Hoover Daily Report

Preventing Future Enrons

Monday, April 15, 2002

How corporations are managed, not who manages them, is the cause of business fraud. The public, the president, and the media focus on the venality of a handful of executives at Enron as the explanation for that company's collapse. Certainly anyone found guilty of violating the law should be punished, but bringing those individuals to justice alone will not stymie future fraud any more than bringing Osama bin Laden to justice will end terrorism. We need to address the causes, not just the symptoms, of fraud. Fraud never arises simply because of greed; it arises because some corporate governance arrangements give executives incentives to misreport performance in hopes of saving their company's reputation.

Research shows that the chances that a company will commit fraud can be predicted two years in advance. An accounting-fraud analysis, for instance, correctly predicted that Sunbeam, Rite Aid, Cendant, Informix, and Medaphis—to mention just a few cases—were at the highest-risk of alleged fraud. It also identified Enron as a high-risk company in the mid-1990s. Of the 4 percent of firms classified as highest risk, 54 percent have subsequently been accused of fraud; that number jumps to 67 percent if a firm reached the highest risk classification more than once.

The fraud classification system relies on publicly available information, focusing on the incentives directors have to engage in oversight. It can help protect shareholders from fraud and enable boards of directors to restructure firms so that executives have the right performance incentives. Every company is organized around a controlling group that determines policies regarding the allocation of resources and the selection and retention of executives. The power of this group is used to predict leadership's actions.

Companies offer two basic categories of rewards: those that benefit shareholders and those that benefit select groups involved with the company. The mix of benefits offered in these two categories—shareholder benefits and insider benefits—makes the risk of fraud predictable.

The mix in senior management's compensation between rewards tied directly to performance (e.g., stock options) and personal rewards tied to its role in the company (e.g., personal salaries) influences its performance on behalf of shareholders. Likewise, the number of people involved in the day-to-day administration of a company influences the extent to which those individuals identify with the management team or with shareholder goals. Generally, the greater the focus on insider benefits to senior management, the higher the risk of fraud; the greater the political clout of senior management relative to external directors, the higher the risk of fraud; and the greater the commitment to stock options and benefits that encourage a long-term view, oversight, and balance between the influence of management and the board of directors, the lower the risk of fraud.

When auditors review governance structures and books, and are encouraged to consult with their clients about problems in the incentive structures, we will have come a long way toward eliminating fraud. Confidence in business requires that we move in these directions rather than putting our energies into finding greedy individuals to blame for what are manifestly corporate governance problems.