8 Remedies

By Daniel Kadlec

Is corporate America falling apart? Each day brings sordid details of dirty dealings at the highest levels of what were once our most respected companies. The sleaze at Enron and Arthur Andersen shocked us. Now it's Tyco's turn, and it won't be the last.

Corporate shenanigans have ended badly on many fronts: bankruptcies, lawsuits and vaporized 401(k) plans. They have also created a general disillusionment with the stock market, which continues to slide even in the face of mounting evidence that the U.S. economy is recovering. That just doesn't happen. Since 1927, when this sort of record was first kept, not once has the market been down six months after the end of a recession. Yet the S&P 500 is down 10% this year--just shy of six months from when the economy first started to perk up.

The deepening erosion of investor trust moved the New York Stock Exchange (N.Y.S.E.) last week to propose rules requiring that a majority of a company's directors have no ties to the company and that shareholders approve all stock-option plans. Henry Paulson, the normally low-profile chairman and CEO of Wall Street giant Goldman Sachs (Tyco's financial adviser), was one of many business leaders ringing the bell for reform. "American business has never been under such scrutiny. To be blunt, much of it is deserved," Paulson said in a speech calling for curbs on when a CEO can profit by selling company stock, among other things.

Even Harvey Pitt, the chairman of the Securities and Exchange Commission, who has been criticized for inadequate policing of the markets, has called for a "massive restructuring of the regulatory regime." Here is a blueprint for how to go about it:

--GET BOARD MEMBERS OFF THEIR BACKSIDES For a company's board of directors not to know or care that its CEO uses company money to buy expensive art and personal digs on Fifth Avenue--as is allegedly the case with Dennis Kozlowski at Tyco, where the board is stacked with insiders--is an egregious breakdown. "It amazes me that you can take 10 or 12 intelligent people and put them in a boardroom, and their IQ drops by half," says shareholder activist Nell Minow.

The N.Y.S.E. proposals in this area are sound: more than half of a board should be independent of management, and those directors should make up all of the audit, nominating and compensation committees. But the proposals don't go far enough. Board members should buy a large chunk of a company's stock as the price of entry, and be paid only in shares or options with long vesting periods. Nothing promotes rigorous oversight like an economic stake. There needs to be a clear definition of "independent" director to exclude those who even indirectly receive any benefit from the company beyond their director's fee.

Board members should meet without management present and should have an open line to operations managers to allow for independent analysis and frank discussion. Directors should not serve more than 10 to 15 years. And the CEO should not serve as chairman. An exemplary board is the one at retailer Target, where 10 of 11 directors have no other ties to the company and directors may serve only 15 years or until age 68. CEO Robert Ulrich allows executives to correspond directly with the board, without going through him.

--DON'T LET FAT CONSULTING FEES CORRUPT CORPORATE AUDITORS The accounting firm Arthur Andersen earned $54 million a year in fees from Enron, making about as much for auditing the books as it did for consulting work. Andersen basically blessed its own advice. And guess what might have happened to those consulting fees if Andersen had stood up to Enron over questionable bookkeeping? The auditing and consulting functions should be performed by separate firms, and auditors should be replaced every three years. The U.S. should also move to "principles based" accounting standards like those in Europe. America's "rules based" approach, known as GAAP (generally accepted accounting practices), has proved so ineffective that China recently rescinded plans to move in that direction. A standard based on the spirit of the rules, not the rules themselves, is already practiced at a few U.S. firms, including Pfizer. "Around here, if you can see the line, you've gone too far," says Pfizer chief financial officer David Shedlarz.

--REIN IN CEO PAY In 1980 the average CEO made 40 times the pay of the average factory worker; by 2000 the ratio had climbed to 531 to 1. This is silly. Talented executives are not that rare. The problem is that too many boards demand someone who has already been a CEO somewhere else, to avoid the criticism that would follow if a rookie CEO didn't work out. So we get a transient band of failed leaders like Michael Armstrong at AT&T and Joseph Nacchio, most recently at Qwest. Whenever possible, companies should promote from within, as at IBM and GE. One immediate improvement would be to index the price at which a CEO can exercise stock options so the options have value only when the stock outperforms a peer group. And as Paulson said, CEOs should be required to disgorge any profit from stock sales in the 12 months before a bankruptcy filing.

--MAKE COMPANIES ACCOUNT FOR EXPENSES THEY INCUR WHEN THEY GIVE STOCK OPTIONS TO EMPLOYEES Currently, stock options do not count as a corporate expense, even though by granting them companies dilute the holdings of existing shareholders--a real cost. Experts such as Warren Buffett and Alan Greenspan have argued that all publicly traded companies should count stock options as an expense. Yet today among big companies only Boeing and Winn-Dixie do so. Why? The current system is so lucrative for company executives, who reap the lion's share of stock options, that few will make the change unless forced. This was not a big deal a few years ago. But this "free money" led to gigantic options grants in the '90s--and now, by some estimates, the cost to shareholders is double what it was just two years ago.

--STOP COMPANIES FROM MAKING LOANS TO EXECUTIVES A company is not a private bank. Kozlowski appears to have borrowed millions of dollars. WorldCom CEO Bernie Ebbers borrowed hundreds of millions. The Rigases, controlling family members at cable giant Adelphia, borrowed billions. In each case, shareholders have been left holding the bag. So let's change the rules. Executives get paid well; let them go to the bank and put their home in hock like the rest of us. And end the practice by which executives at Enron and Tyco have sold stock back to the company, rather than on the open market, to avoid legally disclosing the sale for as long as a year--while exhorting others to buy.

-STOP TAXING FOREIGN INCOME U.S. firms are lining up to reincorporate in Bermuda for one reason: as offshore companies, they will avoid tax on income earned outside the U.S. It is time to recognize that business has gone global. Companies should pay tax only where they earn money. Congress is debating restrictions on offshore relocations. Better to eliminate the tax on foreign income; then such companies as toolmaker Stanley Works will stay in the U.S., and more foreign firms will relocate here. Company tax savings will flow to the bottom line, leading to a higher price for shares, which when sold trigger capital-gains tax and offset lost government revenue.

--MAKE STOCK ANALYSTS WORK FOR INVESTORS New York Attorney General Eliot Spitzer got a lot of political mileage out of a settlement with no teeth. He forced Merrill Lynch to pay $100 million after he showed that its analysts touted stocks to win investment-banking clients, even though the analysts regarded the stocks as poor investments. Under terms of the deal, however, analysts still work with bankers and indirectly share some of their bonus money. Disclosure of conflicts of interest has improved, as has analysts' willingness to speak in language we all understand (e.g., "sell"). But to really fix the problem, analysts should not be allowed to work with their firms' bankers and should be compensated according to how well their advice works out.

--TAKE RESPONSIBILITY Many people also contributed heavily to their own misfortune--by blindly jumping into the latest tech stock or failing to diversify. If you don't have time to research investments, stick with diversified stock and bond mutual funds. "If you ever again buy a stock like Adelphia, where five of nine board members were family," says Minow, "you deserve what you get." --With reporting by Jyoti Thottam/New York

With reporting by Jyoti Thottam/New York