More Reform and Less Hot Air

By Daniel Eisenberg

When it comes to cracking down on corporate crime, retribution seems to be the order of the day in Washington. Not long after Treasury Secretary Paul O'Neill spoke of hanging wayward CEOs from the highest tree, President Bush announced the formation of a "financial-crimes SWAT team." Unfortunately, the proposals most likely to pass into law have more bark than bite. Here's a look at some solutions that are more than just tough talk.

1. MORE ORANGE JUMPSUITS

President Bush last week called for doubling the maximum prison term for mail and wire fraud to 10 years. But the problem isn't the length of the sentence handed down for corporate malfeasance; it's winning a criminal conviction in the first place. Financial misdeeds are often difficult to explain to juries, and proving intent is even harder. More money for investigators would help, but the new $100 million that Bush pledged for the Securities and Exchange Commission is not nearly enough for the underfunded agency.

There is similar posturing in Congress but also some substantive proposals. An amendment introduced by Senator Patrick Leahy of Vermont would make it a felony to defraud shareholders--making it easier to prosecute executives--and also provide more protection to whistle-blowers. Another proposed law would make CEOs liable for the accuracy of their firm's financial statements, a measure supported by nearly 90% of those surveyed in a new TIME/CNN poll.

2. GET RID OF PET-ROCK BOARDS

Even with the improvements of recent years, too many corporate boards of directors still serve as little more than puppets of management. Bush only briefly touched on this in his speech, calling for a majority of each board--and for all members of its audit, nominating and compensation committees--to be "truly independent" and to "ask tough questions." But this should be spelled out further. Independent should mean more than someone who doesn't work for the company; it should exclude anyone who has a consulting gig or supplier deal or who has recently left the company--as the New York Stock Exchange recently proposed.

Board members also need to stop spreading themselves thin on five or 10 boards at a time. They should be subject to 10-year term limits and annual elections. The terms should not be staggered, so shareholders can throw out all board members at once if they wish. Companies should be required to give shareholders election materials about rival candidates; as it stands, small investors who want to wage upstart campaigns don't stand a chance.

To avoid getting too cozy with management, directors need to meet regularly by themselves and with auditors without any of the company's top executives present. They should appoint a lead independent director to balance the power of--or even serve as--the chairman, who these days too often happens to be the CEO. (That should not be allowed.) Finally, directors should be paid primarily with long-term grants of stock, rather than collect a check for showing up occasionally. At AutoZone, a $5 billion-a-year parts-supermarket chain, each board member must invest at least $100,000 in company stock within three years of joining.

3. PRICE THE OPTIONS

Executive pay is out of control. The proposal from President Bush and Congress to bar company loans to executives would help address the problem. Another good idea is letting shareholders approve every grant of stock options. But it's the kind of compensation--in the form of stock options--and the perverse incentives that come with it that pose the biggest concern. Because most corporations do not deduct the cost of options from their bottom line, CEOs have no reason not to stuff their pockets with options. So far, Bush has declined to address this crucial accounting issue, and Arizona Senator John McCain's attempts to push it were blocked last week. But in an encouraging development, West Coast real estate firm AMB Property just became one of the few U.S. companies (along with Boeing and Winn-Dixie Stores) to deduct the expense.

One reason options are troubling is that they encourage executives to expose the company to more risk than they would otherwise; executives have much to gain from reckless or shortsighted tactics and little to lose. Paying top executives mostly in restricted stock would force CEOs to "ride it up and down," says Charles Elson, director of the Center for Corporate Governance at the University of Delaware. And prohibiting CEOs from selling their company stock until after their tenure has ended would remove the incentive to manage earnings for the short term. McCain has called for such a restriction, which 70% of TIME/CNN poll respondents support.

4. STOP BRIBING AUDITORS

Much of the mischief by accounting firms stems from the dual role they often play: as auditors sworn to serve shareholders and as consultants paid much more to please management. Several bills in Congress take aim at the accounting industry, promising increased oversight. None yet propose the full separation that is needed between auditing and consulting firms, as McCain called for last week, but the bills at least stipulate that public companies should not be allowed to have the same firm do both its auditing and its accounting--a proposal endorsed by more than 70% of those polled by cnn and TIME. Auditing firms--or, at the very least, their employees--should be rotated from client to client every few years. Most important, auditors should give detailed statements explaining how aggressive or conservative their client's accounting is, rather than simply signing off on it.

5. END STOCK PIMPING

One had only to witness the grilling that Salomon Smith Barney analyst Jack Grubman endured at the congressional WorldCom hearing last week to get a sense of how low Wall Street analysts have sunk. Too many stopped providing objective stock research to investors long ago, instead spending the bulk of their time helping woo investment-banking business. New York State attorney general Eliot Spitzer has made some small progress toward cleaning up the industry: increasing disclosure of conflicts of interest and separating analysts' compensation from specific investment-banking deals. But those are half measures. The best solution would be to separate investment-banking businesses completely from research, as McCain has proposed. But the financial firms and their pet lawmakers will probably block such a reform. Still, analysts' pay should be based entirely on the performance of their stock picks, and investment banking divisions should have their own, separate army of analysts to work on deals.

6. UNLOCK THOSE 401(K)S

One way to help potential victims of corporate crime is to give employees more power to diversify their 401(k) plan and not get stuck with a rotten nest egg. The Senate is considering legislation that would allow workers to sell company stock after being at a firm for three years. It would also require companies to disclose any planned insider stock sales.

All these measures may help a bit, but they will not do the job entirely. Companies need to stop using a dizzying array of earnings measures, from pro forma and cash to EBIDTA, and focus on a uniform standard that doesn't give a misleading picture of the balance sheet. Also, many observers, such as John Brennan, CEO of mutual-fund giant Vanguard, think earnings should be reported only semiannually so that business can be run for the long term. And without changes in the current, complex tax code, which practically encourages companies to play games, many think the skulduggery will continue. But in an election year, politicians are relieved that--so far, at least--most of the blame is sticking to management.

--Reported by Julie Rawe and Eric Roston/New York and Adam Zagorin/Washington, with other bureaus

With reporting by Julie Rawe and Eric Roston/New York and Adam Zagorin/Washington, with other bureaus