Business Ethics:

Everybody’s Favorite Oxymoron  

Murray Weidenbaum

        Murray Weidenbaum is the Mallincrodt Distinguished University Professor at Washington University in St. Louis where he is also the honorary chairman of the Weidenbaum Center on the Economy, Government, and Public Policy. This article is the text of the Stanley B. Lyss Lecture given on January 30th at Temple Shaare Emeth, St. Louis, MO.  

    It is a great honor to be asked to speak in the Stanley Lyss lecture series on ethics—and I very much appreciate the opportunity. Nevertheless, my pleasure is accompanied by a funny feeling that I have drawn the short straw. Rabbi Stiffman has assigned me the topic of business ethics. I guess it could have been worse. He could have asked me to speak on military intelligence. It turns out that I am a bit of a contrarian on both topics.

        The fact is that the level of business ethics is under serious attack and for very good reason. Almost every day we seem to read about new revelations of corporate malfeasance, accounting fraud, and business conflicts of interest. The wrongdoers are widespread. They have come in every shape, size, and variety. They cover every race, creed, and ethnic group. In the process, many innocent people have lost their reputations, their jobs, and much of their life savings.

        That is very discouraging. It should not surprise us that some people have lost faith in the private enterprise system. Personally, I still strongly believe in the benefits of the private enterprise system. But that does not mean that I support the status quo. I strongly believe that we should throw the book at those business officials who let us down and broke or skirted the law. Some laws need to be strengthened and some traditional practices of business need to be overhauled. Yet I think that it is essential that, in examining the changes that are needed, we look at the donut and not just at the hole—or should I say the bagel.

        I will start with the most basic example of why I still trust the business system. I can go 10,000 miles to the other end of the globe and count on people who never saw me before and probably never will meet me again to provide me with goods and services—in hotels, restaurants, and stores—and they can confidently expect that someone else they never have met will pay them. Less dramatically, I can order from a catalogue and expect the item I requested to arrive without my seeing the person who will send me the item and who will get paid for it by someone else.

        Most of the time, the system works fairly well. Of course, like any human activity, the business system does not work perfectly. But, compared to the millions of transactions that occur daily, very few lawsuits are generated in the process. For most of the business transactions I enter into, I can count on the system working.

        The acid test is that all of the alternative economic systems—feudalism, socialism, Communism—have fallen by the wayside. Capitalism does work, despite the presence of greed and other undesirable attributes. Over much of the twentieth century the capitalist nations fed the Communist countries. On a more mundane level, when I consider the wide prevalence of bribery and favoritism as a way of life in so many parts of the world, the comparison is quite favorable to the level of ethics in American business, warts and all.

        By the way, as someone who has worked in government and the private nonprofit sector as well as in business, I have some experience and hence strong views on the subject of the comparative levels of ethics. I have found saints and sinners in each category. I did not find the average levels of ethics in business, government, and university life to be very different. But there is a great range of ethical behavior in each sector of society. Perhaps the evil doers in business—as well as in government—can do more harm than a professor at a blackboard, but I will not pursue that aspect tonight.

        Some historical perspective is also useful. Enron may have been a high point—or rather a very low point—in business behavior, but it did not invent business corruption and chicanery. Back in the 18th century, while working at the East India Company, Robert Clive accumulated a personal fortune of 280,000 pounds (that was a multi-millionaire’s fortune in those days; a pound was really worth a pound). Clive successfully transferred all of his ill-gotten gains from India to England. Worse than that, employees of the East India company sold opium to China and smuggled into Europe the goods they received in turn. In one of the worst examples of Western imperialism, England used its military power to force China to accept and use the opium. Talk about a modern military-industrial complex!

        The economic historian Charles Kindleberger also reminds us that, in the nineteenth century, business corruption was so much a fact of life that it became a prominent theme for popular novels. He cites the works of Balzac, Dickens, Thackeray, Trollope, Dumas, Zola—and our own Mark Twain.

        The twentieth century produced its full quota of villains. The Boston swindler Charles Ponzi obtained a special type of immortality. He invented the infamous Ponzi scheme. The Teapot Dome scandal in the Harding Administration was a vivid reminder of how low personal behavior in government could fall. Back in the private sector, Bernie Cornfeld created and looted Investors Overseas Services. Ironically, supposed savior Robert Vesco outdid Cornfeld in the outright stealing of investors’ money.

        None of this is meant to be an apology for the shortcomings of the status quo. Rather, each of these episodes led to reforms changing prevailing business practices. At least temporarily, those reforms restored public confidence in business. This historical discussion is a prelude to my fundamental point: we must raise the prevailing level of ethics in our private, as well as public, activities.

        Moreover, I start off with a positive and not a negative outlook. In good measure, that is because any study of the history of American business demonstrates the continued ability of the system to change and improve itself. Here are a few examples of important changes in corporate governance that American companies have made voluntarily, without any legislative action by the government:

        1. In 1977, the New York Stock Exchange required every company listed on the exchange to set up an audit committee. Each committee must consist only of outside directors—members of the board of directors who are not members of the management. Until 1977, many companies did not have an audit committee.

        2. In the 1980s, most larger companies shifted the composition of their boards of directors from management domination to consisting of a majority of outside directors. By then, audit committees became universal.

        3. By early 2002, many companies reduced or eliminated the consulting work that they assign to their outside auditors. In August, Congress legislated specific restrictions.

        4. In the same year, some companies began to treat stock options as a current expense of doing business. However, many companies continue to bury these important transactions in obscure footnotes.

        Of course, these changes are not a panacea to cure all of the shortcomings in the conduct of business corporations. But they do illustrate the capacity of the system to improve itself and to correct its shortcomings.

        As a corporate director, I can report a very substantial change in basic attitudes. Enron is now a vital presence in every boardroom. Arthur Andersen is an equal presence in every audit committee. There is a very substantial reputational cost to business malfeasance. To put the matter bluntly, no corporate director wants to suffer the bitter experience of the Enron directors. Because they were asleep at the switch, they are now pariahs. In addition to being sued, they are being kicked off the other boards they serve on, not for anything they did at these other companies—but just because they were Enron directors. Having served on the Enron board literally has become a badge of shame.

        Pushed by the requirements of recently passed laws—as well as their desire to maintain their reputations—the members of the typical board are changing the way it operates. They are taking the audit process much more seriously. Rather than just rubberstamping the decisions of the management, they are much more involved in choosing the outside audit firm.

        These audit firms are feeling their oats, exercising greater independence. They are not as anxious to please the management. As someone who has served on many audit committees, I know that a strong and effective audit committee can blow the whistle on bad corporate practices. In two cases, our work in the audit committee led to replacing the CEO.

        Nevertheless, I strongly believe that important changes are needed at the top. In too many cases, we have seen the abuses committed by the imperial presidency in business. Actually, the president is no longer top dog. It is the chief executive officer (CEO) who, in most cases, also serves as the chairman of the board of directors. On the surface, that sounds like a very efficient system—and often it does work very well.

        However, Tyco furnished a cogent example of the excesses of the imperial CEO who is possessed with unlimited greed. He charged the company for all sorts of personal extravaganzas. We have all read about the $6,000 shower curtain and, my favorite, the full-size ice replica of Michelangelo’s David that spewed forth vodka. We also learned about the great generosity of General Electric to its outgoing CEO. It is interesting to note that, when the details became public, the ex-CEO voluntarily gave back some of the goodies.

        Yet, when we look at the money involved, the cost of these personal items, expensive as they were, pales into insignificance when we look at the trend of direct executive compensation. In quite a few cases, literally hundreds of millions of dollars of income were conferred on the top management in a given year. What truly hurts is that often the great liberality of these payments had little relationship to the performance of the company. To take one egregious example, in 1998 the senior management of Bankers Trust Company received $1.1 billion in bonuses. The company lost $6 million that year.

        How can we deal with this concentration of executive power? There are no simple solutions. It is important to avoid what unfortunately has been the standard response to business shortcomings in the past: quickly enact more laws without carefully analyzing how they would work in practice. Analysis should come before action.

        I suggest that the place to start is at the top of the business hierarchy. The shareholders select the members of the board of directors. The basic role of the board is to select and compensate the chief executive and to oversee management’s conduct of the business. Yet, most of the time—in nine cases out of ten for the largest corporations—CEOs chair the board. That means that they conduct the board meetings at which this oversight is conducted. It may not be a legal conflict of interest for CEOs to chair the boards that evaluate the CEOs’ own performance and sets their pay, but, to put it mildly, the situation leaves me very uncomfortable. It does not really help to ask the CEO to leave the room when those specific matters are taken up. When the CEO comes back to the room, he or she is in charge once again.

        Granting too much authority to the CEO can be dangerous. But there are limits to the constraints that should be placed on the ultimate leader of any business. An effective enterprise requires a strong CEO. No committee—and that is the organizational form of any board of directors—can or should try to run a business. Every director should understand that the CEO is the day-to-day leader of the enterprise and provides its public face. That does not, however, require a weak or passive board.

        Of course, no CEO is going to volunteer to give away some of his power. The ideal time for the board to make the change to an outside chairman is when they choose a new CEO. In any event, the business community has to face up to and deal with the loss of public confidence. In July 2002, the Harris Poll reported that only 14 percent of the population believed that the typical CEO of a major corporation is more honest and ethical than the average person. A whopping 71 percent said they thought the CEOs were less honest than the average person. If the business system is going to regain the support of the American public, it will have to raise its ethical values and improve its performance.

        I do not mean to focus exclusively on the CEO and ignore the rest of management. A CBS-New York Times poll also in July reported that two-thirds of the American people did not believe that American corporate executives are honest. Only 27 percent said they were. From my own personal experience, I believe that the public is overreacting. I should also note that the Harris poll reported that religious leaders are rated very high for moral and ethical standards—higher than the media, Congress, or business. The only group with a higher ethical rating—remember, I’m just reporting the Harris Poll—were “members of the Bush Administration.”

        More attention needs to be focused on the role of the board of directors. In the midst of rising public criticism of business, the truly independent members of corporate boards must play a more vital role in assuring an ethical operation. The board must take the necessary steps that convince shareholders and society as a whole that the business is being responsibly and honestly managed. Most directors take their role very seriously. It is the lapses from good practice, however, that attract attention and give business a bad reputation.

        In this regard, several director-selection practices should be avoided because they reduce the independence of the board. Examples include celebrity directors who do not understand the basics of corporate governance; overly committed directors who serve on six or eight or more boards while holding down a full-time job; and personal friends of the CEO. That practice still continues. The new corporate finance reform law only deals with directors who simultaneously serve as high-priced consultants or suppliers to the corporation. Of course, they do not qualify as independent outside directors.

        Although recent legislation requires some useful changes in the audit committee, it ignores the vital role of the compensation committee. That’s OK. It is not a task for the government to set the rules for compensating the management of a private enterprise. It is an important task for the board of directors and its compensation committee.

        Unfortunately, that key committee often falls short in exercising its responsibilities. Let us take up the vital case of who advises and assists the compensation committee in its work. Substantial technical effort is required to identify and measure the performance of the “peer” group against which the company’s management will be compared. Also, considerable amounts of data and analysis are needed to determine what are the prevailing trends in the composition of the senior executives of U.S. companies—and especially to relate compensation to performance.

        In too many cases, the management itself selects and determines the pay of the outside consultants who will do all this work for the compensation committee. Whether or not it is a formal conflict of interest, it seems quite unethical for the management to select the people who draw up their compensation plans and then advise the board on these same compensation matters. The compensation committee—which is usually and should be limited to independent outside directors—should choose the people who advise it and determine how much they get paid.

        There’s something else that needs to be done. There is an old saying: sunlight is the best disinfectant. Recall that the unusual compensation package of the recently retired CEO of General Electric was scaled back just as soon as the details became public. It should not have taken a messy divorce case to get that information to the shareholders.

        I would like to emphasize the role of competition. Far from rewarding naked greed, competition in the marketplace encourages good practices and fair dealing. One obvious measure of the intensity of marketplace competition is that three out of five new businesses fail. Capitalism is a profit and loss system. The fear of losing customers is a major restraint on fraud. As Adam Smith taught us, “honesty is the best policy.” Contrary to the common opinion of that wily Scot, Smith gave the better part of his fortune to charity.

        Let us turn to a more contemporary version of Adam Smith—Milton Friedman. Friedman has been widely criticized for a famous article of his in the New York Times Magazine. The theme of the article was that the function of business is to make a profit. I doubt if many of the critics read the full article. In the text, Professor Friedman points out several vital limits to the concentration on profit:

        1. The company must obey the rules set by society (i.e., government).

        2. It must engage in open and fair competition.

        3. It must not practice deception or fraud.

        The Enrons, Tycos, WorldComs, etc., violated the basic Friedman rules on business ethics.

        The reconciliation of honesty and personal advantage is not easy. At one extreme, a modern society could not function if nobody were trustworthy. But, on the other hand, how many of us would work as hard as we do without the incentive of earning a living and otherwise promoting our own self-interest. The market is based on that duality. In fact, this dynamic tension between integrity and self-interest has been called the “market paradox.”

        My final point is to make a vital distinction—between the dramatic shortcomings of individuals in business and the overriding benefits of our system of private enterprise. Of course, society should impose severe punishment on the scoundrels who lied, stole, and cheated their employees, shareholders, and the public. But we should also remind ourselves of the vital contribution that the business system regularly makes. We take most of those benefits for granted. We shouldn’t, especially when we look around the world and see so many countries suffering starvation and deep poverty.

        The noted theologian Michael Novak reminds us that, like no other economic system we know of, the American system of private enterprise is the basic provider of jobs, income, and wealth in our society. I like to quote Dr. Novak because a few years ago my wife Phyllis and I toured Jerusalem with the Novaks. He also reminds us that government plays a vital role but it relies on the income and wealth produced by the private enterprise system to carry out its important functions. So do the vital nonprofit religious, educational, cultural, and medical institutions.

        Moreover, an economy consisting of thousands if not millions of individual enterprises means that power is decentralized in our country. It may sound so uncoordinated if not wasteful to have many different companies, nonprofit institutions, and levels of government in the United States. But that is the basic way we maintain our political as well as economic freedom. That decentralization assures us that no group has a monopoly on power in our nation.

        If the notion of the decentralization of power sounds too theoretical, just consider the situation of religious minorities such as our own. Our congregation did not have to get the approval of a governmental bureau of religious affairs nor do we rely on government for our funds—as is true in countries where government possesses more political and economic power. Nor do our educational and social activities depend on the sufferance of the state.

        Those who want to eat kosher foods do not have to get special approval from a government agency. Recall how the Soviet Union on occasion relented and made a distribution of matzos on Passover. In our country, private enterprises are free to produce and sell almost any kind of food or religious articles that Americans want to buy. As for matzoh, you can buy Manischewitz or Goodman’s or Horowitz Margareten or Streits. You can get it plain or salted, machine baked or hand baked, made at home or imported.

        Because the continuance of public support is vital to the future of our private enterprise system, maintaining a high level of business ethics is a vital concern to us all. In considering future reforms of the business system, we need to realize the close connection between personal freedom and economic freedom. We foster one as we pursue the other.     Ω