Julien mentions in his comment, can indeed be seen as one possible combination of these instruments. But as he mentions as well, it looks like there will always be a part of the control structure which is contingent upon the actors’ integrity, and the risk of fraudulent behaviour cannot be entirely eliminated by organisational design. The efficiency of control mechanisms can be enhanced by the existence of a self-imposed “ethical code” among the business elite, and a social control among these elite guaranteeing the observation of this code. Without social norms within the elite condemning fraudulent behaviour and hence pushing managers to refrain from abusing their power, any control structure can ultimately be bypassed in one way or another…Unfortunately such social norms seem to have gone out of fashion in a more and more cynical society where hedonism and personal profits rank among the highest values…

Tuesday, January 16, 2007


What Links the “Hold”-Strategy to the Swissair case?

Last monday’s NZZ (January 8, 2007) ran a very interesting article on financial analysts in Switzerland. The article reports on a study carried out by StarMine concerning buy recommendations made by Swiss financial analysts. The study shows that Swiss financial analysts recommend more often than financial analysts in other countries to “hold” shares rather than “buy” or “sell”. In fact the hold strategy is the most common recommendation in Switzerland! A hold strategy implies, so the journalist argues, that the analyst recommends a shareholder who possesses already the share in question not to sell it, but other clients who do not have shares from the same company, not to buy them. Different clients get hence contrary advice from the same analyst, which shows that a hold strategy is theoretically not justifiable. Either a share can be expected to out-perform the market in the future, in which case the analyst should suggest a buy strategy, or it will under-perform, in which case the shareholders should sell out their stake.

What is interesting is the explanation the journalist gives for this phenomenon: “Switzerland is a small country, and the smaller a market is, the stronger are personal ties. The probability that a financial institution in a small country that recommends selling a given share is at the same time a creditor of the company in question is much higher than in a large market. […] The fact that in a small country like Switzerland everyone knows each other is enough to result in a situation where none wants to put the other’s nose out of joint” (my translation). Hence, a tendency of Swiss analysts to recommend – following an age-old Swiss penchant for compromises – the “hold”-strategy.

The “hold”-strategy phenomenon is indeed an excellent example of how the Swiss business system works. It shows a central feature of the Swiss economy, i.e. the existence of the “Filz” (“sleaze”). This term designates the multiple interweavements of the members of the Swiss business elite among each other and their connexions to other sub-spheres of the society such as politics and – in the past – the army. Switzerland seems in fact to illustrate very well the concept of the “power elite” – a term coined in 1956 by C. Wright Mills – which controls not only the economy but also other sub-systems of society. This phenomenon, i.e. the same people are influential in different spheres, is not necessarily a conscious strategy – although it can – but the simple fact that the elite is very concentrated in this country leads to situations where close personal ties become inevitable. This becomes particularly clear when looking on board overlaps between companies. Philippe de Weck, former CEO of the Swiss Bank Corporation once stated:

“[i]t is correct that there is in human nature a certain tendency to form clubs and that this tendency is maybe stronger in Switzerland than elsewhere. […] And we also have clubs of boards of directors. This tendency is maybe more pronounced in the German part of Switzerland than in the French-speaking part. In several parts of German-speaking Switzerland, the mentality of the population is still very much affected by the corporations. One can feel that there has been an age-long tradition of trade guilds. And the natural tendency of clubs is to be somewhat closed. In my opinion, this is the reason why, during the years of the economic boom between 1950 and 1970, a certain club mentality developed – certainly without deliberateness - concerning board of directors. I meet you here, so why don’t you come there; I know you, I know how you think; if we take someone else, I don’t know him, maybe it won’t work out with him, etc.” (de Weck 1983: 93; my own translation)

Regarding this “club mentality” and the fact that the board of directors of Swiss companies overlapped – until recently – very strongly, the role of banks is usually considered being particularly important. In fact, due to the importance of banks for non financial companies banks are regularly suspected to take profit of industrial companies in order to satisfy their own, purely financial interests. Thus, Rudolf Hilferding criticised in 1910 already the power of banks and their influence on other companies through their presence on the board of other companies and through their role as capital provider (later on, in 1928 more precisely, however, he started to consider the concentration of capital as a step towards an organised form of capitalism and towards the Stamokap (Staatsmonopolkapitalisum) (see for the question of the socialist criticism of the concentration of economic power since the late 19th century the excellent essay by Martin Höpner). Louis Brandeis criticised in 1914 how US investment bankers used “other people’s money” in their own interest. Sergei Illitsch Ulianow was enthusiastic with both Hilferding’s and Brandeis’ analyses and argued – in a book called “Imperialism: the Highest State of Capitalism” published in 1916 – that the situation in Germany was not much different from the one described by Brandeis. This debate reached eventually also Switzerland. The socialist author Fritz Giovanoli analysed and critisised in his book from 1937 “Libre Suisse, voici tes maîtres” (“Free Switzerland, here are your masters”) board overlaps and the concentration of power in the Swiss business elite. Since then, the debate about the power of banks re-emerges periodically.

Be that as it may, several facts show that the “power of banks” is not as complete as political propaganda suggests. In fact, Swiss banks seem at least as useful to industrial companies as the other way round. To name but one example, Swiss banks controlled usually large amounts of votes during the Annual shareholder meeting of industrial companies because the bank clients who held shares in the company in question could delegate the voting right to a bank representative. This gave banks a considerable potential power of non financial companies. However, as a rule, banks always cast their votes in favour of the board of directors’ propositions to the AGM. During long time, they did so even if the bank client wished that her votes be cast against the board! This shows that banks were loyal to the management of the company and clearly not acting in their own interests. This is of course by no means a self-forgetful behaviour of the banks, but shows that banks – or rather bankers – conceive of themselves as part of a very cohesive business elite.

This cohesion has actually once again made it to the front pages of Swiss newspapers. In fact, this morning started the process against the former directors of the national airline Swissair. In the graph below, I try to illustrate this cohesion. In fact, I took the former directors of Swissair who will appear in court starting from today. Based on a data base on the board compositions of the 100 largest Swiss firms, I looked what board overlaps between Swissair and other large Swiss companies the accused former directors created. (The data base was actually created at the Universtiy of Lausanne in relation with a research project funded by the Swiss National Science Foundation in which participated prof. Thomas David, Dr. André Mach, and lic hist Martin Lüpold).

The people whose board seats I took into account were the following defendants: Philippe Bruggiser, Mario Corti, Gerhard W. Fischer, Jacqualyn Fouse, Bénédict Hentsch, Antoine Höfliger, Eric Honegger, Andreas F. Leuenberger, Lukas Mühlemann, Thomas Schmidheiny, Georges Schorderet, Verena Spoerry, Gaudenz Stählin, , Andreas Simmen, Andreas Länzlinger, Scott Cormack, and Karin Anderegg Bigger. The snapshot takes into account board positions in 2000, i.e. just one year before the debacle. The lines symbolise ties that are created by a director sitting at the same time in two companies. Thicker lines indicate that the companies in question shared several directors:

What does the graph show? Well, it certainly shows that the people that appear in court starting from this morning are not some strange outsiders with dodgy business practices….these people are the very core of Swiss business. This is no big surprise since it has been repeated over and over again since the grounding of Swissair in October 2001. However, what the graph shows visually is how delicate this corporate failure is for the Swiss economy as a whole. In fact, at least ten major companies are directly linked to one of the accused. Hence the dilemma linked to this case: if the accused – or some of them – are guilty, the integrity of the whole business elite will be put into question. If they are not guilty, however, the failure of Swissair is not due to criminal behaviour but to… incompetence, which of course puts the whole business elite not less into question. Maybe, this explains why one of the few things that Gerhard W. Fischer said to the judge this morning was that the debacle would not have occurred without 9/11! Someone has to be guilty after all!

Be that as it may, all this very much confirms what Peter Katzenstein said in 1985 about small states in world markets: The elites in small countries seem to close ranks in order to face threats from outside…

Sunday, November 12, 2006


Helping the State: The Role of the Press and Whistleblowers in Fighting White-Collar Crime

Yesterday’s Tages Anzeiger (November 11, 2006, print edition) revealed a new „corporate scandal“ in Switzerland. This time, however, the scandal is somewhat special. In fact, no law was broken, no regulation by-passed, and no company went bankrupt. What happened? According to the newspaper, 40 mangers of Cablecom, a non-listed telecom company, had acquired during the takeover of the company by American institutional investors in the fall of 2003 a 8% stake in their own company for CHF2.8m. two years later, when the company was sold to the US group Liberty, the same 8% stake was sold by these same mangers for CHF144m. This is of course not shocking in itself. However, what the popular Swiss newspaper Blick decries as being outrageous is the fact that the same year, i.e. in the fall of 2005, the management of Cablecom announced the layoff of 260 staff. Once more, the unlimited greed of the managing elite seems to contrast starkly with the hardship that the “normal” employees have to endure.

Be that as it may, what is interesting in this case is the way in which this issue was made public. In fact, Cablecom, as non-listed company, does not publish any annual report or accounts. Hence, no information about the value of the company and the shareholdings of its executives is available. In fact, the above-mentioned facts and financial figures where made public by an employee who got hold of a copy of the “confidential” annual report and informed the press.

Even though this particular case is, at most, a case of reprehensible moral behaviour (realising a benefit of 5000% on one’s investment and at the same time laying-off 260 staff in order to reduce costs), the mechanism that was at work is very important. Several academics in the field of finance have expressed the view that a functioning (financial) press – i.e. one that is precisely capable of revealing this kind of incidents – can serve as a functional equivalent for legal protection of investors and other stakeholders that do not control the companies decision-making process. In other words, in countries where minority shareholders and other minorities in the firm are not well protected in company law, the public denunciation of “crooks” in newspapers can have a deterring effect on other potential crooks and can permit to punish crimes that otherwise would go unpunished. This at least is the thesis defended by Alexander Dyck and Luigi Zingales in their study on private benefits of control.

This brings us back to a point, which I’ve made in several previous posts. In fact, I have pointed out the limits of public regulation for preventing “misbehaviour” by corporate insiders. The financial press is in fact a mechanism that can denounce criminal or unethical behaviour, push the corporate elite to justify their actions, and put certain issues on the political agenda by creating a public pressure. Even though such mechanisms can of course be (ab)used for populist goals, the financial press can exercise a certain control over corporations in ways that the state cannot.

This is especially the case, where there is no immediate clearly identifiable victim of the insiders’ actions. Most legal offences of corruption are such cases: none is immediately harmed and none is hence going to file a law suit against the delinquent. In such cases, the denunciation of crimes – or supposed crimes – to the press by another corporate insider can prove to be the only way to stop this kind of wrongdoings.

The legislators in different countries seem to have understood this and have adopted legislation that aims at protecting the so called “whistleblowers”, i.e. employees of a company that denounce the fraudulent and criminal behaviour of their collaborators or superiors. In the US, the Sarbanes-Oxley Act reinforces the protection of “whistleblowers”. In Switzerland, following the initiative of a social democratic and a radical democratic MP (Remo Gysin and Dick Marty), the Parliament has asked the Federal Government to elaborate a proposition in order to legally protect whistleblowers. Also, the Swiss branch of Transparency International has established in April 2005, in collaboration with the Federal Government, a hotline for whistleblowers (cf. NZZ Online, October 5, 2006). Once a week, people who detect criminal or unethical behaviour within their company can call this hotline in order to denounce their colleagues. What may appear at first glance as disloyal behaviour towards once company is in fact an important mechanism of corporate control.

All countries, however, do not seem to adhere to this view. Thus, in May 2005, the French commission on the protection of data privacy (Commission nationale de l’informatique et des libertés, CNIL) has prohibited two companies to establish such “ethical lines” for whistleblowers, fearing that such hotlines could lead to an “organised system of professional denunciation”. The risk of some whistleblowers being motivated by personal motives rather than a genuine will to knock criminal behaviour in their company on the head can of course not be completely excluded. However, such hotlines do constitute an instrument for fighting crime, in a place where the state has no chance to do so.

Tuesday, October 31, 2006


Manager Compensations: A Populist Fight with Windmills?

Yesterday’s Swiss newspapers reported the launching of a popular initiative against corporate “rip-off”. A popular initiative is an instrument that allows Swiss citizens to submit a proposal for a constitutional amendment to a popular vote if they manage to collect 100’000 signatures. This “anti-rip-off initiative” proposes, in a nutshell, that the “shareholder democracy” should be strengthened by granting the annual general shareholder meeting (AGM) the right do decide about the total wage bill, bonuses, and other forms of remuneration for mangers and board members. Moreover, executives that occupy a full-time position in the company, but hold other mandates (such as board seats on the boards of other companies) should be obliged to pay a part of this additional income to their principal employer. (NZZ online, October 30, 2006).

What were the reasons for the launching of this initiative? The originator of the initiative Thomas Minder, owner of a small-sized company called Trybol AG, states in an article published in NZZ online october 30, 2006 that he has always been annoyed with the fact that managers pocketed millions in indemnities and compensations, wheras their company announced losses. The immediate reason for the launching, however, Minder says, was the Swissair debacle.

These arguments may seem somewhat bizarre. In fact, excessive executive remunerations are a real problem of corporate governance. However, they concern mainly the shareholders (whose money is paid in excessive salaries) and the other employees of the company (who can consider that it is not justified that they should earn as much as 500 times less than their boss). Hence, the corporate governance problem with excessive remuneration is one of expropriation and agency costs and of distribution of value added. In other words, if a manager of a company is paid too much, this is the problem of the shareholders of that company and of other employees.

So, what has the Swiss citizen to do in this? What is her interest in granting shareholders more control over executive remuneration? Of course, one could argue that most Swiss citizens are now shareholders since a part of their pension fund assets are invested in shares, but the real reason is arguably another. In fact, the whole problem boils down to a question of “social justice” or, to put it in a slightly more polemic way, to envy. In fact, people who have troubles to make ends meet (1m persons in Switzerland have a net income of less than 2450.- CHF a month, whereof approximately 200’000 are “working poor”) can just not understand why some people should earn as much whereas the same economic system seems not to be able to pay them a decent salary.

Also, since the 1980s, like in many industrialized countries, the citizens have become used to hear the litany of the importance of saving costs. Not only in the corporate world, but especially in the public sector: social benefits are continuingly reduced in all sectors with the arguments of budgetary discipline and reducing of public debt. The same is true in corporate life: real salaries of “normal” workers have stagnated or even decreased during the largest part of the 1990s. In such a situation, it is hard to understand for John Doe why management salaries should increase by 18% a year and where this money comes from. Since the end of the postwar boom, the sentiment that economics is a zero sum game has been reinforced: if someone gets a larger part of the cake, someone else has to lose. Hence, an increasing ressentiment against excessive salaries.

As understandable as such feelings may be two questions suggest themselves: firstly, how problematic are the current levels of executive remunerations really? Are they really excessive or do they reflect extraordinary achievements? Or in other words: what are “objective” criteria to assess if managers earn too much? The answer the initiative suggests is that the only ones that can tell are the shareholders, which seems a fairly reasonable approach.

Secondly, is a popular initiative the right means to tackle the problem – if there is one – of executive remunerations? In fact, it is of course not very difficult to find support for such an initiative among the voters, since most of them do not earn salaries of several millions a year. Notoriously populist actors such as the tabloid newspaper Blick – which is worldwide one of the only left-wing tabloid newspapers – are of course very eager to support this initiative. So is such a populist strategy the right answer to a real problem of corporate governance?

Concerning this latter point, one argument of Minder for his initiative is that the new reform proposal of the Stock Corporation Law, which will be debated by the Parliament sometime next year, does not contain any proposal concerning management remuneration. According to Minder, this is due to the fact that the majority of MPs are themselves part of the Wirtschaftsfilz (literally: the “economic sleaze”) and do not wish to curtail their own power and material benefits (NZZ online, October 30, 2006). And he’s probably not completely wrong. In that sense, the popular initiative may be a good means to put on the agenda issues that the political elite – which are of course very close to the business elite notably because of the non-professional Parliament in Switzerland (Milizsystem) – would refuse to address.

What is very interesting, however, is that the initiative does not originate from left-wing parties or trade unions but from the milieu of the SME. In fact, many owners of a SME seem to be sympathetic with Minder’s initiative (see the article in today's Blick) despite the fact that they are on the same side of the class divide as the managers that are aimed. According to the comments one could read in the press, their aim seems to be to fight the greed of the execs of the top firms in the name of economic integrity and of a now bygone way of doing business, where the boss and owner of a company (the “patron”) was preoccupied with the well-being of his employees and not just with his personal benefits. This reflects very well the divide between two parts of the Swiss economy, i.e. the large multinational companies oriented towards international markets and the vast majority of SME who produce mainly for the domestic market, which have different needs and interests and different views on corporate culture and values in general. In a way, the ‘anti-rip-off initiative’ is but a new episode in a conflict that has opposed the two parts of the Swiss economy for a long time.

Thursday, October 26, 2006


Skilling and the Dark Side of the System: Temptations, Laws, and the Importance of a Systemic View on Corporate Scandals

Earlier this week, Jeffrey Skilling, former CEO of Enron, was sentenced to 24 years and 4 month in jail for his role in what has become to be known as the one of the biggest cases of fraud in the history of the
US economy.

Coincidentally, I watched the excellent documentary on Enron “Enron: The Smartest Guys in the Room” just a couple of days before. This movie sets out in a very entertaining but still highly substantial way the history of Enron from its beginnings in the 1980s until its collapse. It is really highly recommendable!

There was just one thing that kind of bothered me: the whole film focused very much on the personality of the people that were involved in the fraud. At some point, the filmmakers suggest that the criminal activities of the Enron execs were somehow linked to their need to prove their manliness (they loved to show-off with scars they got during motorbike races etc.).

This completely blinds out the more systemic aspect of the Enron scandal. Maybe this criticism is not justified, because there are scenes in the movie that suggest that it was not just the problem of one isolated firm, but that the whole scandal implied more people then just the nerdy Enron execs. Thus, the involvement of all major US (and some Swiss) banks, of law firms, and of Arthur Andersen are discussed. This shows that such behaviour is not necessarily linked to a particularly evil and ruthless CEO, but is rather the result of the system as a whole. From the simple employee to the CEO of any industrial corporation, bank, or any other type of business enterprise, every single one has first and foremost to live up to the expectations that are set in her in order to keep her job. This creates pressures from a various sides – your boss, your colleagues, the stock market, creditors, clients etc. – and leads to situations where cheating can appear appealing. Especially the expectations of stock markets press more and more down on listed companies. Will the quarterly report satisfy the investors or will it lead to a decrease in the share price, exposing the company to the threat of hostile takeover or to me losing my job? In such a situation, it doesn’t take a Jeff Skilling to be tempted to find a way to satisfy these expectations…In the movie this is best expressed, I find, in the recordings of the taped telephone conversations between Enron traders during the Californian Energy Crisis of 2000 (the tapes can be down loaded on the movie web page). The cynicism of these conversations is just outrageous…but at the same time not very surprising.
At least since Hanna Arendt’s book on the Eichmann trial in
Jerusalem, we know that anybody has to some degree the potential to “act evil” when the circumstances are favourable to such behaviour. In a highly competitive business environment where the stakes are very high for each cog in the machinery, the circumstances are ideal to put aside ethical and legal considerations. What I’m saying here is not meant to excuse such criminal – or even “just” unethical – behaviour. My point is that it’s too easy to say that Enron collapsed because Jeff Skilling is a particular ruthless person. That was also Sheron Watkins’ – former executive of Enron – point, I believe, when she said in one scene in the movie that Enron is not an isolated case – except for the extent of the fraud maybe – but that this can happen in any company. And apparently it happens more and more often, not just in the US but all over the world. White-collar crime is on the rise...

In yesterdays’ Echo der Zeit – a Swiss radio show on DRS 1 – a study on white-collar crime in Switzerland that was carried out by PWC was quoted. It states that in 2003 25% of the Swiss companies were affected by some sort of white-collar crime (mostly though embezzlement and fraud). One year later, this proportion had risen to 33%. Another study, carried out by, KPMG finds even higher proportions.

The trend seems to be towards even more white-collar criminality in the future. Thus, the Swiss Federal Police Office identifies in its Report on Homeland Security 2005 – still according to Echo der Zeit – a particular risk of criminality in the hedge fund industry.

Recent examples of supposedly criminal behaviour by managers (most of them have not been sentenced yet) are many in Switzerland and I have alluded to several of them in previous postings (Swissair and Swissfirst notably, but others can be cited such as OZ Bank, the SUVA scandal etc.).

Again the legislator has undertaken steps in order to counter this development: A reform proposal of the Stock Corporation Law has been elaborated by the Federal Administration, a public supervisory agency on audit companies will take up its activities in 2007 and legal responsibilities concerning corporate fraud have been newly defined: since 2003, the company as a legal entity can be held responsible for crimes committed by its employees.

However, and that’s the point I want to get at, it seems that the problem – in Switzerland – is not so much the legal framework than its implementation. In fact, in yesterday’s Echo der Zeit, Christof Müller – a lawyer and specialist in white-collar crime – stated that Switzerland lacks behind other countries not so much concerning the legal framework, but concerning the implementation of these rules. As an example he compared Enron, the Parmalat case in Italy to the Swissair case. All three scandals happen approximately at the same time. However, whereas the in the Enron case the trial court has rendered its judgement and the Parmalat case is well undeway as well, the Swissair case has barely begun. This is precisely what Julien was suggesting in one of his comments on my previous post on corporate scandals: rather than talking about the number of legal rules that exist, we should talk about the resources that are provided for the achievement of a certain goal. In Switzerland, the judicial system seems to lake the necessary resources in order to implement the laws that already exist. What good could new laws do in such a situation? The problem is not just one of efficiency but touches the question of justice directly. In the Swissair case for instance several of the accused are almost sure that there crimes will be prescribed by the time the process will begin. Again, this suggests that talking about new laws may not be the decisive issue after all…

Friday, October 06, 2006


Corporate Scandals, Economic Crises, and the State

Karl Marx predicted that the successive economic crises, which are inherent to the capitalist system, would eventually lead to revolution and to the downfall of capitalism. Max Weber contradicted this view in a speech held in Vienna in July 1918. Not revolution, but increased regulation of economic activity – either through economic actors themselves or through state action – would be the consequence of economic crisis. Hence, each crisis would lead to an increase in economic organisation, i.e. to a development away from the original liberal (or savage) capitalism towards a regulated form of capitalism.

This latter view is highly relevant to the contemporary debate on corporate governance. In fact, an analogy can be made between economic crisis and corporate scandals. Of course one could object that a corporate scandal, involving only one company, cannot be compared to a full-scale economic crisis that can menace the wealth of an entire population. Right…but still, if we look at the size of modern companies, the analogy does not seem that far-fetched after all. Multinational companies (MNCs) have annual sales that exceed the GDP of not just some poor sub-Saharan states but of quite large European countries (e.g. the sales of Ford exceeded the GDP of the Czech Republic in 2005 by far). Hence, corporations have become enormous economic entities and the failure of such a company, one could argue, have an economic impact that can be compared to an economy crisis.

Be that as it may, Max Weber’s prediction has been supported by evidence from many crises and scandals throughout the 20th century. From the ‘Kreuger Crash’ triggered by the suicide of the Swedish ‘Match King’ Ivar Kreuger on March 12, 1932 in Paris, to the failures of Enron and WorldCom, corporate failures have often had as a consequence an increased activism by policy makers and major changes in the legal framework governing the economy. And there are certainly good reasons to do so. In fact, corporate failures and economic crises are bad for those involved, but good for people who are interested in understanding the functioning of the economy. In fact, crises and scandals reveal the functioning of the economy much better than any other economic phenomenon. They reveal loopholes in the existing legislation, and allow us to learn a great deal about economic practices that develop in between the lines of the legal text. This can be profitable to policy makers. In fact, policy making is of course much easier with the benefit of hindsight. So, why should the state not learn from past mistakes and integrate the new insights in new laws?

Well, many examples show that the scurried adoption of legislation subsequent to a scandal might not always lead to the best results. Take the Sarbanes-Oxley Act of 2002, which was adopted right after the Enron and WorldCom disasters when the gun was still smoking. Of course, this piece of legislation brought about some improvements notably concerning accounting rules. However it was adopted – under the pressure of the popular outrage – first and foremost in order to show that politicians are capable of effective crisis management. The result was a not so well thought-out law that introduced arguably unrealistic dispositions implying enormous costs for companies. The compliance costs with the SOA were especially for smaller companies completely out of scale so that the Securities and Exchange Commission (SEC) eventually proposed to exempt them from compliance at least with section 404 of the SOA (Report of management on internal control over financial reporting).

A similar precipitous law could be adopted in Switzerland in the near future following the Swissfirst scandal that I wrote about in an earlier posting on this blog. The alleged corruption scandal around the merger of Swissfirst and Bank am Bellevue, implying several pension funds, has opened a breach for all sorts of regulatory moods. Politicians agreed quickly on the source of the problem, i.e. the so called “parallel trading”, which designates the fact that the administrators of pension fund assets buy privately the same shares as they buy for their fund. In the online edition of the NZZ of October 4, 2006, one could read that politicians of all political orientations attacked this ‘new’ evil. The administrators of pension assets, so they argue, should be prohibited by law to trade with the same shares as they buy for the fund. One Social Democrat in the lower house described the ideal pension fund administrator as “a eunuch in a harem” (NZZ October 4, 2006)!

Such a rule may seem sensible at first glance. Especially if one thinks of another – minor – recent scandal that implied one of the investment companies belonging to Bank am Bellevue, BB Medtec. This investment company published, in August 2006, a report for its customers recommending buying shares of Nobel Biocare. At the same time, BB Medtech had reduced its own stake in Nobel Biocare from 10.2% in December 2005 to 9.6% in June 2006. It probably even further reduced that stake after that date since BB Medtech refuses to disclose its current stake in that company (NZZ, September 24, 2006). This kind of behaviour is of course unacceptable. Yet, what the Swiss Parliament is actually aiming at are – consciously or unconsciously – not such very problematic contradictions between one’s own trading strategy and recommendations to ones costumers. The discussions turned explicitely around parallel trading, which does of course not do any harm to whosoever. In fact, prohibiting these kinds of activities would even contradict a central principal of good corporate governance as it is advocated by many corporate governance specialists, i.e. the fact that the management of a company should hold stock (or stock options) of the company they manage. This permits to link the managers personal wealth to the company’s success, creating thus necessary incentives. Similarly, a pension fund administrators who buy the shares they also buy for their fund is a sign of the conviction that the fund’s investment strategy is a good strategy and will potentially make administrators more attentive to the evolution of these shares.

Hence, ‘parallel trading’ is clearly not the most urgent problem – if it is a problem in the first place – that the legislator should tackle. In fact, Here, policy makers propose – under the pressure of public opinion and because an opportunity window for new regulation was opened by the scandal – to regulate a question, which is not even remotely responsible for the actual scandal. The question is if politicians are aware of the fact that they are off the mark concerning this question, but just don’t care, or if this the result of overhasty policy making. Be that as it may, rather than firing a snapshot in the heat of the battle, what the Swiss Parliament should do in this situation is continue the reform of pension fund surveillance that was commenced by the Federal Government before the Swissfirst scandal. Maybe for once the proverbial slowness of the Swiss decision making process can have a positive effect in the sense that in a couple of weeks factual and dispassionate problem-solving could be possible again …

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