Copyright Kluwer Academic Publishers
Oct 2002
| [Headnote] |
| ABSTRACT. This paper discusses internal dynamics of
the firm that contribute to the failure of knowledge conditions, using the
Enron scandal as a case study. Ability of the board to effectively monitor
conduct at operational levels includes various dynamics: senior management
being isolated from those at operational levels; individuals pursuing
subgoals that are contrary to overall corporate goals; information flow
along a narrow linear channel that effectively forecloses adverse
information from getting to senior management; a corporate culture of
intimidation, discouraging open expressions of doubt or skepticism,
resulting in reluctance to challenge senior officials, and pushing the
limits of ethics and the law. |
| [Headnote] |
| Elements of information blockage in the corporation
include: the "law of diminishing control"; deliberate concealment of
information by officers; motivation to report to the boss what one
perceives the boss wants to hear; theory of "bounded rationality" that
explains surprising role of irrationality in decisionmaking - unconscious
emotions and motivations. Discussion of behavioralist studies of cognitive
dissonance, belief perseverance, confirmatory bias,
|
| [Headnote] |
| entity effect, motivated reasoning, group cohesion or
"groupthink," and the false consensus effect. Problem of overoptimism -
tendency of many people to overrate their own abilities, contributions and
talents - and tendency toward puffery and dismissal of risks in
formulating disclosures and press releases. |
| Imposing liability on directors for failure of
oversight is extremely difficult to sustain in a court of law. Directors
are likely to face much greater demands of accountability in the wake of
Enron. Solutions to enhance flow of information include programs to
encourage employees to expose wrongdoing without fear of retribution;
devising of communication system that enables important information to
move upward to the proper decisionmaker without getting distorted;
restructuring of audit committees, providing adequate training for new
directors, expanding the number of independent directors on the board. In
the wake of Enron, corporations may simply have no choice but to meet
increased demands by workers, shareholders, customers and the government
for greater accountability. |
| [Headnote] |
| Appendix to paper discusses the history of the
corporation, moral dilemmas of the shareholder-centric model, and whether
important social goods sometimes trump the notion of profit-maximization.
|
Introduction
We can understand the dissemination of information
within a corporation only if we can understand the realities of behavior within.
The focus of this paper will be on the internal dynamics of the corporation. I
will address selected issues involving the failure of knowledge conditions that
arose from the Enron implosion. The Enron scandal brought to light a recurring
communication dysfunction within the organizational structure of the corporation
itself. How does a corporation behave internally? Where does corporate
accountability break down? Why is there a failure of knowledge conditions? What
makes up a corporate culture of intimidation? What dynamics operate to lead
individuals and units to pursue subgoals that are contrary to overall corporate
goals?
In the past various scandals and business
conspiracies have failed to uncover evidence of involvement by the senior
management.1 What goes on in board rooms remains one of the best kept secrets of
corporate America. The theme of "directors who do not direct" has received
extensive commentary over the years.2 One theme is that the board is so isolated
from managers at operational levels that it cannot effectively monitor or
control the conduct of managers.3 That appears to be due to the decentralized
nature of the corporate structure itself, the hierarchical chain of command that
requires information to travel along a narrow linear channel, and a technical
orientation of those at operational levels that makes them impervious to risky
behavior.4 At times subordinates who may want to "blow the whistle" may be
thwarted by an intimidating corporate culture, or simply because of the
hierarchical structure that effectively forecloses adverse information from
getting to senior management.5 In addition, the norm in large American
corporations is to have multiple and autonomous divisions, each self-contained
and headed by a divisional chief with full operational authority, thus fostering
decisionmaking that is decentralized and prone to subgoals. It is as if there
are several independent corporations within the larger structure.
What happened at Enron?
How it is that Enron's directors failed to provide
enough oversight to prevent the company's collapse, and the loss of billions of
dollars of investors' money? An Enron executive, Sherron S. Watkins, told the
House Energy and Commerce Committee that she believed Enron's former chairman,
Kenneth L. Lay, was largely unaware of the severity of the company's troubles,
that he "did not understand the gravity of the situation. . . "6 She submitted
an anonymous memorandum detailing her revelations to Mr. Lay, and later met with
him personally to discuss it.7 She said that even after she personally explained
to him that the company appeared to have questionable accounting practices that
hid huge losses, Mr. Lay still "didn't get it."8 Enron's former chief executive,
Jeffrey K. Skilling portrayed himself as ignorant of the company's questionable
practices in testimony before the same House committee.9 He said, "This was a
very large corporation. It would be impossible to know everything going on."10
The practices under scrutiny were partnerships which investigators say were used
to conceal debt and unprofitable investments from Enron's shareholders.11
Top Enron officials told employees that the company's
stock price would continue rising at the same time other officials were raising
serious questions about the stability of the company's finances.12 The optimism
of the company's chairman, Mr. Lay, occurred even while Ms. Watkins, who was a
senior Enron employee, explicitly warned him that several years of improper
accounting practices threatened to bring down the company.13 This suggests that
Mr. Lay was on notice about the company's accounting problems even while he was
assuring employees and the investment public that Enron's stock would rebound.
According to an economist at Enron Energy Services, "It was important for
employees to believe the hype just as it was important for analysts and
investors to believe it."14 Some in Congress claim that Wall Street analysts
should have seen red flags as early as two years before Enron's implosion, based
upon a string of warning signs in Enron's public securities filings.15 Instead,
most analysts still rated Enron as a "buy" or "strong buy" on November 8, 2001,
the same day Enron acknowledged it had overstated profits by almost $600
million.16 The problem may be that analysts who question the value of a popular
company are branded as controversial, and "[i]f you want to move up the
hierarchy of the Wall Street establishment, you don't rock the boat."17
Jeffrey McMahon, Enron's new president, told a
congressional committee that Enron had a corporate climate in which anyone who
tried to challenge questionable practices of Enron's former chief financial
officer, Andrew S. Fastow, faced the prospect of being reassigned or losing a
bonus.18 Ms. Watkins described a culture of intimidation in which there was
widespread knowledge of the company's tenuous finances, but no one felt
confident enough to confront Mr. Skilling or other senior officials, about it.19
Ms. Watkins was alarmed at the information she was receiving about Enron's
manipulation of income, but was not comfortable confronting either Mr. Skilling
or Mr. Fastow with her concerns. "To do so, I believe, would have been a
job-terminating move. Frankly, I thought it would be fruitless, that nothing
would happen. . . ."20 Ms. Watkins said she believed that Mr. Skilling and Mr.
Fastow "did dupe Ken Lay and the board."21
Two trustees of Enron's 401(k) plan told Congress
that they did little to protect employees in the plan as the company's stock
plummeted to less than $1 a share from more than $90.(22) One trustee, Cindy
Olson, disclosed that despite her knowledge of a memorandum that warned Mr. Lay
that Enron could implode because of accounting irregularities, she did nothing
to warn plan participants about the possible accounting problems and the damage
they could do to Enron's share price. She said she did not warn anybody because
she thought the assessment might be untrue.23
Further, Enron's board was faulted for failing to ask
pertinent questions or to get involved in "any meaningful examination of the
nature or terms of the dubious partnership transactions that moved debt off the
company's sheet.24 And even when the board did ask questions, they were not
given the right answers.25 By failing to delve more deeply, the board appears to
have missed the opportunity to uncover fundamental flaws in the company's
accounting practices.
William C. Powers, who became the chairman of a
special committee on Enron's board that issued a report about Enron's shaky
transactions that inflated its reported earnings, told a House committee that
his inquiry had uncovered "a systematic and pervasive attempt by Enron's
management to misrepresent the company's financial condition."26 The report
concluded that numerous related-party transactions and accounting errors were
the result of failures at many levels and by many people in the company. The
report blamed numerous factors for these failings: "A flawed idea,
self-enrichment by employees, inadequately designed controls, poor
implementation, inattentive oversight, simple and not-so-simple accounting
mistakes, and overreaching in a culture that appears to have encouraged pushing
the limits."27
Enron is widely reputed to have had a "gogo" culture,
in which senior officials cast aside traditional business controls.28 The
corporate culture was such that top officers were unaware of financial details,
and cast a relaxed attitude about conflicts of interest of executives.29 Joseph
F Beradino, chief executive of Arthur Andersen, the former Enron auditor,
testified that important information about Enron's finances had been withheld
from his firm.30
Commentators are concerned that other bombs like
Enron's may be ticking.31 The possibility exists that ignorance streams such as
these are not confined to a small range of cases, but that the modern American
corporation harbors millions of individuals who operate in a state of
communication myopia throughout their careers.
Overview of the board's oversight function and the
business judgment rule
The failure of oversight by Enron's directors, many
of whom were financially sophisticated, leaves one wondering what the purpose of
a board is. Corporate law generally provides that the board of directors is
responsible for managing the corporation, a function that is viewed as one of
oversight.32 In carrying out their oversight responsibilities, directors owe
fiduciary duties, including the duties of care and loyalty, to the corporation.
As discussed in the Appendix, there is a tendentious divergence of opinion as to
precisely what stakeholders are entitled to be beneficiaries of the board's
fiduciary duties. But generally, officers and directors are expected to perform
their duties "in good faith and with that degree of care that an ordinary
prudent person in a like position would use under similar circumstances."33
The business judgment rule generally governs judicial
interpretations of director decisions, and is an evidentiary presumption that
directors, in making business decisions, act on an informed basis, in good faith
and in the honest belief that their actions are in the best interest of the
company.34 The business judgment rule requires directors to oversee the
corporation only insofar as they should make inquiries where "suspicions are
aroused, or should be aroused" by the existence of "red flags."35 In a leading
case addressing the board's oversight responsibilities, the Delaware Supreme
Court rejected a claim by shareholders that the board has an affirmative duty to
install an internal system of monitoring, saying
it appears that directors are entitled to rely on the
honesty and integrity of their subordinates until something occurs to put them
on suspicion that something is wrong. If such occurs and goes unheeded, then
liability of the directors might well follow, but absent cause for suspicion
there is no duty upon the directors to install and operate a corporate system of
espionage to ferret out wrongdoing which they have no reason to suspect
exists.36
The standard of a board's oversight duty was
expounded upon in In re Caremark International Inc. Derivative Litigation,37
involving the question of whether the directors breached their fiduciary duty of
care by failing to monitor activities of the company's employees regarding
corrective measures that may have prevented certain unlawful conduct. In
discussing the liability of "inattentiveness" the court said that a director's
obligation
includes a duty to attempt in good faith to assure
that a corporate information and reporting system, which the board concludes is
adequate, exists, and that failure to do so under some circumstances may, in
theory at least, render a director liable for losses caused by non-compliance
with applicable legal standards.38
Significantly, the court further noted that:
only a sustained or systematic failure of the board
to exercise oversight - such as an utter failure to attempt to assure a
reasonable information and reporting system exists - will establish the lack of
good faith that is a necessary condition for liability.39
The court added that
absent grounds to suspect deception, neither
corporate boards nor senior officers can be charged with wrongdoing simply for
assuming the integrity of employees and the honesty of their dealings on the
company's behalf.40
Thus, imposing liability on directors for failure of
oversight is extremely difficult to sustain in a court of law unless there is
evidence tatamount to total abdication of responsibilities.41
In the wake of Enron, boards may scramble to review
just how they go about monitoring in the corporate hierarchy. The right degree
of monitoring can to some extent help workers know that violations of the law or
of corporate policies will be detected and punished. But excessive monitoring of
workers creates an atmosphere of distrust.42 Excessive monitoring gives the
impression that people in the company cannot interact on an assumption of good
faith, and this can backfire by eroding the level of commitment of workers
throughout the company, and by shifting time and attention from doing "real
work" to managing the impressions of the monitor. "[P]eople do not like to be
monitored. They may well mistake monitoring and questioning for distrust. . .
.."43 Another cost of distrust is that people are less healthy and less happy44
Elements that constitute information blockage in the
corporation
Information blockage is a pervasive problem within
large corporations.45 Enron is hardly the first company to have come under fire
for holding back adverse financial news from the public until the last possible
moment, leading to a rapid plunge in its stock price once the adverse
information hit the news, followed by lawsuits from unhappy investors based on
material misrepresentations by officers who kept an optimistic public face.
Scores of cases decided by the courts each year under the antifraud provision of
the SEC's regulations, Rule 10b-5,(46) fall into this category.47 The tendency
to report information selectively, emphasizing the positive while omitting the
negative, is characteristic of all bureaucratic organizations, from the Army to
the Red Cross. The SEC and congressional reports have chronicled this alarming
situation, dating back many years, in such corporate collapses as Penn Central
and Stirling Homex.48 One commentator remarked that the board "was always the
last group to hear of trouble in the great business catastrophes of the
century."49 One economist put the problem this way: "[T]he larger and more
authoritarian the organization, the better the chance that its top
decision-makers will be operating in purely imaginary worlds."50
Information blockage can occur by deliberate
concealment of information by officers to other board members, by the chief
executive officer to the public, even in the face of direct inquiries by the
press, by attorneys in rendering opinions to the board on sensitive
transactions, and by outside accountants who may tolerate the falsification of
corporate books and records without a fuss.51
The hallmarks of a successful company include
flexibility and the ability to act and react quickly, but these are thwarted to
the extent that information is blocked from the board.52 Supervisory executives,
given they are a step or two removed from the nuts and bolts of a project, have
a compromised ability to monitor the situation if they get no more than
distorted information and have no alternative sources of data to examine.
Sociologist Robert Jackall describes the typical
bureaucratic corporate structure this way:
Power is concentrated at the top in the person of the
chief executive officer (CEO) and is simultaneously decentralized; that is,
responsibility for decisions and profits is pushed as far down the
organizational line as possible.
. . . [Pushing details down protects the privilege of
authority to declare that a mistake has been made .... Moreover, pushing down
details relieves superiors of the burden of too much knowledge, particularly
guilty knowledge.
. . . .
. . .[Middle managers] become the "point men" of a
given strategy and the potential "fall guys" when things go wrong.53
In many instances of corporate misdeeds the
misconduct apparently occurs at a level well below that of senior management.54
Senior executives may often enough discover, albeit much to late, that the truth
is indeed quite different from what they had been led to believe. With Enron,
adverse information may not have reached the board until the crisis became
unavoidable.
A common phenomenon known as the "law of diminishing
control," states: "The larger any organization becomes, the weaker is the
control over its actions exercised by those at the top."55 That is why so many
boards have limited impact in most forms of corporate decisionmaking. "Boards do
not set policy, do not veto management, seldom intervene short of a major
crisis, and do not even select their own successors or the next chief executive
officer."56
The board of Enron, along with other modern
corporations, appears to be analogous to the seventeenth century monarch -
holding absolute power in theory, but cut off from access to information and
thereby manipulated by the ministers who are its nominal servants. Occasionally,
the board may erupt into forceful action, but in the long run its domination by
its ministers seems inevitable.57
Blockage of information occurs in a variety of ways.
For instance, in a hierarchical structure it is often the duty of middle
managers to discern between the important and unimportant findings, and to limit
the upward flow of information to relevant and unusual information.58 This
deliberate filtering of information is compounded by a frustrating feature of
human nature whereby messages simply get changed passing from one supervisor to
the next in a hierarchy, with only a very diluted message ever reaching the top
through regular lines of communication.59
It is probably safe to assume that most people prefer
to be known as trustworthy rather than as untrustworthy, even if they are not.
Collectively, managers have a natural incentive toward candor.60 The reputations
of a company's executives are usually closely aligned with the ongoing interests
of the firm as reflected in not only its share price, but in the firm's
reputation for truthfulness. Concealment usually only delays the apprehension of
the truth rather than permanently putting it out of public view, given the
layers of outside scrutiny from professional analysts, accountants and lawyers.
To have a reputation for trustworthiness means that people are likely to place
their trust in you. Trusted managers in an organization are more easily able to
persuade others to accept their decisions, and cooperation is facilitated if
workers are able to readily accept the decisions of managers.61 Thus, given the
obvious damage to one's reputation, to the trust reposed in people by the
company, as well as legal consequences, it is puzzling why employees in the firm
would deliberately conceal the truth.
Motivations to lie or deliberately conceal the truth
in an organization
Corporate officers receive information from multiple,
and sometimes conflicting, sources, that may well undergo distortion in
transmission. With Enron, the "lies" came in a variety of forms. There was
misrepresentation of hard data, that is, concealment of debt, lying about
accounting results, as well as about the stream of earnings, and distortion of
the company's future prospects.
For some, the motivation to lie is that disclosure of
the truth may put the company into bankruptcy, with attendant group firings, and
the loss of one's own job. There is also an emotional attachment to one's
involvement in a project that motivates one to hold off transmitting information
if it would flagrantly signal danger to the firm. Concealment can also buy time,
as there is always the hope of some reversal of fortune after initial setbacks.
Adverse situations are usually open-ended; that is, poor performance seldom can
be established conclusively, and a turnaround is always possible. And one may
just want to hold on to one's salary and perquisites for as long as possible.
This can go on until a catastrophe presents an overwhelming case that requires
the company to acknowledge that wrong decisions were made.
Disclosure of adverse information can be embarrassing
to executives, leading to a drop in management morale. Also, disclosing a
mistake means that one will have to "backpedal," which calls into question one's
reputation for consistency, a highly valued asset in business organizations.62
Bad news can also affect overall optimism among workers as a whole and threaten
continued external support from suppliers, customers, etc.63
A further motivation is that the promotion and
termination protocols commonly found in corporations make it tempting to
transmit information in a way that minimizes the potential for blaming oneself
for bad news, and to convey as much good news as possible - consistent, of
course, with a general desire to maintain a reputation for credibility with
senior management. This was precisely what Sherron Watkins alluded to in telling
a congressional committee that confronting senior management with her concerns
"would have been a job-terminating move."64 Distortion or concealment can become
a dominant strategy regardless of explicit injunctions of senior management to
"give me accurate information," if workers fear the possibility of being fired
or deadended in light of a candid portrayal of a situation.
Thus, subordinate managers have a pervasive interest
in concealing bad news, and are tempted to vary the message to conform to their
selfinterest.65 Doing so avoids or delays both personal embarrassment and the
associated risk of being terminated, and the unpleasant and wealth-- reducing
likelihood of a stock price drop. Some counterbalancing incentive to report bad
news may be the need to foster an ongoing corporate reputation for credibility
with outside suppliers, customers and lenders. But human nature - often in the
form of self-deception - provides ample reason to believe that managers will
often enough try to sweep the bad news under the rug, or give it an
unrealistically positive spin.
There is also the motivation to report to the boss
what one perceives the boss wants to hear.66 This is complicated by the fact
that junior managers on the executive track moving from one role to another
every couple of years, feel pressed to accentuate the positive and distort bad
news or at least defer bad news that might tarnish one's chances for promotion
until one has moved on to a higher position, thus leaving the problem for one's
successor.
Based on the foregoing motivations, individual
executives in Enron who made the decisions to hide the company's debts in
dubious partnerships and through other means, feared an erosion of status within
the organization if the company's expectations to increase income could not be
delivered. Like most successful executives, they had a rather high regard for
their abilities, and were unconsciously protective of both self- and
external-image. In addition, officials who engage in misconduct may think they
are doing so to benefit, not to injure, the corporation, because the results
will, in theory at least, help maximize the company's profits.67
Information flow in a corporate hierarchy
Apart from lying and deliberate concealment, there
are different features that contribute to a myopic information flow in an
organization. First, people usually only have a small amount of data available
to them in most situations - far short of that necessary to make inferences that
meet anything resembling well-grounded empiricism. Thus, everybody must go about
one's business on the basis of insufficient information. Through a variety of
shortcuts, the mind fills in the gaps.
Further, we all have limited cognitive capacities, so
that even when people have abundant data, they might not be able to assimilate
it because the mind lacks the capacity to process all that is available. Busy
executives deal with information overload by processing the information, that
is, by sifting through data and extracting what seems relevant.68 Given the
finite time and mental capacity with which we live, people tend to adopt
simplifying strategies such as reducing the number of factors considered or
simply seeking some minimal threshold of satisfaction with a choice, foregoing
any more careful consideration of it or other possibilities.
Second, many companies are informationbased, such as
finance, software, media, health care, and other companies. Information in these
companies is based on individual skills, insights, knowledge, and talent.
Production in information-based firms does not proceed in linear, assembly line
fashion - but interactively, with the creative input of individuals at a number
of levels. For instance, with scientists working on a satellite, the creative
flow of information is multidirectional, going from the development team to the
software writer to an engineering committee, and then back again for refinement
and perfection. Members of the production process must have sufficient
understanding of the others' jobs in order to be able to communicate with them,
to provide feedback, and to help refine the product. It's like the various
members of a symphony orchestra, each one having specialized tasks but
nonetheless needing to have some understanding of how one's colleagues'
instruments work and interplay with their own sounds; and they must closely
coordinate their work in order to make the whole piece come out right. The
various members of a surgical team all have different specialized tasks, but
each must have some understanding, even expert understanding, of the other
members' functions.
Third, in large companies with numerous decentralized
divisions, some economists have pointed out a kind of corporate schizophrenia
called "subgoal pursuit,"69 by which managers at lower levels have a bias for
the expansion and growth of their own division, and will therefore, tend to
maximize the interests and autonomy of their own unit rather than the company's
welfare as a whole.70 There may be a lack of congruence between the interests of
the corporation and the career aspirations of executives in the corporate
divisions. From this perspective, the problem of information blockage is not a
technical failure but is instead part of a deliberate and predictable strategy
rationally employed by lower echelons to protect their own interests from both
senior management and the board alike. When subgoal pursuits are at risk, there
is a motivation to "decouple" topmost management from crucial information.
Irrationality and cognitive biases in corporate
governance: the formation and persistence of initial beliefs
Corporate governance operates on the premise that
workers are autonomous and rational beings. But legal and economics scholars now
acknowledge that the neoclassical assumption of rationality often fails as a
descriptive model of economic actors and their behavior. In other words,
individuals are not rational all of the time. Innumerable studies by
behavioralists show that human beings display a remarkable ineptitude for
understanding causal relations and probability.71
Members of boards are human beings and, as such, they
are unlike the classical economic actor who "can perfectly process available
information about alternative courses of action, and can rank possible outcomes
in order of expected utility."72
Irrationality plays a surprisingly important role in
human decisionmaking. By "irrationality" I mean such things as unconscious
emotions and motivations. In many ways our lives are governed and even sustained
by unknown, and sometimes unknowable, motivations and feelings. Maternal love,
friendship, romance, artistic creativity, faith in an afterlife, and heroic
greatness are examples of the life-affirming power of the irrational in our
lives. We recognize in our own behavior, something essentially absurd in
irrational acts, for which no explanation can be given. People failing to abide
by the rules of logic is something behavioralists claim is a consistent and
persistent human trait.73 In other words, irrational tendencies in human
cognition are systematic and predictable.74
Psychoanalysis takes seriously the important place
unconscious motivations and feelings have in human conduct, and suggests that
irrationality is at the center rather than the periphery of human experience.
Today, cognitive psychologists claim that perception as well as mental processes
such as memory, judgment, and attention take place below the level of conscious
awareness -- and includes instincts, emotions, fantasies, desires, and
conflicts. The behavioral economist Herbert Simon once observed that "we cannot,
of course, rule out the possibility that the unconscious is a better
decision-maker than the conscious."75
Neuroscientists also claim that much of what happens
in the brain goes on outside of conscious awareness.76 Neuroscientists who have
studied unconscious processing of information claim that most decisions are made
subconsciously, with many gradations of awareness.77 These findings, which are
gaining wide acceptance, challenge the notion that people always make conscious
choices about what they want and how to obtain it.
Cognitive psychology has developed the concept of
bounded rationality, now popular in the economic literature, to help explain
irrational behavior.78 The theory of bounded rationality identifies systematic,
and somewhat predictable, deviations from rational and somewhat predictable,
deviations from rational behavior. The theory focuses on cognitive biases,
heuristics, and limitations that lead individuals to depart from outcomes
otherwise predicted by the neoclassical rational choice model.
Behavioralists have extensively studied and
documented several kinds of cognitive phenomena that demonstrate how we form
initial beliefs or hypotheses outside of rational or logical norms, and how we
then maintain a bias for the persistence of these beliefs even when we are
confronted with thoroughly discrediting evidence. An examination of these
cognitive biases is helpful to understand how individuals in a corporate
hierarchy are susceptible to irrational decisionmaking in processing, giving or
receiving information to and from others in the organization.
We start from the premise that managers become
committed to a company's agreed upon course, and they cannot easily step away
from it, even if signs of trouble become prounounced. There is likely to be
distortion in the flow of information if various cognitive biases are in
operation, and hence, fewer danger signs will be reported up the hierarchy as
"relevant," while those who do report danger signs to senior managers will tend
to give negative information a positive spin. Should serious problems arise,
there is a high degree of commitment to support the prevailing beliefs, that is,
a strong motivation to preserve the status quo.
In general, the various kinds of bias are based on
the longstanding theory of cognitive dissonance, holding that the human mind has
an innate drive to maintain consistency between its preexisting attitudes and
the information it receives.79 Behavioralists say that cognitive dissonance is
the tendency to reject or downplay information that contradicts other, more
favorable views, about oneself or one's state of affairs. This explains why
executives are often overoptimistic. (See discussion below.) With cognitive
dissonance, the mind filters out tmuch information that is inconsistent with
one's prior attitudes. Hence, people unconsciously focus on and relay only the
information that reinforces their preexisting attitudes, and filter out
conflicting information.
For instance, once a project is set into motion,
there is a heavy commitment for the project to succedd. Those invlved with it
recognize the reality that the project can still be killed. Once a commitment is
made to a particular course of action, adverse information that arises
subsequently is unlikely to be evaluated with the same objectivity as it would
for managers assessin ga proposal to which they have no prior commitment.
Cognitive dissonance suggests that managers will systematically underestimate
external threats to their projects. Those who receive risk-related information
may sense the need to give it a positive spin or to use other defense
mechanisms. After all, it is still early in the project, so that any risks shown
by early data may be speculative and thus can be discounted.
Revising plans based on discomfirming information can
be both bothersome and anxietyprovoking. Bias induces people to simply ignore
information pertaining to risks that seem to be remote or highly contingent.
Only a fairly vivid or flagrant threat will be sufficient to prompt revision. A
manageable and stress free way to handle information that might contradict
decisions that have already been set into motion is to rationalize it away or
ignore it, simply not report it and forget about it, or communicate it upward in
a way that sanitizes it.80 It thus becomes easy to preserve an aura of optimism.
Senior management is then unlikely to sense serious cause for concern.
"Troubling bits of information are subject to dismissal or rationalization,
without much conscious deliberation. . . ."81
Cognitive dissonance manifests in various types of
bias that impact the flow of information in corporate hierarchies:
1. One cognitive phenomenon is called confirmatory
bias, which involves misreading of evidence that contradicts one's initial
beliefs.82 The strategy is to construe information and events in such a way as
to confirm prior attitudes, beliefs, and impressions.83 People will tend to
reduce the complexity of evidence by focusing on the portion of evidence that
supports one's initial belief, and when faced with disconfirming evidence,
formulate "alternative interpretations" to help explain away the evidence.84
This is exacerbated if the evidence is ambiguous or complex. Confirmatory bias
also involves the tendency to exaggerate or imagine a correlation when doing so
confirms one's belief that such a correlation "should" exist, and to
underestimate a correlation that might go against one's belief.85 That is,
people often perceive correlations between variables based on their preconceived
biases.
Confirmatory bias helps bolster one's chosen course
of action by construing information in such a way as to confirm one's beliefs
and impressions, resisting taking in disconforming information, at least
subconsciously. This may help explain why Enron's lawyers failed to rule any
feathers in their investigation of the claims of accounting abuses voiced by
Sharron S. Watkins.86 People who commit to a company's course of action, such as
lawyers, may find it difficult to appreciate evidence of client wrongdoing,
making them less than fully competent gatekeepers.87
2. Another cognitive phenomenon is called belief
perseverance, which is the tendency of people to construct "theories" to account
for events or circumstances, and then to disregard evidence that contradicts
their first impressions.88 Belief perseverance tends to cause managers to
misperceive events and risks, inducing them in their good faith to perpetuate an
unrealistic set of beliefs.89 In doing so people may have a kind of bias against
revision, relying, somewhat unconsciously, on stock understandings and
preconceived beliefs about people and situations.
There is a significant tenacity in belief
perseverance: "[I]nitial beliefs may persevere in the face of a subsequent
invalidation of the evidence on which they are based," even when the initial
evidence is itself weak and inconclusive.90
3. Another cognitive phenomena is called the entity
effect, whereby peoples' hypotheses often take on a life of their own, so that
people will continue to believe something they initially held to be true even
after it is thoroughly and completely discredited.91
4. Another phenomenon is called motivated reasoning,
which refers to the tendency of people to utilize a biased set of cognitive
strategies to arrive at a belief they privately already desired to obtain.92
People in organizations often need to make decisions about the future in a
context that is ambiguous is highly stressful, and to reduce the anxiety, people
unconsciously impose an order on their environment, a set of causal explanations
that lead to an artificial, but a more comfortable sense of predictability.93
This tendency influences how people evaluate evidence, to wit, by picking and
choosing from evidence so as to make it fit into one's preconceived hypothesis.
One commentator states that "the practice of motivated reasoning appears to be a
universal and, perhaps, immutable characteristic of human nature."94
5. Another cognitive phenomenon involves group
cohesion. Once a group commits to an idea or a course of action, there is a
strong motivation to resist evidence that it was the wrong move. This group
cohesion phenomenon functions as a stress reduction mechanism, and has been
dubbed "groupthink."95 The possibility of a mistake means that the group will
have to reverse its position. Members risk exclusion from the group if they
introduce stressful dissonant information into the group setting.96 Thus, groups
tend to edit out negative information in order to maintain cohesion. "This, in
turn, leads to the suppression of information and ideas and cognitive
conformity. . . ."97 Ambiguous information tends to be dismissed as
unmanageable.98 The group cohesion tendency works so that if one member brings
up some information that suggests that the group has failed to consider
something troubling, a certain sense of stress arises, and members tend to
dismiss or rationalize away the danger signals.99 Each member of the group tends
to have a strong bias toward the status quo, and will subconsciously seek to
rationalize away or dismiss any dissonant information, only bringing it to the
group's attention if it is difficult or impossible to avoid.100 This not only
aids in reducing stress, but also helps increase the group's focus,
concentration and persistence. It also increases a sense of group confidence and
trust among members.
In addition, promotion patterns place a premium on
"team players" - those able to conform their attitudes to the immediate needs of
the team, typically as articulated by senior managers - and as a result the
organization develops a collective egocentric bias.
6. In boards there may also be a tendency for people
to engage in what psychologists call the false consensus effect, a tendency to
think that others share one's own attitudes, beliefs and inferences."' The false
consensus effect distorts decisionmaking because believing that others are in
alignment with you creates the hazard of acting on the false premise that others
will agree in advance with your choices. The false consensus effect manifests,
often enough, by one person holding back information because of the
misperception that other people on the board, for instance, are "on the same
page," when in fact they might not be.
These various types of cognitive bias show that
attitudes and beliefs do not change easily, and indeed can persist even though
not justified by probative evidence. From the board's perspective, cognitive
bias may easily manifest itself by holding onto and promoting originally formed
beliefs so that adverse bits of information are, first of all, slow to come in,
and second, that the information may be rationalized away and forgotten, however
sanitized it may be at that point.
Even less committed outsiders, such as lawyers and
accountants, may find it difficult to introduce any dissonant information that
would threaten a company's status quo because they, too, can be susceptible to
cognitive biases. A lawyer who authorizes certain dubious partnership
transactions becomes committed to a certain scheme from that point on.
Overconfidence and overoptimism in the firm
As we have seen, much of what people believe is based
on insufficient empirical data, and often is inaccurate. Their level of
confidence in those beliefs is often enough based on irrational cognitive
processes. Many people, in other words, confidently hold beliefs that are
illusions or myths. Confidence and optimism are closely related, and both are
viewed as genetically favored in behavioral studies in economics,102 and in
biology.103 The reason is simple. Doubt and uncertainty produce inaction, while
confidence is associated with initiative and persistence. Confidence is
energizing, and lack of confidence debilitating. If I strongly believe that I
understand what is going on, I can feel more confident in my prediction about
where things will end up. In group settings the opinions of those who display
confidence will often be deferred to by others.104
An excessively optimistic "face" of the firm appears
to have become the norm in external press releases of American corporations.105
Corporate press releases tend to be in a style that creates a strong image of
confidence and control, and this prescription creates a certain pressure on
firms surrounding corporate publicity.106 Failure to comply with the norms
surrounding the public's expectation of press releases may result in the
tainting of the organization's image and the hampering of the flow of support
from public markets. Thus, any company that is not careful to adhere to this
norm and instead is entirely candid risks signaling weakness, setting off
negative reactions, disengagement of relationships, rumors, and reputational
loss.
Enron appears to have a generic story in common with
Apple Computer,107 TimeWarner,"108 Polaroid,109 and other cases in which
shareholders relied upon statements of "false optimism," only later to claim
that these statements constituted fraud. In most of these cases, the board
undertook a course of action with respect to some product or strategy and was
later faulted for concealing some bits of adverse information later found to be
material.
Optimism is an important feature for success. The
most successful person, on average, tends not to be the realist, but rather the
optimist.110 Part of the leadership role of a senior executive is to communicate
confidence and optimism about the company. Optimism is attractive to others,
enhancing the ability to influence and persuade. Optimism is probably a virtue
insofar as it functions as an energy source in a business. Optimism is important
for business leaders, because decisiveness and aggressiveness are considered
indicators of a successful manager.
A proper dose of optimism and confidence are not only
good internal motivators, but they also influence others. Exhibitions of
confidence and optimism make people more persuasive and influential. Managers
who are optimistic can help motivate workers, and create the expectation of
future growth and profitability that leads individuals to invest their human
capital in the firm more willingly and to defer present consumption in favor of
future rewards. Firms with "can-do" cultures generate higher levels of internal
effort and, by projecting self-confidence, can be more successful in attracting
external resources.111 "High levels of optimism and confidence are not only good
internal motivators, but they can also influence others; exhibitions of
confidence and optimism make people more persuasive and influential."112 The
risk of failure is reduced if managers project a strong sense of optimism about
the long-term growth of the company.
On the other hand, many studies show that people
develop higher levels of confidence in the accuracy of their beliefs than is
warranted by the facts. This is the famous "overconfidence effect,"113 observed
especially among American males. Asked to estimate their confidence in the
accuracy of their judgments, people usually estimate too high. The tendency
towards distorting reality by overconfidence and overoptimism are commonplace
among skilled, professional people.114 People want to see themselves as good and
reasonable, and they may rationalize facts to bolster or maintain a positive
self-image, or subconsciously distort evidence.115 "One tells stories to oneself
that inflate feelings of efficacy and control, establishing a sense of identity
less susceptible to the threats of the everyday world. That is why egos are so
prickly, people so averse to criticism."16 People will often tend to buffer
anxiety by maintaining an illusion of normalcy, that is, by interpreting new
data as consistent with the status quo rather than seeing red flags that suggest
danger.117 This strategy helps people feel that their world is more
"understandable, predictable and controllable than it really is."118
Behavioralists refer to the term illusion of
control119 as the human tendency to "treat chance events as if they involve
skill and hence, are controllable."120 Even when confidence is illusory or
irrational, it has an action-guiding function. A story from World War II told by
Albert Szent-Gyorti captures this perfectly.121 A platoon of soldiers got lost
in the Alps. They became gripped with fear and despair, and they did little
until an officer found a map. They then felt energized, rallied around the map,
and finally found their way to safety. Only later did they learn that the map
was of the Pyrenees, not the Alps, and hence, was totally useless.
This story is a metaphor for what goes on in
corporate hierarchies. The map metaphor fits well because in corporate
hierarchies the consequences of our actions rarely become evident immediately.
And there often can be a range of plausible explanations as to why things turned
out a particular way. In the face of ambiguity, executives may easily develop
excessive confidence in their explanations of situations and events. Executives
who are confident enough in their beliefs and want to sustain them, whether true
or false, can operate according to these beliefs for long periods of time
particularly when they have sufficiently vague and delayed feedback from their
decisions.122
There is a systematic tendency of many people to
overrate their own abilities, contributions and talents. People dwell on
successes and attribute them to skill and diligence. Failures are more likely to
be dismissed based on external or unforeseeable causes.123 This finds expression
in excessive optimism and overconfidence, and a sense of omnipotence regarding
one's ability to control events.124 People tend to claim that positive events
are due to their skill, and that negative situations are caused by outside
circumstances. Groupthink can increase optimistic biases, fueling a tendency to
place unwarranted confidence in one's decisions.125 The excessive confidence of
senior officials in an organization only works to solidify the phenomenon of
groupthink.
Excessive optimism is not a virtue, but is
essentially a subconscious tendency to distort reality in a positive
direction.126 The phenomenon of excessive optimism can trickle down in a
corporate culture, with the persistent belief that one's own company is superior
to competitors, or that one's company is on a winning streak that has no end.
This can induce a tendency toward puffery and dismissal of risks in formulating
disclosures and press releases.127 An optimistic culture can blind managers so
that, faced with risk or trouble, they will more likely persist in normal,
functional activity than take appropriate corrective action, or not see risks
clearly or construe them unrealistically.
The dark side of optimism is that it justifies the
preservation of the status quo, and hence can result in an entrenchment of
denial and lead to ultimate failure.128 Many supervisors, consciously or not, do
not want to know precisely how their subordinates achieve their results. As long
as the bottom line is profitable, there is little incentive to discover how
those results were achieved. Focusing on the bottom line also facilitates the
denial of either moral or legal complicity should severe problems be
uncovered.129
Corporate "culture" and its influence on information
flow
The corporation is said to be a cooperative
association.130 "Cooperative association" is a term that implies that the
participants in the enterprise subscribe to a set of common goals, and they
accept the centrality of the common goals or purposes of that enterprise.131
Each firm has a particular "culture." Studies of organizational behavior show
that institutions develop belief systems - shared ways of interpreting a
company's environment, its past, and its future prospects. These belief systems
are important because they color the interaction and communication between
managers and employees. An organization's culture - the norms, routines, and
shared understandings and expectations of those who work in a firm - impacts how
information flows through the hierarchy. The interpretation of a given bit of
information in a company as a whole depends upon the social processes, the
patterns - the overall institutional culture, that one learns as one becomes a
member of that firm.
There are pre-given social mechanisms in a corporate
culture that determine the context and the content of individual decisionmaking
and choices. For instance, many corporate cultures discourage open expressions
of doubt or skepticism, which stifles the flow of information.132 Or, if a
company's CEO promulgates a culture of trust, transparency of communication,
direct lines of communications despite decentralized management - stressing
honest behavior, honoring the spirit as well as the letter of the law, putting
safety before profits, encouraging kind acts and respect to all employees, and
frowning on backbiting and internal politicking - this company will have a
markedly different culture than one that emphasizes profit-maximization at all
costs, and that cheating is okay if you can get away with it. We can find one
decent and the other reprehensible.
Senior officials in a company often develop large
egos, bolstered by the repeated promotions and increasing responsibility they
have accrued, and they are likely to exhibit considerable confidence in their
own managerial and decisionmaking abilities. Ego in organizational settings can
reverberate by inducing subordinates to conform their presentations to what they
think their boss wants to hear, even when the boss emphasizes the need for
accuracy and accountability.133 Many a CEO is strong-willed, imperious and
dominating, and seldom confides in or relies upon the board.134 Robert Jackall
once said that middle management is guided first and foremost by the maxim,
"When [the CEO] sneezes, we all catch colds."135
Senior officials might impart the sense that the
board would rather not be put on formal notice as to the ugly "facts of life" of
illegal or improper activity. Senior managers in a company may well have a
particular facility for rationalization. "As a result, the leader's vanities
often trigger a cascade of conforming behaviors that, in turn, reinforce those
vanities."136
Ego blindness explains why people will not give
enough attention to situations that trigger some worry response. That is, the
ego will want to quickly dismiss one's gut reaction, and forget about it. This
pattern of cognitive dissonance occurred in the actions of Beech-Nut executives
who allowed the introduction of increasing levels of foreign substances into
apple juice that a large number of children consumed.137
The diffusion of authority in a hierarchical
organization tends to reduce an individual's sense of moral responsibility for
his or her actions.138 For instance, when supervisors parcel out subtasks to a
number of subordinate employees, none of the subordinates may have more than an
inkling of what the entire project is about, while the supervisor may know
little of the details of each subordinate's subtasks. No one in the firm might
recognize a moral problem, because the problem arises not out of what any single
worker is doing, but out of everyone's action as a whole. The fact that everyone
is merely a member of a large work force helps workers feel a sense of security,
with little need to find out more about what is going on even if they have their
suspicions.
A particular person can always choose to violate a
norm and adopt behavior that bypasses the company's norms. There may be a shared
feeling on the part of subordinate officials that they owe their loyalty chiefly
to senior management and not to the board. Cynicism in a corporate culture can
foster the breaking of rules as a means to succeed. An element of cynicism in a
company's culture about accounting norms or about SEC regulatory protocols may
affect the actor's evaluation of the legitimacy of the regulation. One might
understand that certain ethical rules are underenforced, that the probability of
sanction from some violation is remote, or that successful people can question
the legitimacy of ethical principles and make excuses.139 To be successful in a
highly competitive environment one needs to filter legal and ethical
expectations through the group lens. "For many, that filtration will involve an
implicit and unconscious search for ways to maintain consistency between the
desire to be good and the desire to be successful. This form of rationalization
can readily blunt the power of 'official' norms."140
It has been pointed out that people in corporations
tend to make decisions that may not be in keeping with their own sense of
morality. People working within corporations often have a distinct business
persona, different from the one they display within their family relationships
or in other roles in society. The idea is that people may act in seemingly
altruistic ways outside the corporation, but in the firm there is a business
morality that is somehow different from one's personal morality, that "business
is business," with the focus being to maximize profit without regard to other
considerations.141
Benjamin Cardozo, the judge and moral scholar,
referred to distinct "morals of the market place"142 that are different from
everyday morality outside the business world. Robert Jackall commented regarding
corporate culture that independent morally evaluative judgments get subordinated
to the social intricacies of the bureaucratic workplace. Notions of morality
that one might hold and indeed practice outside the workplace . . . become
irrelevant . . . Under certain conditions, such notions may even become
dangerous. For the most part, then, they remain unarticulated lest one risk
damaging crucial relationships with significant individuals or groups.143
This idea conjures up a culture in which corporate
agents who engage in business wrongdoing escape "not only moral and
psychological responsibility but legal responsibility as well. Legal rules
designed to deter individual wrongdoing are simply not directly transferable to
the corporate setting."144 Thus, the convergence of various factors, including
the pressure people feel from their superiors, their peers and the norms of
corporate culture, the fact that most corporate cultures hold power in high
esteem and have a diffusion of responsibility, may contribute to a sense that
certain wrongful conduct is permissible.145
People who act in groups may impose greater risks to
society, and thus deserve greater blame (or at least some blame) when they act
wrongly, than individuals acting alone. That is, there are special dangers
associated with group plots, as reflected in the common law of conspiracy.146 As
noted by a classic commentary, "[I]t is more difficult to guard against the
antisocial designs of a group of persons than those of an individual. . . . The
advantages of division of labor and complex organization characteristic of
modern economic society have their counterparts in many forms of criminal
activity."147
The fact that there is a certain permissive corporate
culture in a given company should not excuse conduct any more than a criminal
syndicalist associating with bad associates would be excused from responsibility
due to keeping bad company. That is, blaming a culture does not excuse or
mitigate the conduct of the individuals who are part of it, in my opinion.
We all move in and out of various roles during the
day, operating as moral agents in being a parent, being a driver, being a friend
to someone, or being a consumer, and so on. It seems unreasonable to demand that
anyone operate in the firm with blinkers shielding one from the moral awareness
that operates in other sectors of one's life.
Solutions
I have attempted to explain how insiders may overlook
danger signs obvious to a neutral observer. What sort of solutions are possible
to move the board closer to the locus of problems?
How can a company be structured so that the board can
monitor the corporation's internal environment, and discover or correct trouble
before it reaches the emergency stage?
1. Companies should implement programs to encourage
employees to expose wrongdoing without fear of retribution. Organizational
theorists agree that in order for information sharing within an organization to
be optimal there must be a reasonable degree of trust and confidence between the
informant and the recipient.148 There needs to be incentives for subordinates to
divulge potentially adverse information. A complication is that any potential
informer may be reluctant to supply information because there may be feelings of
loyalty to one's superior and coworkers. There is concern for backlash,
retaliation, and ruination of one's own chance for advancement, and the risk of
losing one's position and accumulated benefits even if there is a strong company
policy to prevent such backlash. Directors need to implement procedures through
which employees with knowledge of wrongdoing may make such information known in
a manner that will permit objective evaluation of the information.
An ombudsman of some sort, with direct access to a
senior official, would be helpful. Exxon Corporation, among other companies, has
enacted a policy requiring employees who notice possible misconduct or dangerous
or troublesome situations, to notify their superiors in writing, and if no
written response is forthcoming, the employee must jump the chain of command and
inform senior executives.149
2. The reputational risk of concealment of
information, both to the company and to top executives, is substantial.
Corporations need to devise some kind of communication system that enables
important information to move upward to the proper decisionmaker without getting
distorted. I would not recommend the simplistic solution of allowing all units
of a company to communicate directly with senior management. That could easily
create informational overload, an overabundance of irrelevant information, and
the problem of sensory decoupling on the part of senior management, and thus
might be ineffective.
3. Directors should make it an affirmative duty for
individuals in the firm to discern the nature of their own projects and to know
what other employees are working on the same project. This will enable them to
know where they can go to gather further information about the project, or to
"compare notes."
4. The directors must satisfy themselves periodically
through reports that the company has appropriate programs in place to inform its
employees on an ongoing basis of the need to avoid conflicts of interest, and of
the need to comply with laws applicable to its operations. Directors should
understand that even the unqualified advice of legal counsel as to the
lawfulness of conduct will not necessarily immunize the board or the corporation
from legal sanctions.
5. In corporate settings power and responsibility are
diffused, but connected. Many boards seem to lack the time and expertise to deal
with all the complexities of modern public corporation business. Often directors
seem to perform a largely reactive function. Thus, developing an effective
program for discovering corporate wrongdoing and preventing its reoccurrence is
a daunting task."150 But it is always possible to implement some system of
corporate checks and balances that reduce the likelihood that one or a small
number of biased managers will cause significant failure of disclosure. It is
important to work out a policy to reduce the likelihood that plans may
subsequently turn into unethical or unlawful operations. A commitment is
required from both the board and senior management that deviations from the
policy of compliance with the law will not be tolerated.
Implementation of such a policy requires an adequate
monitoring system at both the board and management levels. Of course, monitoring
has its own problems in accomplishing the aim of oversight while avoiding the
negative feature of setting up such an elaborate system of signals, checks,
balances, and reviews as to stifle all activity. A good monitoring program will
protect the interests of the shareholders by avoiding governmental and private
litigation against the company and the depletion of the corporate reputation,
not to mention its stock value.
6. Some companies may want to have more widespread
use of an outside director who plays a lead role. One of the more radical
solutions involving outside directors was proposed by Ralph Nader in 1976,
namely the "politicization" of the corporation by requiring the presence of
various representatives of "public interest" groups on the corporate board.151
The suggestion here is that each director would represent a specified special
interest constituency, such as environmentalists or consumers, and others whose
goals may be in conflict with the goal of profit maximization. It is far from
clear, however, how such a restructuring of the board would solve the problem of
information blockage from lower echelons to the board, and it interjects a more
acute adversarial dimension between the board and management, not to mention
within the board itself.
7. In cases where a corporation's own system of
internal accountability has broken down, the SEC has structured consent orders
to force companies to restructure their audit committee, provide adequate
training for new directors, install a majority of independent directors, and
expand the number of independent outsiders on the board.152
8. Another solution is to hire emotionally
intelligent workers. A CEO who throws his or her weight around, intimidates
other directors - the table-pounding type - might be temperamentally ill-suited
for the job. Search committees should look for people with people skills.
Emotions are relevant in deciding an issue.
Appropriate appeals to emotion are important ingredients that contribute to,
rather than sabotage, corporate decision making.153 Emotion tends to mold strict
logic to achieve truly balanced quest for the truth. Proving the truth of an
issue requires not just an analysis of the concrete evidence, but the shading of
emotional sensitivities.
Emotional responses can send us important messages to
which we should listen. Emotions help us sort through vast quantities of
information, highlight those aspects that have particular meaning for us, and
help us assign meaning to things that might otherwise seem chaotic. Emotions
open us to the possibilities of enhanced awareness and improved judgment.
Emotions serve as warning signals that certain
judgments or decisions need to be scrutinized more carefully. People should be
aware of warning signals that may prompt them to reconsider a particular
decision or action. If we feel a negative feeling immediately upon hearing a
proposal, this is what researchers refer to as intuition.154 We cannot
rationally explain this initial gut reaction, but we commonly take the negative
feelings to mean that something is wrong, and feel moved to search for more
facts or to reflect further on the issue. Once people are aware of the validity
of intuitive feelings, they can deploy rather than suppress powerful feelings
that can help guide decisionmaking. Intuition doesn't guarantee truth, but it is
a form of knowledge which we can develop and let run alongside our rational
thinking.
According to Justice William J. Brennan, Jr.,
ignoring what our passions tell us cuts us "off from the wellspring from which
concepts such as dignity, decency, and fairness flow."155 Understanding reality
and responding to it appropriately requires "the full measure of all our human
capacities."156
Emotion can be used by a forceful manager to block
communication or to shut down dialogue. This is an abusive and wrong use of
emotion. Outbursts of anger and table-pounding in an attempt to suppress
critical questioning of others closes down creates a corporate culture that
denigrates legitimate discourse, and limits the quest for the truth.
Conclusion
There are numerous subtle but powerful forces at work
in corporations. The mere existence of a hierarchical structure prevents
individuals from obtaining complete knowledge needed to make informed moral
decisions, and prevents them from really knowing the role their acts play in the
larger corporate scheme. Directors are likely to face much greater demands of
accountability in the wake of Enron. There is growing awareness among directors
themselves of the need to take their role seriously.157 Companies are likely to
put more emphasis on having directors who are not afraid to challenge senior
management by asking inconvenient questions.
The public has traditionally regarded information
disclosed by corporations with a certain degree of trust, on the assumption that
managers have unique access to certain kinds of risk-related information, and
that securities laws make it punishable to mislead investors. Business
organizations are undeniably human affairs, and classic occurrences of
information blockage undermine the board's ability to monitor the company. Savvy
investors and market professionals are able to discount many kinds of corporate
hype. But there is a difference between corporate hype and corporate deception
and fraud that are due to information flow blockages. A corporation's disclosure
to investors may sometimes be distorted, not in bad faith, but rather because
cognitive forces and information flow problems lead to a skewed perception of
reality by senior officials.
In my opinion, the true purpose of corporations is to
make society better off, and to create societal wealth, not just to create
wealth for shareholders. To accomplish this, the corporation must be viewed as a
holistic blend of constituencies with multiple and changing interests, neither a
shareholder-centric model nor a stakeholder model, but a corporate constituency
model, that balances the two (see Appendix). This concept focuses on the
interests of "the corporation" broadly construed as representing various
constituencies.
Perhaps rejection of traditional corporate norms will
come from an internal desire to become socially responsible together with
society's pullings for the corporation to act on conscience, and to operate on
the maxim that there are other important social goods that sometimes trump the
notion of profit-maximization. And in the wake of Enron corporations may simply
have no choice but to meet increased demands by workers, shareholders, customers
and the government for greater accountability.
| [Footnote] |
| 1 John C. Coffee, Jr., Beyond the Shut-Eyed Sentry:
Toward a Theoretical View of Corporate Misconduct and an Effective Legal
Response, 63 Va. L. Rev. 1099, 1132 (1977). |
| [Footnote] |
| 2 The theme dates back to at least 1907, with the
discussion, Dwight, Liability of Corporate Directors, 17 Yale L.J. 33
(1907). |
| 3 Id. at 1133.. |
| 4 Id. |
| 5 Id. |
| [Footnote] |
| 6 See Richard A. Oppel, Jr., Enron Official Says Many
Knew About Shaky Company Finances, N.Y. Times, Feb. 15, 2002, at Al.
|
| 7 See "Lone Voice": Excerpts From Testimony of
Executive Who Challenged Enron (excerpts from the testimony of Sherron S.
Watkins), N.Y. Times, Feb. 15, 2002, at C7. |
| 8 See Richard A. Oppel, Jr., supra note 6 at C6.
|
| 9 See Stephen Labaton and Richard A. Oppel, Jr.,
Testimony of Enron Executives is Contradictory, N.Y. Times, Feb. 8, 2002,
at Al. |
| 10 Id. |
| 11 Id. |
| [Footnote] |
| 12 See Steven Greenhouse and Stephen Labaton, Enron
Executives Say They Debated Freeze on Pension, N.Y Times, Feb. 6, 2002, at
Al, C8. |
| 13 See Don Van Natta, Jr. and Alex Berenson, Enron's
Chairman Received Warning About Accounting, N.Y. Times, Dec. 29, 2001, at
Al. |
| 14 See Neela Banerjee, At Enron, Lavish Excess Often
Came Before Success, N.Y. Times, Feb. 26, 2002, at C1.
|
| [Footnote] |
| 15 See Richard A. Oppel, Jr., Wall St. Analysts
Faulted on Enron, N.Y. Times, Feb. 28, 2002, at A1. |
| 16 Id. |
| 17 Id. |
| 18 Id. |
| [Footnote] |
| 19 See Richard A. Oppel, Jr., supra note 6. |
| 20 See "Lone Voice": Excerpts From Testimony of
Executive Who Challenged Enron (excerpts from the testimony of Sherron S.
Watkins), supra note 7. |
| 21 Id. |
| [Footnote] |
| 22 See Steven Greenhouse, U.S. Pressing For Trustees
Of Enron Plan To Step Down, N.Y. Times, Feb. 11, 2002, at A20. |
| 23 Id. |
| [Footnote] |
| 24 See Reed Abelson, Enron's Board Quickly Ratified
Far-Reaching Management Moves, MY Times, Feb. 22, 2002, C6. |
| 25 Id. |
| [Footnote] |
| 26 See Excerpts From Testimony Before House
|
| [Footnote] |
| Subcommittee on Enron Collapse (quoting from a
prepared statement by William C. Powers, Jr.), N.Y. Times, Feb. 5, 2002,
at C4. |
| 27 Id. (emphasis added.) |
| 28 See Neela Banerjee, supra note 14. |
| 29 Id. |
| [Footnote] |
| 30 See Steven Greenhouse and Stephen Labaton, Enron
Executives Say They Debated Freeze on Pension, MY Times, Feb. 6, 2002, at
Al, C8. |
| 31 See, eg., Gretchen Morgenson, A Bubble No One
Wanted to Pop, N.Y Times, Jan. 14, 2002, at Al. Aggressive accounting like
Enron's method of shifting large obligations off its balance sheet, is not
limited to Enron, but has become not uncommon in recent years. See id.
Moreover, Wall Street analysts cannot be relied upon to dig deeply into
the books of firms because they are eager to generate business selling
securities to investors and have made it a habit to ignore negative data
regarding corporate misdeeds. See id. |
| [Footnote] |
| 32 See, eg., Del. Gen. Corp. Law (sec) 141 (a) (Del.
Code Ann. tit. 8 141(a)(1991). |
| 33 See, e.g., N.Y [Bus. Corp.] law 717(a). See also
Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963), in which
the Delaware Supreme Court stated that "directors ... in managing the
corporate affairs are bound to use that amount of care which ordinarily
careful and prudent men would use in similar circumstances." |
| 34 See generally Dennis J. Block, Nancy E. Barton and
Stephen A. Radin, The Business Judgment Rule: Fiduciary Duties of
Corporate Directors (4th ed. 1993) at 5-28. |
| [Footnote] |
| 35 See S. Samuel Arsht, Fiduciary Responsibilities of
Directors, Officers and Key Employees, 4 Del. J. Corp. L. 652, 659 (1979).
|
| 36 Graham v. Allis-Chalmers Manufacturing Co., 188
A.2d 125 (Del. 1963). |
| 37 In re Caremark International Inc. Derivative
Litigation, 698 A.2d 959 (Del. Ch. 1996). |
| 38 Id. at 970. |
| 39 Id. at 971. |
| 40 Id. at 969. |
| [Footnote] |
| 41 See Samuel Arsht, Fiduciary Responsibilities of
Directors, Officers and Key Employees, 4 Del. J. Corp. L. 652, 659 (1979);
E. Norman Vessey and Julie M. S. Seitz, The Business Judgment Rule in the
Revised Model Act, the Trans Union Case, and the ALI Project A Strange
Porridge, 63 Tex. L. Rev. 1483 (1985); Charles Hansen, The Business
Judgment Rule and the American Law Institute Corporate Governance Project,
48 Bus. Law. 1355, 1360 (1993); Bayless Manning, The Business Judgment
Rule and the Director's Duty of |
| [Footnote] |
| Attention: Time for Reality, 39 Bus. Law 1477, 1494
(Aug. 1984). |
| [Footnote] |
| 42 See Julian P. Rotter, Interpersonal Trust,
Trustworthiness, and Gullibility, 35 Am. Psychol. 1 (1980). |
| 43 Carol M. Rose, Trust in the Mirror of Betrayal, 75
B.U. L. Rev. 531, 540-541 (1995). See also Michael E. Porter, Clusters and
the New Economics of Competition, Harvard Bus. Rev. Nov.-Dec. 1998, at 9,
10 (noting that German and Japanese companies are more
relationship-oriented in contrast with American companies, which are more
"transaction-- driven"). The "stick" style of monitoring that often is
found in American companies is in sharp contrast to the management
practices of other countries with a more benign approach, such as German,
Japan and the Scandanavian countries. David M. Gordon, Fat and Mean: The
Corporate Squeeze of Working Americans and the Myth of Managerial
"Downsizing" (1996) As the French philosopher Michel Serres remarked, "In
America, money is the goal and things are the means to achieve it, while
in Europe our goal is to achieve things, with money as the means.
|
| [Footnote] |
| 44 See, e.g., Julian P. Potter, Interpersonal Trust,
Trustworthiness, and Gullibility, 35 Am. Psychol. 1 (1980) (providing
empirical support for the proposition that higher trusting people are more
likely to be happier than lower trusting people); Morton Deutsch, Trust
and Suspicion, 2 J. Conflict Resol. 278 (1858) ("trusting people are
'nicer' than suspicious people"). |
| 45 John C. Coffee, Jr. supra note 1 at 1131. |
| 46 17 C.FER. 240.10b-5 (2000). |
| 47 See Donald Langevoort, Organized Illusions: A
Behavioral Theory of Why Corporations Mislead Stock Market Investors (And
Cause Social Harms), 146 U. PA. L. Rev. 101 (1997).
|
| [Footnote] |
| 48 See John C. Coffee, Jr., supra note 1 at 1134.
|
| 49 Peter Drucker, Management: Tasks, Responsibilities,
Practices 628 (1973). |
| 50 Kenneth Boulding, The Economics of Knowledge and
the Knowledge of Economics, Am. Econ. Rev., May, 1966, at 1, 8.
|
| [Footnote] |
| 51 See John C. Coffee, Jr. supra note 1 at 1127--
1129. |
| [Footnote] |
| 52 See Lawrence E. Mitchell, Cooperation and
Constraint in the Modern Corporation: An Inquiry into the Causes of
Corporate Immorality, 73 Tex. L. Rev. 477, 508 (1995).
|
| [Footnote] |
| 53 Robert Jackall, Moral Mazes: The World of Corporate
Managers 17, 20-21 (1988). |
| 54 See John C. Coffee, Jr., supra note 1 at 1104-1105.
|
| 55 Anthony Downs, Inside Bureaucracy (1966) at 143.
|
| [Footnote] |
| 56 John C. Coffee, Jr., supra note 1 at 1136. |
| 57 Id. at 1143. |
| [Footnote] |
| 58 See Roy Radner, Hierarchy: The Economics of
Managing, 30 J. Econ. Literature 1382, 1387-1401 (discussing corporate
hierarchies). |
| 59 See John C. Coffee, Jr., supra note 1 at 1138.
|
| 60 See Frank H. Easterbrook and Daniel R. Fischel,
Mandatory Disclosure and the Protection of Investors, 70 Va. L. Rev. 669,
673-677 (1984) (describing management's interest in its own
trustworthiness). |
| 61 Tom R. Tyler and Peter Degoey, Trust in
Organizational Authorities: The Influence of Motive Attributions on
Willingness to Accept Decisions, in Trust in Organizations: Frontiers of
Theory and Research (Roderick M. Kramer and tom R. Tyler eds., 1995) at
331. |
| [Footnote] |
| 62 See Barry M. Staw, The Escalation of Commitment to
a Course of Action, 6 Acad. Mgmt. Rev. 577, 580-581 (emphasizing the
virtue of appearing consistent). |
| [Footnote] |
| 63 The temptation to distort disconfirming information
increases until the information becomes so clearcut that its implications
are unavoidable. In a company that may take some time, but at some point
the project's risks or dangers crystallizes. At that point an active
cover-up might begin. As one of the more polite sayings goes, the managers
may find themselves "knee-deep in the big muddy." Barry M. Staw et al.,
Knee-Deep in the Big Muddy: A Study of Escalating Commitment to a Chosen
Course of Action, 16 Org. Behav. & Hum. Performance 27 (1976) (quoting
the title). |
| [Footnote] |
| 64 See "Lone Voice": Excerpts From Testimony of
Executive Who Challenged Enron, supra note 7. |
| 65 See, e.g., Kenneth J. Arrow, The Limits of
Organization 75 (1974) ("The efficiency loss due to informational overload
is increased by the tendency in that situation to filter information in
accordance with one's preconceptions."). |
| 66 See Canice Prendergast, A Theory of "Yes Men", 83
Am. Econ. Rev. 757 (1993). |
| 67 Id. at 1105. On the other hand, action undertaken
to maximize corporate profits in the short run at the expense of long-term
growth brings to the surface a conflict of interest between management and
investors. Management's interest may be particularly focused on the short
term, because salary, bonuses and stock options are likely to be based
upon performance in the short term, while the investor usually is more
interested in long-term capital appreciation. See Bower, On the Amoral
Organization, in The Corporate Society (R. Morris, ed. 1974) at 178,
191-192. |
| 68 See Donald C. Langevoort, supra note 47 at 135.
|
| [Footnote] |
| 69 See e.g., O. Williamson, Corporate Control and
Business Behavior (1970) at 47-49. |
| 70 Id. |
| [Footnote] |
| 71 See Jon D. Hanson and Douglas A. Kysar, Taking
Behavioralism Seriously: The Problem of Market Manipulation, 74 N.YU. L.
Rev. 630, 672 Gune 1999). |
| 72 Robert C. Ellickson, Bringing Culture and Human
Frailty to Rational Actors: A Critique of Classical Law and Economics, 65
Chi.-Kent L. Rev. 23, 23 (1989). |
| 73 Id. |
| [Footnote] |
| 74 See Jon D. Hanson and Douglas A. Kysar, supra note
71 at 633. |
| [Footnote] |
| 75 Herbert A. Simon, A Behavioral Model of Rational
Choice, 69 Q. J. Econ. 99, 104 (1955). |
| 76 See id. |
| [Footnote] |
| 77 See Sandra Blakeslee, Hijacking the Brain Circuits
With a Nickel Slot Machine, MY Times, Feb. 19, 2002, at Dl.
|
| [Footnote] |
| 78 See Anne C. Dailey, Striving for Rationality, 86
Va. L. Rev. 349, 383 (Mar. 2000). |
| 79 See L. Festinger, A Theory of Cognitive Dissonance
(1957). |
| 80 Id. |
| [Footnote] |
| 81 Donald C. Langevoort, supra note 47 at 136. |
| 82 See Jon D. Hanson and Douglas A. Kysar, supra note
71 at 646. |
| [Footnote] |
| 83 See Susan T. Fiske and Shelley E. Taylor, Social
Cognition 149-151, 150 (2d ed. 1991) ("Welldeveloped schemas generally
resist change and can even persist in the face of disconfirming
evidence."). |
| 84 Jon D. Hanson and Douglas A. Kysar, supra note 71
at 648. |
| 85 Id. at 649. |
| [Footnote] |
| 86 See text accompanying note 20 supra. |
| 87 See Donald C. Langevoort, Where Were the Lawyers?:
A Behavioral Inquiry into Lawyer Responsibility for Clients' Fraud, 46
Vand. L. Rev. 75, 111 (1993) ("[T]here are reasons . . . to doubt that
lawyers will be very good gatekeepers once they have committed to
representation and built a positive schema regarding the client and the
situation."). |
| 88 See Jon D. Hanson and Douglas A. Kysar, supra note
71 at 646. |
| [Footnote] |
| 89 See, e.g., Marjorie A. Lyles and Charles R.
Schwenk, Top Management, Strategy and Organizational Knowledge Structures,
29 J. Mgmt. Stud. 155, 170 (1992) (noting that "[strategic responses to
new situations may be the result of generalizing from the existing
knowledge structure"); see also William H. Starbuck, Congealing Oil:
Inventing Ideologies to Justify Acting Ideologies Out, 19 J. Mgmt. Stud.
3. |
| 90 See Craig A. Anderson, Mark R. Lepper, Lee Ross,
Perseverance of Social Theories: The Role of |
| [Footnote] |
| Explanation in the Persistence of Discredited
Information, 39 J. Personality & Soc. Psychol. 1037, 1045 (1980).
|
| 91 Jon D. Hanson and Douglas A. Kysar, supra note 71
at 650. |
| 92 Id. at 653. |
| [Footnote] |
| 93 Donald C. Langevoort, Taking Myths Seriously: An
Essay for Lawyers, 74 Chi.-Kent L. Rev. 1569, 1571 (2000).
|
| [Footnote] |
| 94 Jon D. Hanson and Douglas A. Kysar, supra note 71
at 654, |
| [Footnote] |
| 95 Irving L. Janis, Groupthink 9 (1982). |
| 96 See Donald C. Langevoort, supra note 93 at 1578.
|
| 97 Id. |
| [Footnote] |
| 98 See Craig D. Parks and Rebecca A. Cowlin,
Acceptance of Uncommon Information into Group Decisions When That
Information Is or Is Not Demonstrable, 66 Org. Behav. & Hum. Decision
Processes 307, 307 (1996) ("Facts that are known by only one member are
treated with skepticism by others and do not factor terribly into the
group's decision."). |
| 99 See Irving L. Janis and Leon Mann, Decision Making:
A Psychological Analysis of Conflict, Choice, and Commitment 129 (1977)
(The authors claim that when adverse information is introduced into a
group, "the members use their collective cognitive resources to develop
rationalizations supporting shared illusions about the invulnerability of
their organization or nation and display other symptoms of `group-think' -
a collective pattern of defensive avoidance." |
| 100 See id. at 280-284. |
| [Footnote] |
| 101 See Gary Marks and Norman Miller, Ten Years of
Research on the False-Consensus Effect: An Empirical and Theoretical
Review, 102 Psychol. Bull. 72, 72 (1987). |
| 102 See generally, Richard R. Nelson, Recent
Evolutionary Theorizing About Economic Change, 33 J. Econ. Literature 48
(1995). |
| 103 In sociobiology literature. See generally Lionel
Tiger, Optimism: The Biology of Hope (1979). |
| 104 See, Paul Zarnoth and Janet A. Sniezek, The Social
Influence of Confidence in Group Decision Making, 33 J. Experimental Soc.
Psychol. 345 (1997). |
| 105 Courts have been increasingly protective of
optimistic statements by corporate officials, requiring significant
evidence of bad intent or scienter in securities fraud cases. See, eg., In
re Apple Computer Sec. Litig., 886 E2d 1109, 1113-1115, 1118-1119 (9th
Cir. 1989), cert. denied, 496 U.S. 943 (1990); Raab v. General Physics
Corp., 4 EM 286, 290 (4th Cir. 1993) ("No reasonable investor would rely
on these statements [i.e., statements of "puffing" that predicted the
company's growth], and they are certainly not specific enough to
perpetrate a fraud on the market. |
| [Footnote] |
| Analysts and arbitrageurs rely on facts in determining
the value of a security, not mere expressions of optimism from company
spokesmen. . . . '[P]rojections of future performance not worded as
guarantees are generally not actionable under the federal securities
laws."' [citations omitted]; see also Carl W Schneider, Soft Disclosure:
Thrusts and Parries When Bad News Follows Optimistic Statements, 26 Rev.
Sec. & Commod. Reg. 33 (1993). Moreover, corporate law typically
insulates the business judgments of corporate officials when made in good
faith, so long as the process of deliberation is not grossly deficient.
See American Law Institute, Principles of Corporate Governance 54.01
(1992) ("A director or officer has a duty to the corporation to perform
the director's or officer's functions in good faith, in a manner that he
or she reasonably believes to be in the best interests of the corporation,
and with the care that an ordinarily prudent person would reasonably be
expected to exercise in a like position and under similar circumstances.")
For a criticism of this rule, see Franklin A. Gevurtz, The Business
Judgment Rule: Meaningless Verbiage or Misguided Notion?, 67 S. Cal. L.
Rev. 287 (1994). |
| [Footnote] |
| 106 See, e.g., Jeffrey Pfeffer, Management as Symbolic
Action: The Creation and Maintenance of Organizational Paradigms, in 3
Research in Organizational Behavior 1, 4 (L.L. Cummings and Barry M. Staw
eds., 1981 (stating that "it is the task of management to provide
explanations, rationalizations, and legitimization for the activities
undertaken in the organization"). |
| 107 See In re Apple Computer Sec. Litig. 886 F2d 1109,
1119 (9th Cir. 1989). |
| 108 See In re Time Warner Sec. Litig. 9 F3d 259 (2d
Cir. 1993). |
| [Footnote] |
| 109 See Backman v. Polaroid Corp., 910 f.2d 10 (1st
Cir. 1990). |
| [Footnote] |
| 110 See Susan T. Fiske and Shelley E. Taylor, Social
Cognition 543-550 (2d ed. 1991). |
| 111 See Donald C. Langevoort supra note 47 at 155.
|
| 112 Donald C. Langevoort, supra note 47 at 154. |
| 113 See Max H. Bazerman, Judgment in Managerial
Decision Making 37-39, 46 (3d ed. 1994). |
| 114 See Donald C. Langevoort, supra note 93 at 1581.
|
| 115 See id. at 74. |
| 116 Id. at 1575. |
| [Footnote] |
| 117 See, e.g., Dennis A. Gioia, Pinto Fires and
Personal Ethics: A Script Analysis of Missed Opportunities, 11 J. Bus.
Ethics 379 (1992). |
| 118 See Donald C. Langevoort, supra note 93 at 74.
|
| 119 See Ellen J. Langer, The Illusion of Control, 32
J. Personality & Soc. Psychol. 311 (1975). |
| 120 See Robyn M. Dawes, Rational Choice in an
|
| [Footnote] |
| Uncertain World 256 (1988) (reviewing modern origins
of rationality theory). |
| 121 See Donald C. Langevoort, supra note 93 at 1574.
|
| 122 See id. at 1574. |
| [Footnote] |
| 123 See Donald C. Langevoort, Selling Hope, Selling
Risk: Some Lessons for Law from Behavioral Economics About Stockbrokers
and Sophisticated Customers, 84 Cal. L. Rev. 627 at 639 (May 1996). |
| 124 See Max H. Bazerman, Judgment in Managerial
Decision Making 37-39 (3d ed. 1994) (discussing overconfidence among
managers). |
| 125 See Donald C. Langevoort, supra note 47 at 140.
|
| 126 See Martin E.P. Seligman, Learned Optimism (1991),
98-101. |
| 127 See id. at 141. |
| [Footnote] |
| 128 See Andrew D. Brown, Narcissism, Identity and
Legitimacy, 22 Acad. Mgmt. Rev. 643, 651-660 (1997).
|
| [Footnote] |
| 129 See Jack Katz, Concerted Ignorance: The Social
Construction of Cover-up, 8 Urb. Life 295, 297 (1979) (discussing
insulation of individual from group culpability that can result from
concerted ignorance); see also John C. Coffee, Jr., supra note 1
(discussing similar observed phenomenon in corporate hierarchies of
directors acting as "shut-eyed sentries" - deliberately looking away from
management operations in order to avoid witnessing misconduct). |
| 130 See Lawrence E. Mitchell, supra note 52 at 481.
|
| 131 There might also be subsidiary motivations whereby
a worker may be interested in adopting the company's "mission" because he
or she wants to keep the job, while another worker may be interested in
building his or her reputation and rising in the hierarchy.
|
| [Footnote] |
| 132 See Chris Argyris, Overcoming Organizational
Defenses 14-31 (1990). |
| 133 See Canice Prendergast, A Theory of "Yes Men", 83
Am. Econ. Rev. 757, 769 (1993). |
| 134 See, e.g., Clearing Payoff Storm, Northrop Chief
Keeps Firm Hand on Controls, Wall St. J., Dec. 15, 1976, at 1.
|
| [Footnote] |
| 135 Robert Jackall, supra note 53 at 22. |
| 136 See, e.g., Donald C. Langevoort, Ego, Human
Behavior, and Law, 81 Va. L. Rev. 853, 873-874 (1995).
|
| [Footnote] |
| 137 See Philip G. Zimbardo and Michael R. Leippe, The
Psychology of Attitude Change and Social Influence 120-121 (1991). At the
outset, a cheating supplier introduced small amounts of the substances,
which raised some suspicion in quality control. Executives felt that
preliminary data was inconclusive so they choice to continue using the
supplier pending results of an internal investigation. The executives
|
| [Footnote] |
| then were motivated to justify their actions to
themselves, rationalizing away data as being a simple misunderstanding,
that the existence of a health threat was inconclusive, and acknowledging
that the supplier had a good reputation in the past. The executives
convinced themselves that their actions were neither harmful nor wrong.
This false consensus effect fostered the likely assumption that most
others would share their perception. Thus, they allowed the use of the
adulterated apple juice to continue unchecked until it blew up in their
face. |
| Another example of the false consensus effect involved
Michael Milken and the demise of Drexel Burnham Lambert. Milken invented
the junk bond market and apparently sincerely believed that it was a
significant financial boon to investors and his company. He apparently
took small steps along the way to conceal some of the more tentative
features of the scheme. Each incremental action was part of a slippery
slope, and the accumulated efforts at concealment eventually resulted in
flagrant improprieties. But a host of self-protective posturing, including
rationalizations, optimism about the market and the wealth that he had
produced for some clients, apparently deflected concerns that he might be
engaging in fraudulent conduct. See Jesse Kornbluth, Highly Confident: The
Crime and Punishment of Michael Milken 367 (1992). |
| 138 See Richard T. De George, Business Ethics 90-96
(2d. ed. 1986). |
| [Footnote] |
| 139 "No feelings of guilt are required, no
attributions of moral blame permitted" in corporate decisionmaking
"because [t]he institution defines the moral role, and in the case of the
corporation the moral role is narrow indeed." Lawrence. E. Mitchell, supra
note 52 at 523-524. |
| [Footnote] |
| 140 Donald C. Langevoort, supra note 93 at 1590.
|
| 141 See Lawrence E. Mitchell supra note 52 at 522.
|
| 142 See Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y
1928). |
| [Footnote] |
| 143 Robert Jackall, supra note 53 at 105. |
| 144 Dennis R. Fox, The Law Says Corporations are
Persons, but Psychology Knows Better, 14 Behav. Sciences 7 Law 339, 349
(1996). |
| 145 See David Luban, Alan Strudler and David
Wasserman, Moral Responsibility in the Age of Bureaucracy, 90 Mich. L.
Rev. 2348 (1992). In contrast to ordinary moral choices confronting
individuals, certain knowledge conditions are frequently absent in
corporations: |
| [Footnote] |
| (1) The actor might not have any time constraint
regarding when a decision must be made. |
| (2) There may not be much clarity that a decision
|
| [Footnote] |
| needs to be made in the first place on a given point
or at a given juncture in a project. |
| (3) The actor may not know the full range of available
options in making a decision. |
| (4) The actor may have only piecemeal information and
therefore, be further in the dark. |
| By contrast, when we make individual moral decisions,
as we do every day, we know that a decision must be made, when a decision
must be made, what options are available, and what steps are necessary in
order to make the decision. For instance, as a lawyer confronted with a
client who intends to lie on the witness stand, I know that a decision
must be made on my part, when it must be made, what choices are available
(be silent or blow the whistle, or resign as attorney), and what is needed
to make the choice. See id. at 2364 from which this four-prong analysis is
derived. If these conditions are missing, most moral systems allow that
the agent "knew not what he was doing," and should therefore be excused
from moral blame. |
| 146 A conspiracy is an agreement by two or more
persons to commit an unlawful act. See W LaFave and A. Scott, Criminal Law
453 (1972) The crime of conspiracy is completed, and may be prosecuted,
before any overt action occurs beyond the formation of the agreement. See
Thomas Church, Jr., Conspiracy Doctrine and Speech Offenses: A
Reexamination of Yates v. United States from the Perspective of United
States v. Spoke, 60 Cornell L.R. 569, 572 (Apr. 1975). An "overt act"
refers to any legal or illegal act in furtherance of the conspiracy. A
conspiracy is thought to pose a greater threat than the same plot in the
mind of a single individual because the joint illegal intent of two or
more individuals is significantly more dangerous than a similar intent on
the part of an individual. Id.; see also LaFave and Scott, supra, at
459-460. |
| [Footnote] |
| When two agree to carry [a plot] into effect, the very
plot is an act in itself . . .The agreement is an advancement of the
intention which each has conceived in his mind; the mind proceeds from a
secret intention to the overt act of mutual consultation and agreement.
|
| [Footnote] |
| State v. Carbone, 10 N.E. 329, 336-337, 91 A.2d 571,
574 (1952). |
| [Footnote] |
| 147 Note, The Conspiracy Dilemma: Prosecution of Group
Crime, 62 Harv. L. Rev. 276, 283-284 (1948) (footnotes omitted). |
| 148 See John C. Coffee, Jr., supra note 1 at 1265.
|
| 149 See David Luban, Alan Strudler and David
Wasserman, supra note 145 at 2389. |
| [Footnote] |
| 150 This task involves problems similar to those faced
by any law enforcement agency, including the difficulty of securing
reliable evidence of wrongdoing, the need to protect the rights of
potential accused, the need to encourage disclosure, and the need to apply
appropriate sanctions. The handling of information concerning corporate
misconduct is a delicate matter, since there will tend to be support, at
least initially, for a manager who has performed well and in whom trust
has been reposed by the company. In addition, the accuracy and motivates
of the informant may be suspect for several reasons, including incomplete
information, unreliable or ambiguous facts, reasonable disagreement over
the ethical or legal conclusions, and ulterior motives of the informant
such as desire for advancement, or personal antagonism. |
| 151 See R. Nader, M. Green and J. Seligman,
Constitutionaliational of the Corporation: The Case for the Federal
Chartering of Giant Corporations (1976). |
| [Footnote] |
| 152 See John C. Coffee, Jr., supra note 1 at 1236.
|
| 153 See D. Don Welch, Ruling From the Heart: Emotio--
based Public Policy, 6 S. Cal. Interdisc. L.J. 55 (1997). |
| 154 Research has identified intuition as a brain
function. A brain region called the limbic system, which is involved with
emotions, interacts with another brain region called the prefrontal
cortex, involved in decisionmaking. When people think about doing
something, the prefrontal cortex calls up knowledge related to feelings
they recall from their memory about earlier similar situations. |
| We are not conscious of the signals, although more
sensitive people are. These emotional signals are very active and they
trigger what we call intuition. See Sandra Blakeslee, "Study Links
Antisocial Behavior to Early Brain Injury That Bars Learning," N.Y. Times,
Oct. 19, 1999, Science Section. |
| Scientists define intuition as a sudden, strong "gut
feeling" to do something, or coming to suddenly get a hunch or
premonition, a kind of knowing, without any rational explanation or how
this idea came about at this moment. Intuition is like an inner voice
giving you a strong feeling about what's right, sometimes subtle enough to
be easily disregarded,. Sometimes it manifests like a flash of knowledge,
or sudden insight. |
| [Footnote] |
| Intuitions are things which we "know" immediately -
they are unmediated, non-inferred feelings, a sense of knowing tied to a
feeling or an emotional draw, an attractive emotional draw or a negative
one. You may feel a strong intuition about something but there is no
guarantee that your hunch is true. Time will tell. People who are rigidly
logical have blocked |
| [Footnote] |
| their intuitive skills. Japan is often cited as a
culture that encourages and fosters intuition in workers, which they think
helps advance science and technology. Also, as people become experts in
their given field, they tend to be more in touch with intuition. 155 See
William J. Brennan, Reason, Passion and "The Progress of the Law,"
Forty-Second Annual Benjamin N. Cardozo Lecture delivered at the
Association of the Bar of the City of New York (Sept. 14, 1987), reprinted
in 10 Cardozo L. Rev. 3, 22 (1988). |
| 156 Id. at 22-23. |
| [Footnote] |
| 157 See Reed Abelson, Enron's Board Quickly Ratified
Far-Reaching Management Moves, supra note 24. |
| 158 See, e.g., Paramount Communications v. Time, Inc.,
571 A.2d 1140, 1150 (Del. 1989) ("[A] board of directors, while always
required to act in an informed manner, is not under any per se duty to
maximize shareholder value in the short term .... ). |
| 159 Fiduciary duties are governed by state law in this
country, and the majority of states describe fiduciary duties of directors
in this manner. See Lawrence E. Mitchell, Theoretical and Practical
Framework for Enforcing Corporate Constituency Statutes, 70 Tex. L. Rev.
579, 630-640 (1992). |
| [Footnote] |
| 160 See. eg., Frank Easterbrook K. and Daniel Fischel,
The Economic Structure of Corporate Law (1991); see also Andrei Shleifer
and Robert W Vishny, A Survey of Corporate Governance, 52 J. Fin. 737,
738, 740-748 (1997). |
| [Footnote] |
| 161 See Steven M.H. Wallman, Understanding the Purpose
of the Corporation, 24 J. Corp. L. 807 (Summ. 1999).
|
| [Footnote] |
| 162 See id. at 813. |
| 163 See id. |
| [Footnote] |
| 164 James Willard Hurst, The Legitimacy of the
Business Corporation in the Law of the United States, 1780-1970, 15-17
(1970). |
| 165 Id. at 15. |
| [Footnote] |
| 166 See, eg., cases cited in John C. Coates IV, State
Takeover Statutes and Corporate Theory: The Revival of an Old Debate, 64
N.YU. L. Rev. 806, 834 n. 175 (1989). |
| [Footnote] |
| 167 See Dennis R. Fox, supra note 144 at 344. |
| 168 Steven M.H. Wallman, The Proper Interpretation of
Corporate Constituency Statutes and Formulation of Director Duties, 21
Stetson L. Rev. 1, 170-171 (1991). |
| 169 See A. A. Berle, Corporate Powers as Powers in
Trust, 44 Harv. L. Rev. 1049 (1931); A. A. Berle, For Whom Corporate
Managers Are Trustees: A Note, 45 Harv. L. Rev. 1365 (1932); and E.
Merrick Dodd, Jr., For Whom Are Corporate Managers Trustees?, 45 Harv. L.
Rev. 1145 (1932). |
| [Footnote] |
| 170 See id. at 44 Harv. L. Rev. 1049, 1049. |
| 171 See E. Merrick Dodd, Jr. supra note 169 at 1148.
|
| 172 See id. at 1148. |
| 173 Id. at 1153-1154. |
| [Footnote] |
| 174 See, e.g., Bangor Punta Operations, Inc. v. Bangor
& A.R.R., 417 U.S. 703 (1974) in which a majority of the Court seemed
to accept the proposition that directors are fiduciaries only for those
possessing a "tangible interest in the corporation," not the public at
large. See id. at 716 n. 13. |
| 175 See AT Smith Mfg. Co. v. Barlow, 98 A.2d 581, 583
(NJ. 1953) (tracing the general shift in the perspective on corporate
activity from a public service focus, which dated from at least 1702, to a
more profit-based orientation in the 1930s). |
| 176 See Lawrence E. Mitchell, supra note 52 at
534-535. |
| [Footnote] |
| 177 See Steven M.H. Wallman, supra note 161 at 810.
|
| 178 See, e.g., Conn. Gen. Stat. Ann. 33-313(e) (West
Supp. 1994); Fla. Stat. Ann. 607.0830(3) (West 1993); La. Rev. Stat. Ann.
12:92(g) (West 1994); Ohio Rev. Code Ann. 1701.59(D) (Baldwin 1993); R.I.
Gen. Laws 7-5.2-8 (1992). |
| [Author Affiliation] |
| John Alan Cohan |
| [Author Affiliation] |
| John Alan Cohan is an attorney, writer, teacher and
philosopher. He is a native of Los Angeles, California, and has been a
lawyer since 1972, with clients throughout the United States and Europe in
the fields of tax law, aviation law, and farming and livestock law. He was
graduated from the University of Southern California in 1969, Loyola Law
School in 1972, and admitted to the California Bar in 1972. He has studied
philosophy in the Philosophy Department of UCLA with the equivalent of a
master's degree in philosophy. |
| [Author Affiliation] |
| Law Offices of John Alan Cohan, 415 North Camden Dr.
Suite 100, CA 90210, Beverly Hills, U.S.A. |
| [Appendix] |
| Reevaluation of the shareholder-centric model
|
| [Appendix] |
| The problem of the nature and purpose of the
corporation, its function in society, has been of longstanding concern.
Corporations make things, do things, buy things and sell things, they have
different commitments and different goals, and the levels of commitment to
these goals vary. That is, the duties of the board entail focusing on a
panoply of concerns, above and beyond maximizing shareholder profits.158
|
| [Appendix] |
| Directors owe fiduciary duties to "the
corporation."159 For decades the prevailing theory of corporate governance
rested on the shareholder-centric model, that is, on the assumption that
the primary duty, or even the sole task, of officers and directors was to
maximize shareholder wealth.160 |
| Corporations are granted limited liability for
shareholders and given life in perpetuity because they are thought to be
business vehicles that serve the goal of promoting overall societal
wealth. The genius of U.S. corporate law is that it gives directors and
officers the flexibilty to balance shareholders' interests against other
stakeholders.161 The corporate vehicle for providing dividends to
shareholders is not an end in itself, but is a means to the further end of
benefiting society. Increasingly we see that the model of "shareholder
primacy" certainly does not tell the whole story, and it may not be the
appropriate corporate governance norm. Today it seems that most corporate
officers and directors take their job to be a much more complex balancing
act in which they must serve not just shareholders' interests, but also
those of other stakeholder groups such as managers, creditors, employees,
other companies, the community and the environment. |
| The idea that directors owe their duty solely to
shareholders leads to perplexing dilemmas, troubling results, and
long-term disadvantages for society. Which shareholders ought to be the
focus of maximizing shareholder wealth? Shareholders of the moment?
Long-term shareholders? Should actions be directed to maximize the current
share price? What about action that will be detrimental to the current
share price but will, at least in the directors' view, benefit long-term
shareholders, or shareholders at a much later date? And in principal how
can corporate action taken today to benefit long-term
share |
| [Appendix] |
| holders be detrimental to the current share price--
oughtn't it help increase today's share price? |
| Should the directors regard polluting as a matter of
trade-offs? That is, are the costs of polluting including the amount of
any potential fine, less than the cost of not polluting? If so, then
pollute. The fact that pollution could have devastating side effects on
the environment and on members of the public might be irrelevant under the
shareholder-centric model if no harm is expected to be visited on the
polluting corporation's share price. The only question is whether more
money can be made from destroying the last old growth of ponderosa pines
than from not doing so. |
| It is not entirely clear how the notion focusing on
promoting shareholder interests started to dominate academic discussions
of corporate law. In fact, the concept that directors owe their fiduciary
duty exclusively to shareholders is not now the law nor has it ever been
the law in this country.162 Rather, the law generally grants directors
trustee status for the firm as a whole, meaning that they have the
discretion to consider the interests of other corporate constituencies, in
addition to the interests of shareholders, in shaping business policy.
|
| In the late eighteenth and early nineteenth centuries,
American corporations were chartered with the integral purpose of serving
public interests.163 As one commentator observed:
|
| [Appendix] |
| Almost all of the business enterprises incorporated .
. .in the formative generation starting in the 1780's were chartered for
activities of some community interest - supplying transport, water,
insurance or banking facilities. that such public-interest undertakings
practically monopolized the corporate form implied that incorporation was
inherently of such public concern that the public authority must confer
it.164 |
| [Appendix] |
| The courts recognized that this integral
public-interest purpose was exacted as "a regulatory quid pro quo" in
exchange for conferring the corporate entity status.165 While it was clear
that shareholders in early American corporations had legal control over
the corporation, the early charters emphasized the corporation's larger
public-interest purposes. Charters imposed strict limits on corporate
organization, function, and even length of existence.167 Similarly,
starting with the earliest court cases, the directors' fiduciary duties
were interpreted so as to subsume the shareholders' interests to the
larger sphere of duties to "the corporation" itself.166
|
| [Appendix] |
| Only in the past century and a half has the United
|
| [Appendix] |
| States treated the corporation as private property
rather than as a creation of the state designed to serve a public
function. |
| These core principles underscore the view that the
interests of the corporation historically go beyond the
wealth-maximization concerns of shareholders. Its interests also include
|
| [Appendix] |
| the interwoven interests of its various
constituencies, such as . . . employees, customers, the local community,
and others. Linking these interests to the corporation's interests
resolves much of the tension that would otherwise exist. . . . [T]hese
constituencies' interests are balanced by the board of directors acting in
the best interests of the corporation as a whole, as opposed to the best
interests of any one particular constituency [such as the
shareholders].168 |
| [Appendix] |
| The idea that corporate managers are trustees who must
serve the public interest has been debated for many years. A debate from
the 1930s involved Professors Adolph A. Berle, Jr. and E. Merrick Dodd,
Jr., who debated the obligations of the corporation in Harvard Law
Review.169 Professor Berle argued that the corporation was responsible
only to its stockholders.170 Professor Dodd argued that a corporation must
not only profit its stockholders, but must also engage in social
service.171 |
| [Appendix] |
| The debate focused on the idea that the law may be
approaching a position in which it will regard all business as affected
with a public interest. Their debate discussed the public opinion of the
1930s, which had been moving towards the view that companies are economic
institutions that have a social service as well as a profit-making
function, and that it was unwise for corporations to emphasize the
profit-maximization function. Professor Dodd noted that before modern
corporations arose the law regarded engaging in business to be a public
profession rather than a purely private matter, with certain high
fiduciary standards that have survived in duties owed by public carriers
and innkeepers.172 Based on the court of public opinion, Professor Dodd
argued that "our corporate managers who control business should
voluntarily and without waiting for legal compulsion manage [business] in
such a say as to fulfill these responsibilities."173
|
| [Appendix] |
| Professor Berle's view that the fiduciary
responsibility of directors is for the exclusive benefit of shareholders
has been embraced by the courts.174 Thus, while the general view prior to
the 1930s was that corporations have a certain societal orientation, this
view got eclipsed by the "modern" belief that profit
|
| [Appendix] |
| maximization for shareholders was the controlling
function of firms except those classified as public utilities.175
|
| [Appendix] |
| But it seems to me that concern for the profitability
of stockholders and ethical concerns are not inherently separate and
apart. Society is free to impose its collective will on the behavior of
corporate agents in light of shifting values. Evidence of consumer
boycotts against companies that engage in socially irresponsible action,
unfair labor practices, or that do business in violation of human rights
or in violation of environmental norms - indicates that society wants
companies to take account of social concerns in corporate
decisionmaking.176 This observation is supported by the fact that over
half the states (and almost all the states, absent Delaware, that have a
significant number of public companies incorporated in their jurisdiction)
have adopted "corporate constituency" statutes.177 These laws allow boards
to take into account the interests of a variety of constituencies
sufficiently broad enough to accommodate most social concerns.178 These
laws seem to endorse Professor Dodd's view, discussed above, by making it
clear that directors do not owe their fiduciary duty exclusively to
shareholders, and giving corporate managers a green light to behave as
morally whole persons both inside the corporate bureaucracy. These laws
suggest a growing public policy that encourages directors to take into
account other corporate constituencies. Proponents of shareholder primacy
seemingly ignore these ubiquitous state laws that reject the shareholder--
only model. |
| [Appendix] |
| Professor Dodd's view is not inconsistent with the
objective of maximizing shareholder profits, but rather provides a certain
flexibility. When acting to fulfill their fiduciary duties to society and
stakeholders at large within certain parameters, directors need not fear
legal action on the part of shareholders for the exercise of its authority
in this manner. This does not mean abandonment of the profit motive, but
complements it with a broader mandate to permit corporate actors to be
more responsive, and more responsible, as a market-driven institution. It
means allowing corporate agents to make decisions grounded in their many
relations and obligations in life, from the wellspring of their whole
moral arena. |
| Proponents of the shareholder-primacy model may want
to point out, however, that management is under no obligation to forego
stockholder-centric philosophy in favor of public interest. Management
simply has the freedom to choose among the conflicting interests involved.
If it does not want to do so in any particular case, it does not violate
the law. |
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