In his classic account of market bubbles, the economist JK Galbraith said that there were few fields in which "history counts for so little" as in finance. So it seems that financial scandals, when they happen, have an air of inevitability, with lots of people saying, I told you so.
Except for investors, who are surprised to lose everything. Our understanding of management best practice is shaped by success stories. But to become better managers and investors, we need to study corporate failure, particularly those episodes that catch us by surprise. This well-researched book by Alicia Micklethwait and Stewart Hamilton reviews nine corporate scandals, starting with the collapse of Barings Bank and ending with Parmalat, covering Enron and Tyco along the way.
Many of these scandals have received book-length treatments by others.
Thus, the authors' rendition, strung together using mostly business school cases, serves as a review of the major events and a chance to explore some common causes. Each scandal is followed by an in-depth analysis of its determinants, along with a summary of the key messages.
The most interesting premise in the book is that both investors and corporate boards tend to drop their guard when performance is good. This was most apparent at Enron, where the board rubber-stamped management's decisions, as well as approving egregious management compensation packages. The increasing stock price played a role in their willingness to look the other way.
Boards struggle to be effective even when they are under pressure, and thus tend to relax after good performance. Investors too can be blinded by success.
The problem is that this is precisely when managers have the greatest ability to destroy shareholder value, by overpaying for acquisitions, or by granting themselves generous compensation. These managers become the victim of expectations created by their performance. In at least three of the scandals, fraud was simply an attempt to meet the stock market's unrealistic earnings expectations. Therein lies the difference between spectacular failure and plain old under-performance - true disasters are notorious because these firms were once perceived as giants.
The authors argue that firms succumbing to scandal are victims of poor strategic decisions, but this is with the benefit of hindsight - it is too easy to point fingers after the fact. The nature of most decisions is that they involve judgment as well as some uncertainty. Swissair's strategy of small equity stakes in European airlines, for example, might have turned out better had the airline industry not suffered from the downturn in 2001. In the recent corporate scandal in Japan, Livedoor's CEO graced magazine covers only a year ago as a genius; now that the stock price is in the gutter, he is branded a greedy charlatan. 'Confidence' and 'vision' become 'hubris' when decisions don't turn out well. What we need is a way to predict future mishap. In this regard, the book falls short.
A repeated theme is that corporate scandals involve unchecked greed.
But to blame greed is wrong: many of these CEOs, such as Enron's Ken Lay and Parmalat's Calisto Tanzi, built firms from the ground up. Their ambition, which is a virtue on the way up, then becomes a fault. Perhaps the failure lies not so much in these managers, but in governance structures that allow them to ignore shareholder interest.
The book concludes with a set of recommendations for avoiding future mishap. The US should follow the UK model and separate the roles of chairman and CEO, and boards should be forced to take more responsibility for management.
But investment banks are asked to take more responsibility in their recommendations.
But can we blame them for closing deals? CEOs who allow bankers or consultants to tell them how to manage have only themselves to blame, and boards should always have the final word on an acquisition.
Even in well-functioning capital markets, corporate governance leaves much to be desired. But a quick fix is improbable. The elimination of one problem usually introduces another; equity-based pay, for example, grew during the 1980s and 1990s to incentivise lazy managers. This had the unforeseen consequence of making these managers too sensitive to short-term fluctuations in the stock prices. One can argue that this calls for a more measured approach, in contrast to hurried legislation pushed through while the scandal is fresh in the public mind. Eventually we will figure it out, one scandal at a time.
Greed and corporate failure: the lessons from recent disasters, Stewart Hamilton and Alicia Micklethwait, Palgrave Macmillan, £25, ISBN: 1-403-98636-3.
Professor Robin Greenwood, Harvard Business School, researches the effects of market conditions on corporate financing and investment policies, and stock price manipulation.