CEO Crime & Punishment

[This is a guest post from my business partner, and co-founder and CEO of Opsware Inc., Ben Horowitz. Ben has been CEO of a US public company since March 2001.]

As CEO of a public company who grew up in the People’s Republic of Berkeley, one question I get from a lot of my old buddies is, “Why are there so many criminals in corporate America?”

Given the high-profile scandals that led to massive securities law reforms such as Sarbanes-Oxley, and the more recent stock option accounting imbroglio, this is a good question indeed.

Warren Buffet once said that “marrying for the money probably isn’t a good idea in any case, but if you are already rich, it makes no sense at all.” The variation that applies to CEOs is “robbing investors probably isn’t a good idea in any case, but if you are already rich, it makes no sense at all.”

So, why all the fraud? Are CEOs just natural crime bosses who have found a better hustle?

While there has been much written — justifiably — about the real and devastating impact of corporate crime on employees, investors, and our society as a whole, there has been little written about why these crimes were committed. As I explore that question, please realize that I am not endorsing these actions, but trying to understand and explain them so that they might be prevented in the future.

To find the answer, we’ll first take a look at regular old run-of-the-mill corporate crime; you know, the Enron, WorldCom, Qwest variety. Then, we’ll delve into the very special case of stock option accounting.

What were Bernard “Bernie” Ebbers, Kenneth “Kenny Boy” Lay, and Joe “this guy doesn’t even need a nickname to sound like a crime boss” Nacchio thinking? What motivated such legitimately rich and powerful men to risk and ultimately lose everything?

To find that out, we have to examine what motivates CEOs in general. Is it pure greed — the burning desire to have more money than Bill Gates? 
Surprisingly (at least for anyone who watches TV or movies made in Hollywood), the answer is: not necessarily.

What motivates most CEOs — not all, but most — is some combination of winning and, as a result, building something great. Building a great institution, a great place to work, a great place to do business with, and a great investment. This is what’s most motivating and what’s most gratifying. And what they’ll fight to hold on to most dearly. And this is where the crime often comes in.

So if winning and building motivate CEOs, how does this lead to crime?

While every case is different, and specific degrees of guilt vary widely, let’s use as an illustrative example the case of Bernard “Bernie” Ebbers and his motivation to build a huge company. In case you aren’t familiar with Bernie’s crime, accounting fraud at WorldCom during Bernie’s tenure led to the largest bankruptcy ever. And Bernie got sentenced to 5 nickels hard time.

But the curious thing about Bernie was that he didn’t sell any of his WorldCom stock while he was committing this fraud. In fact, he got himself into massive personal financial crisis by borrowing $366M against his WorldCom stock to avoid selling it. If Bernie committed this crime out of personal greed, how do you explain that?

Bernie was the classic American success story. He came from humble beginnings. He dropped out of college twice prior to graduating from Mississippi College. He began his career as a high school physical education teacher. He worked as a milkman by day and a bouncer by night. He built himself up from nothing to arguably the most important and powerful man in the multi-trillion dollar telecom industry.

As WorldCom grew at a rapid pace, Bernie set expectations high. This led investors to give him advance credit, thus boosting his stock, which was the currency he used to build his company. When Bernie saw that WorldCom wasn’t going to meet those high expectations, and that thousands of shareholders to whom he had promised great performance would lose their money, and thousands of employees who he had hired would lose their jobs, he was willing to do anything to make things right. Even if it meant doing things that were wrong.

Like a killer committing his second murder, the decisions to commit fraud must have come easier as Bernie gained experience. In addition, the stakes continued to get higher. He continued to commit fraud, because if he hadn’t, there was a 100% chance that he would let everyone down who mattered to him and he would no longer be the person that he had worked so hard to become. He wouldn’t be Bernie Ebbers #11 in Time Magazine’s Cyber Elite; he’d be Bernie Ebbers, former milkman, bouncer, and disgraced CEO.

By committing the crime, he was taking a chance that something much worse would happen (i.e. jail), but he was willing to take that risk. He very likely talked himself into thinking that he wasn’t taking much of a risk at all. Bernie’s conversation with himself probably went something like this: “The accounting is complex and I can argue the accounting treatment either way. I am a good person. I have donated enormous amounts of money to charity and done outstanding work with my church. I care more about others than I do myself. Since a good person would not commit accounting fraud and I think that this is a reasonable approach, I am not committing accounting fraud.”

Much like blue collar crime, there is no flashing sign that tells you when you enter into the world of white collar crime. When somebody has five drinks and then walks to their car to drive home, it’s likely that nobody tells them they are drunk and about to commit a crime. When Bernie agreed to financial treatment that made the numbers but wasn’t quite right, his team might not have pointed out that he was crossing the line.

Of course, accounting fraud and bankruptcy in the telecom sector did not begin and end with Bernie. Bernie just got the ball rolling. There were also bankruptcy and/or accounting issues — the two tend to go together even if not publicly — at Qwest, Exodus, and Williams Communications to name three (there were many more).

This is where the “winning” part comes in. The burning desire to win is why corporate crime becomes contagious. This will be important when we get into stock option accounting.

Once WorldCom started committing accounting fraud to prop up their numbers, all of the other telecoms had to either (a) commit accounting fraud to keep pace with WorldCom’s blistering growth rate, or (b) be viewed as losers with severe consequences.

How severe were the consequences for not breaking the law? Well, like a baseball player who refuses to take steroids, CEO Mike Armstrong of AT&T did not keep pace with the cheaters. As a reward for his honesty and integrity, he was widely ridiculed in the press prior to being fired and AT&T, perhaps America’s most valuable brand, was acquired for cheap. Now you see why Barry Bonds needed something to help him keep pace with Mark McGwire.

So how do CEOs avoid committing accounting fraud? There are a few important keys:

  1. Be clear with yourself –- As CEO you must realize that every incentive for every employee in the company drives them to make the numbers. The only counterbalance to all those incentives is the law. But the law is not always crystal clear, so the company looks to the CEO to make the final call.
  2.  

  3. Be clear with others –- It’s important to let the people who account for the business know that they are not responsible for making the numbers; they are responsible for reporting them accurately. I always say to my finance people: “we may whiff a quarter, but we are not going to jail.” It may seem silly to have to say that, but it’s critically important for everyone in the company to know that the CEO is not asking them to push the legal limits.
  4.  

     

  5. Stay away from the gray –- It’s very tempting to be “aggressive” when making an accounting judgment, but it’s also very dangerous.
  6.  

     

  7. Organize to stop fraud –- One of the most important things that your friendly blogger pmarca insisted upon when we started our company was to make sure that the General Counsel reported directly to the CEO and not to some other executive. When things go bad in the company, it’s important that the organizational structure enables you to find the badness rather than hiding it.
  8.  

     

  9. Heed advice of JaMarcus Russell’s mom — she says: “trouble is easy to get into, but hard to get out of.”

 

Now, it is true that many disgraced CEOs did sell stock as their companies tanked — including Ken Lay and Joe Nacchio. But in many cases they didn’t sell a majority of their stock, and I think that if you could peer inside their heads, you’d be surprised how much they also believed they were building great companies even as things went badly wrong.

Let’s move on from the most egregious crimes to the most common. There are at least 139 companies under investigation for stock option accounting issues. Holy crap. That’s a lot of investigations. What the hell happened?

Well, for starters, 139 investigations doesn’t mean that there were 139 crimes committed.

If a company has a stock option accounting issue, there are generally five possibilities:

  1. The company had a bad policy which did not comply with the rules.
  2.  

  3. The policy was poorly administered and, as a result, options were priced inconsistently.
  4.  

     

  5. The policy was poorly administered and, as a result, was manipulated by employees –- employees worked around the rules and gave themselves extra money.
  6.  

     

  7. Executives attempted to get employees better stock prices by violating the rules.
  8.  

     

  9. Executives attempted to get themselves better stock prices or tax treatment by violating the rules.

 

Let’s dive into the case of the moment.

Greg Reyes, former CEO of Brocade, is currently on trial for stock option accounting fraud. Greg Reyes is an extremely smart guy and, by almost all accounts, an extremely good guy. He has not been accused of manipulating stock options to his benefit. In fact, the only benefit that Greg Reyes got for the alleged “backdating” was better deals for some of his employees. Now, you might argue that those better deals were very valuable and helped the company, etc, but here’s the issue: a CEO worth a billion dollars risked jail for what? Better option packages for a few employees? Does it make sense to you that a guy who is known for his ability to pick the risks with the highest reward would do the corporate equivalent of ghost riding? I don’t think so. No, I think that it’s pretty clear that one of two things is true:

  1. Mr. Reyes, as he credibly claims, did not know this particular corner of accounting law and received either particularly poor advice or no advice.
  2.  

  3. Mr. Reyes understood the rules, but did not fully understand the consequences of breaking the rules and grossly underestimated the price of moving the date on a stock grant.

 

Or perhaps a little of both.

So why would a CEO be ignorant of the law?

Unlike the crimes committed by Bernie and Kenny Boy, it’s not clear that investors either cared much or were meaningfully hurt by moving someone’s grant date and the impact of the associated non-cash charge. In fact, with the introduction of FAS123R, the accounting differences between the dates in question become quite small (although the tax differences are stark).

Perhaps more importantly, there were no cases of stock option accounting irregularities until very recently. It’s hard to become an expert in a law when there is no case law to motivate and illustrate.

Even if Greg Reyes was ignorant of the law, why didn’t he have someone advising him who knew the law? I mean we’re talking about Brocade, an important public company. Surely he had top-notch accountants and legal counsel explaining the law to him.

Well, you would think so, but stock options are compensation and compensation is in the domain of Human Resources. It turns out that many HR executives believe that they have a working knowledge of accounting and the law as it relates to employee matters. It also turns out that these same HR executives do not know what they are talking about when it comes to accounting and the law beyond a very surface-level understanding.

As a CEO, you must rely on your General Counsel to protect yourself and the company in matters of the law. You cannot defer to a HR executive who knows “best practices.” Those best practices may well be illegal. As Warren Buffet says, “The five most dangerous words are: ‘Everybody else is doing it.'”

So, by running his business in the “normal” way, Greg Reyes may have gotten himself into some seriously abnormal trouble.

In any case, this alleged crime falls into a category well known by governance experts called “the price of not paying attention.”

If you’ve been paying attention, you’ve probably realized that the new wave of corporate crime has been disproving the old adage that rich and powerful people don’t go to jail. Sure, rich celebrities like OJ, Baretta, and Jacko commit heinous crimes and get off with no consequences, but corporate criminals such as Bernie, Kenny Boy, and No Nickname Required do hard time. Is this fair?

Well, while murder seems like a much more serious crime than stock option accounting fraud, keep in mind that corporate crime is contagious. If Greg Reyes grants in-the-money options to his employees and I don’t, then I am at a competitive disadvantage. If you are a CEO, you either hate competitive disadvantage or you won’t be a CEO for long. As a result, corporate crime is contagious and creates issues of systemic integrity.

Pete Rose was locked out of the baseball hall of fame not because betting on baseball was the worst crime he could have committed, but because if left unpunished it would jeopardize the integrity of the game.

When a public company CEO commits a crime, she jeopardizes the integrity of the financial markets and the competitive market. And that’s no bueno.