Implicitly Assuming that the CEO is Not a Crook Misses the Problem

Gretchen Morgenson has brought a revealing study to the attention of the public in her article entitled "The CEO is My Friend, So Back Off." Here's the bad news -- the situation is vastly worse than the authors of the study conclude and the policy advice that experts offered Morgenson in response to the findings would fail where they were most needed.

Morgenson begins her article by describing a recent speech by the head of the SEC to an audience containing many board directors.

"Mary Jo White, the chairwoman of the Securities and Exchange Commission, [stood] in front of an audience that included a fair number of corporate directors, urging them to be more accountable.

In the speech, at the Rock Center for Corporate Governance at Stanford University, Ms. White emphasized their crucial duty to protect shareholders from abusive practices at companies they oversee.

'Setting the standard in the boardroom that good corporate governance and rigorous compliance are essential goes a long way in engendering a strong corporate culture throughout an organization,' Ms. White said, later adding that 'ethics and honesty can become core corporate values when directors and senior executives embrace them.'"

White is channeling corporate ethics' sole meme -- "tone at the top." If the CEO and the board set an ethical tone at the top they can produce an ethical organization. Even Alan Greenspan explicitly made the same statement. But what Greenspan, White, and virtually all those who peddle this business ethics meme fail to do is ask themselves two logical questions if we assume for purposes of analysis that the meme is correct.

• What can we infer from the fact that rampant fraud was the norm at our largest and most prestigious financial institutions, hundreds non-prestigious mortgage banking firms, and tens of thousands loan brokers and brokerages with terrible reputations arranging loans that the industry called (behind closed doors) "liar's" loans? As I have documented, we are talking about millions of cases of fraudulent loan origination and the fraudulent sale of those fraudulently originated loans to the secondary market, plus Libor, plus the epidemic of foreclosure fraud. Under the corporate governance and ethics meme we can infer that the CEOs of these hundreds of institutions refused to "embrace " ethics and honesty" and selected board members that they believed would sallow these millions of felonies share that refusal.
• Why would CEOs fail to set an ethical "tone at the top" and run firms that, collectively, created these millions of felonies? There is one obvious answer to that question. The answer has two related parts. CEOs are made wealthy by modern executive and professional compensation if they engage in the "sure thing" of running a firm that engages in widespread fraud. Depending on the type of "control fraud" that they lead, the fraud may enrich or "loot" the shareholders. Accounting control frauds create fake (record) profits and real (record) losses, but other forms of control fraud enrich the shareholders as well as the CEO.

Second, when these frauds create a competitive advantage they create a "Gresham's" dynamic that drives honest firms, professionals, CEOs, and board members from the marketplace.

These two questions and their answers are essential to understanding why we suffer recurrent, intensifying financial crises, so I am happy that the study should, logically, lead to people focusing on those questions. Unfortunately, no one involved even asks, much less focuses, on those questions and answers.

Does anyone seriously think there is a CEO of a publicly traded company in America who is so stupid or ignorant that he had not heard of the concept of creating a culture of integrity and need to learn about it from White? Control frauds have terrible ethics in reality because that facilitates the fraud. Their CEOs typically provide a thin veneer of faux ethical trappings in the form of "ethical codes" that are actually designed to reduce punishment under the Sentencing Guidelines and to fool the credulous. Does anyone think that the CEOs that control firms and use them as "weapons" to defraud want to pick board members who would obstruct those frauds? Does anyone doubt the ability of CEOs who control these frauds to select board members who will tell regulators to "back off" from criticizing the CEO?

The standard economics joke (punch line: "assume a can opener") should be the standard business ethics joke. Yes, CEOs can insure that corporations, even massive corporations, act in an overwhelmingly honest fashion and one of the means by which honest CEOs would do this is by choosing directors of impeccable integrity and a track record of "speaking truth to power." It is useless to tell CEOs running frauds that they should select great directors. It is easy for them to find people with great resumes to serve as sycophantic directors.

The question that gets asked instead is why directors would fail to "embrace " ethics and honesty?"

Why wouldn't board members embrace these values? Cozy board ties with the chief executive might be one reason. A recent academic study, to be published in the July-August issue of The Accounting Review, suggests that lax oversight can result when a director of a company is friendly with the chief executive overseeing it.

But the research makes a counterintuitive finding as well. The conventional wisdom holds that when you disclose personal ties, you create transparency and better governance. The experiment found that when social relationships were disclosed as part of director-independence regulations, board members didn't toughen their oversight of their chief-executive pals. Rather, the directors went easier on the C.E.O., perhaps believing that they had done their duty by disclosing the relationship.

I don't think their finding is counter-intuitive and I think the researchers are correct about the psychological processes involved with this form of disclosure.

But this does not explain why CEOs would select board members who failed to "embrace" integrity.