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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