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THE GREED CYCLE: How the financial system encouraged corporations to go crazy.
BY: John Cassidy
The New Yorker
September 23, 2002
There are many ways to take the measure of what has happened to corporate America in recent
years. As good a way as any is to flip through some back copies of the Financial Times, which
recently published a remarkable series of articles on what it termed the ?barons of bankruptcy - a
privileged group of top business people who made extraordinary personal fortunes even as their
companies were heading for disaster.? The FT examined the twenty five biggest business
collapses since the start of last year. From the beginning of 1999 to the end of 2001, senior
executives and directors of these doomed compa-nies walked away with some $33 billion in
salary, bonuses, and the proceeds from sales of stock and stock options. Some of the names on
the list were fa-miliar to anybody who reads the pa-pers: Global Crossing?s Gary Winnick
($512.4 million); Enron?s Kenneth Lay ($246.7 million); and WorldCom?s Scott Sullivan ($49.4
million). How-ever, there were also many names that haven?t received much public attention,
such as Clark McLeod and Richard Lumpkin, the former chairman and the former vice chairman,
respectively, of McLeod USA, a telecommunica-tions company based in Cedar Rapids, Iowa.
These two corporate philan-thropists cashed in stock worth ninety nine million dollars and a
hundred and sixteen million dollars, respectively, before the rest of the stockholders were wiped
out.Even veteran observers have been taken aback by recent events. ?It became a competitive
game to see how much money you could get,? Paul Volcker, the former chairman of the Federal
Reserve Board, told me when I visited him at his office in Rockefeller Center a couple of weeks
ago. Earlier this year, Volcker tried and failed to rescue Arthur Ander-sen, Enron?s accounting
firm, which ended up going out of business. ?Corporate greed exploded beyond anything that
could have been imagined in 1990,? Volcker went on: ?Traditional norms didn?t exist. You had
this whole culture where the only sign of worth was how much money you made.?
Economists from Adam Smith to Milton Friedman have seen greed as an inevitable and, in some
ways, desirable feature of capitalism. In a well regulated and well balanced economy, greed
helps to keep the system expanding. But it is also kept in check, lest it undermine public faith in
the entire enterprise. The extraordinary thing about the last few years is not the mere presence of
greed but the way it was systematically en-couraged and then allowed to career out of control.
Kenneth Lay, in quietly sell-ing stock and exercising stock options worth more than two hundred
million dollars shortly before Enron collapsed, wasn?t just being a selfish, unscrupulous
individual: he was defying the social contract that underpins a system, which, despite its faults
has lasted almost two hundred years.
In 1814, Francis Cabot Lowell, a Bos-ton merchant, founded the first pub-lic company, when he
built a textile fac-tory on the banks of the Charles River in Waltham, Massachusetts, and called it
the Boston Manufacturing Company. Lowell had smuggled a plan of a power loom out of
England, and he intended to compete with the Lancashire mills. But he couldn?t afford to pay for
the construction and installation of expen-sive machinery by himself, so he sold stock in his
company to ten associates. Within seven years, these stockholders had received a cumulative
return of more than a hundred per cent, and Lowell had established a new business model Under
its auspices, mankind has invented cures for deadly diseases, ex-tracted minerals from ocean
floors, ex-tended commerce to all corners of the earth, and generated unprecedented rates of
Initially, most economists were skep-tical of Lowell?s innovation. At the heart of any public
company there is an implicit bargain: the managers promise to run the company in the owners
interest, and the stockholders agree to hand over day-to-day control of the business to the
managers. Unfortu-nately, there is no easy way to make sure that the managers don?t slack off, or
divert some of the stockholders? money into their own pockets. Adam Smith was among the first
to identify this problem. ?The directors of such com-panies.? being the managers rather of other
people?s money than of their own, it cannot well be expected that they should watch over it with
the same anx-ious vigilance with which the partners in a private [company] frequently watch
over their own,? Smith wrote in ?The Wealth of Nations.? And he went on, ?Negligence and
profusion, therefore, must always prevail, more or less, in the management of the affairs of such
Smith thought that private com-panies would remain the normal way of doing business, but
technological change and financial necessity proved him wrong. With the development of the
railroads, for example, companies like the New York Central and the Union Pacific needed to
raise tens of millions of dollars from outside in-vestors to lay track and buy rolling stock. And
because the administrative com-plexity of the railroads was too much for a single entrepreneur to
handle, a new class of full time executives, men like Collis P. Huntington and Ed-ward C.
Harriman, emerged to run them. Though the emerging industry attracted dubious financiers like
Jay Gould, most of the professional managers were content to collect generous salaries and
pensions rather than habitually attempt to rob the stockholders and bondholders. ?It is a strong
proof of the marvelous growth in recent times of a spirit of honesty and uprightness in
commercial matters, that the leading officers of great public companies yield as little as they do
to the vast tempta-tions to fraud which lie in their way,? the British economist Alfred Marshall
said in 1890.
Alas, by the late nineteen twenties it was clear that corporate perfidy was prospering in an
impressive variety of forms, most of them involving insiders exploiting their position to fleece
out-siders. After the stock market crash of 1929, congressional investigators un-covered
widespread insider trading, stock price manipulation, and diver-sion of corporate funds to
personal use. Then, as now, the revelations of corpo-rate wrongdoing prompted the federal
government to respond. The Securi-ties Act of 1933 imposed extensive disclosure requirements
on any com-pany wanting to issue stock, and out-lawed insider dealing and other at-tempts to
manipulate the market. In 1934, the Securities and Exchange Com-mission was set up to enforce
the new regulations.
Public confidence in business even-tually recovered, but the potential conflict of interest at the
heart of public companies was never fully resolved. Dur-ing the nineteen sixties and early
seven-ties, corporate managers were often cav-alier about the interests of stockholders. Back
then, the chief executive?s com-pensation was usually linked to the size of the firm he ran - the
bigger the com-pany, the bigger the paycheck. This encouraged business leaders to build
sprawling empires rather than focus on their firms? profitability and stock price. Many of them
spent heavily on per-quisites of office, such as lavish head-quarters and corporate retreats, and
they kept on spending even when their com-panies ran into trouble.
In theory, the stockholders could have joined together to force out managers, but organizing such
a collective effort was costly and time consuming, and it rarely happened. Nor was managerial
waste constrained by competition from rival firms that didn?t splurge on pink marble for the
office bathrooms. Com-panies like General Motors saw their businesses decimated by foreign
com-petition, but CEOs, such as G.M.?s Roger Smith, rarely suffered. From a stockholder?s
perspective, something more potent was required to get those who ran the companies to serve the
in-terests of those who owned the compa-nies. When the solution materialized, it would turn out
to be more potent than anybody had imagined.
Thirty years ago, two obscure young financial economists provided the spark for reform.
Michael Jensen and William Meckling had graduate de-grees from the University of Chicago,
where Milton Friedman and his disciples taught that there was little wrong with the American
economy that more competition wouldn?t resolve. During the early seventies, Jensen and
Meck-ling, who were then both at the Univer-sity of Rochester, tried to apply this idea to the
internal workings of the public company. They began with the supposi-tion that senior managers,
faced with competition from other firms, would do the best they could for their stockhold-ers, by
cutting costs and trying to make as big a profit as possible. ?But the more we thought about it the
more we real-ized that what we had been taught in Chicago and believed most of our lives
wasn?t true,? Jensen recalled recently. ?It wasn?t automatically true that corpora-tions would
Jensen and Meckling couched their arguments in the mathematical jargon favored by assistant
professors seek-ing tenure, but the model they came up with had an enormous practical impact. It
planted the idea that the most im-portant people in any company are not the employees or the
managers but the owners - the stockholders and bond-holders. This model provided an
intel-lectual rationale, of sorts, for the con-troversial explosion in CEO pay that began in the
nineteen eighties; and it justified the widespread adoption of executive stock options.
Jensen and Meckling analyzed the relationship between stockholders and managers as a
?principal - agent prob-lem? - a dilemma that arises whenever one party (the principal) employs
an-other (the agent) to do a job for him. It might be a family hiring a contractor to renovate its
house, a company hiring a brokerage firm to manage its retire-ment fund, or even an electorate
choos-ing a government. In all these cases, the same issue arises: How can the prin-cipal insure
that the agent acts in his or her interest? As anybody who has dealt with a contractor knows,
there is no simple solution. One option is to de-sign a contract that rewards the con-tractor for
doing the job well. Municipal construction projects, for example, have a chronic tendency to
overrun, snarling traffic and infuriating the public. So when the City of New York, say, puts out
tenders for roadwork, its contracts often include financial incentives for finishing the work early
and penalties for being late.
Jensen and Meckling were the first economists to apply this idea to corpo-rations. They argued
that there was no perfect way to align the interests of the owners and the managers. In any firm
that relied on outsiders for financing, the senior executives would make some damaging
decisions. If the firm issued stock, they would waste some of the proceeds on perks like
corporate jets. If the firm issued debt, the managers, knowing that the bondholders would be the
main losers if anything went wrong, would make too many risky investments. The ?agency
costs? that the business incurred as a result of these ac-tions were unavoidable. It didn?t matter
whether the firm was a cosseted mo-nopoly or a company facing extensive competition:
managers would destroy value.
Jensen and Meckling had a hard time getting their ideas accepted. ?I gave a seminar at the
University of Chicago, and it was just a disaster,? Jensen recalled. ?People were shouting at me,
?How can you say competition doesn?t solve all problems??? Eventually, though, most
economists accepted Jensen and Meck-ling?s logic, and they began to ask more questions: How
should the performances of senior executives be measured? Was it better to give them money in
the form of salaries or bonuses, or company stock? If some managerial inefficiency was
inevitable, how could it be minimized? Principal - agent theory provided a clear answer to these
questions: treat chief ex-ecutives just like plumbers, contractors, or any other truculent agent, and
reward them for acting in the best interest of the principal - i.e., the stockholders.
At the time, many chief executives saw their main task as overseeing the welfare of their
employees and custom-ers. As long as the firm made a decent profit every year and raised the
dividend it paid its stockholders, this was considered good enough. But, once CEOs were viewed
as merely the agents of the firm?s owners, they were urged to live by a new, simpler credo:
shareholder value. Henceforth, economists and manage-ment gurus agreed, their overriding aim
should be to maximize the value of the firm, as it was determined in the stock market.
The shareholder value movement soon attracted rich and aggressive investors who used the
economists? argu-ments to justify attacks on corporate America. During the hostile takeover
wave of the nineteen eighties, contro-versial figures like T. Boone Pickens and Carl Icahn bought
stakes in public companies they considered undervalued and, claiming to represent the ordinary
stockholder, often tried to seize control. Since the corporate raiders financed their attacks with
borrowed money, their takeovers became known as ?lever-aged buyouts,? or LBOs. In a typical
LBO, the acquirer would buy out the public stockholders and run the com-pany as a private
concern, slashing costs and slimming it down. The ultimate aim was to refloat the company on
the stock market at a higher valuation. Individual raiders weren?t the only force behind LBOs.
Wall Street firms like Kohlberg Kravis Roberts and Hicks, Muse also got in on the game. Nearly
half of all major public corporations received a takeover offer in the eight-ies. Many companies
were forced to lay off workers and sell off under performing divisions in order to boost their
stock price and fend off potential bidders. Raiders were popularly de-nounced as speculators and
predators, which, of course, most of them were. Thomas Eagleton, a Democratic sena-tor from
Missouri, called Carl Icahn ?a fourteen karat pirate motivated by one instinct - greed.?
Still, many economists defended LBOs as an effective way to overcome the agency problems
that Jensen and Meckling had identified. The stock-holders who sold out often made
con-siderable profits, and the managers of bought out companies were usually given large
chunks of equity. Senior executives would be forced to run the firms more efficiently, it was
argued, because of all the debt that had been taken on, and, if they boosted the value of the firm,
they should make a lot of money themselves. Michael Jensen became one of the strongest
supporters of LBOs. In 1989, he published an article in the Harvard Business Review in which
he claimed that the traditional public company had ?outlived its usefulness in many sectors of the
This declaration proved premature. When the economy went into a reces-sion during the early
nineteen nineties, many of the firms that had gone private, such as Macy?s and Revco, couldn?t
keep up their interest payments, and the re-sulting wave of bankruptcies discred-ited the LBO as
a business model. Far from creating value, many LBOs had ended up wiping out the investors
and bondholders who financed them. The only people who consistently made money were the
stockholders and se-nior managers who sold out early on. The enduring economic lesson of the
LBO era was that unleashing greed wasn?t enough to raise efficiency. But the message that
corporate America took from its ordeal was quite different: senior executives who converted to
the new religion of shareholder value tended to get very rich, while those who argued that
corporations ought to consider their employees and customers as well as their stockholders often
ended up with-out a job.
At the same time, corporations came to realize that leveraged buyouts weren?t the only way to
align the interests of managers and shareholders. There was a much simpler tool available, which
didn?t involve going to all the trouble of a multibillion dollar takeover: the exec-utive stock
option. Once endowed with a generous grant of these magical in-struments, a senior executive
would no longer think of himself as a mere hired hand but as a proprietor who had the long term
health of the firm at heart. That was the theory, anyway.
An executive stock option is a legal contract that grants its owner the right to buy a stock in his
or her com-pany at a certain price (the ?strike price?) on a certain date in the future. Take a
company with a stock price of fifty dol-lars that grants its chief executive the right to buy a
million shares three years hence at the current market price. As-sume the stock price rises by ten
per cent each year, so that after three years it is trading at about sixty six dollars and fifty cents.
At that point, the chief exec-utive can ?exercise? his option and make the company sell him a
million shares at fifty dollars. Then he can sell the shares in the open market, and clear a profit of
sixteen and a half million dollars.
The first stock option incentive plan was introduced in 1950, the year in which Congress decided
that recipients of stock options could defer paying tax until they exercised them and sold the
shares. Soon thereafter, the Accounting Principles Board, the accounting industry body that laid
down guidelines for how com-panies calculate their earnings, decided that stock options, unlike
salaries and bonuses, would not be counted as a cor-porate expense. This decision had
mo-mentous consequences, since it meant that, from a firm?s perspective, execu-tive stock
options were free. Companies could issue as many options as they wished, and they wouldn?t
have to deduct a cent from the earnings they reported to shareholders.
Eventually, this accounting ruling transformed the way corporations paid their senior managers,
but at the time it provoked little comment. Back then, executive stock options were still rare.
Most senior executives thought that they were too risky and insisted on being paid in cash. This
remained true throughout the nineteen sixties and seventies, ex-cept in the technology sector,
where firms developing untested products often didn?t have enough money to pay high salaries.
For young firms, stock options provided a convenient way to maintain the loyalty of valuable
em-ployees while conserving cash. If things went well for the company, options could be
extremely lucrative: in 1982, after the Dow finally broke out of its de-cline, Frederick W. Smith,
the chief ex-ecutive of Federal Express, cashed in options worth more than fifty million dollars.
In 1980, fewer than a third of chief executives of public companies were granted stock options.
Most firms still depended on bonuses and profit shar-ing to motivate and reward their senior
managers. As the nineteen eighties pro-gressed, and the Dow tripled, stock op-tions began to
look much less risky. Thanks to the startling growth of firms that used them heavily, such as
Micro-soft and Intel, they also became fash-ionable. For blue chip companies, issu-ing generous
packages of stock options to their managers became a way to mimic the technological dynamism
and entrepreneurial culture of Silicon Valley.
Yet the real benefit of granting stock options - or so economists insisted - was that they solved
the problem of providing incentives to senior execu-tives. Once again, Michael Jensen was an
influential figure. In 1990, Jensen and Kevin Murphy, an economist who is now at the University
of Southern Cal-ifornia, published an article in the Har-vard Business Review which argued that
even after the events of the eighties the compensation that most senior execu-tives received was
barely connected to the performance of their firms. In par-ticular, changes in a firm?s stock price
had little impact on the take home pay of its chief executive. ?On average, corporate America
pays its most im-portant leaders like bureaucrats,? Jen-sen and Murphy concluded. ?Is it any
wonder then that so many CEOs act like bureaucrats rather than the value maximizing
entrepreneurs companies need to enhance their standing in world markets??
By 1994, seven in ten chief execu-tives received option grants, and stock options made up about
half of their average take home pay. In the second half of the nineties, so called ?mega options? options grants worth at least ten million dollars - became the norm. In 1997, according to the
executive compensation consulting firm Pearl Meyer & Partners, ninety two of Amer-ica?s top
two hundred chief executives received mega options, with an average value of thirty one million
dollars. A year later, two Harvard economists, Brian J. Hall and Jeffrey Liebman, took another
look at managerial pay and con-firmed what anybody who followed the financial pages already
knew: CEOs weren?t paid anything like bureaucrats. They were paid more like rock stars.
Wittingly and unwittingly, Wash-ington encouraged the great giveaway. During the 1992
election campaign, Bill Clinton and Al Gore made a polit-ical issue out of lavish CEO pay. A
year later, the new Administration lim-ited to a million dollars the tax deduc-tions that
corporations could take for executive salaries. The reform turned out to be counterproductive.
Since ex-ecutive stock options weren?t counted as regular compensation, corporations had yet
another reason to pay their senior managers less in salary and more in op-tions. In 1994, the
Financial Account-ing Standards Board (FASB), the de-scendant of the Accounting Principles
Board, set out to force companies to deduct the value of the stock options they granted from their
earnings. Fol-lowing an intense lobbying campaign by Silicon Valley companies, several leading
members of Congress, includ-ing Joseph Lieberman and Dianne Fein-stein, threatened to put the
FASB out of business if it went ahead with the change. The board backed down, and the latest
official attempt to control cor-porate avarice came to an end.
The rise of the stock option revolutionized the culture of corporate America. The chief
executives of blue chip companies, who in the nineteen eighties had portrayed Icahn, Pickens,
and their ilk as corporate vandals, now embraced the values of the raiders as their own. For
decades, the Business Roundtable, a lobbying group that represents the CEOs of dozens of major
companies, had stressed the social role that corporations played in their communities, as well as
the financial obligations they owed their stockholders. In 1997, the Business Roundtable changed
its position to read, ?The paramount duty of management and board is to the shareholder.?
In many cases, the CEOs turned into corporate raiders themselves, albeit internal raiders.
Companies like IBM, Xerox, and Proctor & Gamble, acting on their own volition, fired tens of
thousands of workers. Their chief executive insisted that the ?downsizing? was necessary to
compete effectively, and that was sometimes true. But once the CEOs were in possession of
mega options, they had another motivating factor: an enormous vested interest in boosting their
firms? stock price. For the first time, they had an opportunity to create fortunes on a scale
hitherto reserved for industrial pioneers like Rockefeller, Morgan, and Gates. In 1997, Michael
Eisner, the chairman and chief executive of Walt Disney, earned five hundred and seventy
million dollars. A year later, Mel Karmazin, the chief executive of CBS, exercised options worth
almost two hundred million dollars.
The scattered protests at these startling payouts notwithstanding, many economists credited the
doctrine of shareholder value for reinvigorating American business. In spite of fears that
downsizing would devastate communities, the economy thrived, and the total number of jobs in
the country increased. Far form being pilloried, ruthless businessmen ended up being lauded. In
1996, one of the most cutthroat, Albert (Chainsaw Al) Dunlap, wrote a best selling book, ?Mean
Business,? in which he defended the cost cutting tactics he perfected at companies like American
Can and Scott Paper. ?The most important person in any company is the shareholder,? Dunlap
declared. ?I?m not talking here about Wall Street fat cats. Working people and retired men and
women entrusted us with their 401Ks and pension plans for their children?s college tuition and
their own long term security. If we?re not concerned about them every step of the way, we?re
As long as the economy kept expanding and the stock market kept going up, most Americans
were content to avert their eyes from the lopsided manner in which the rewards of the long boom
were being distributed. For those who looked closely, though, there was already evidence that
execu-tive stock options were sometimes being abused. In 1997, David Yermack, an econo-mist
at NYU?s Stern School of Busi-ness, published an article in the Jour...
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