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This section will provide our readers with a number of items by the authors that, for space reasons, did not appear in The Naked Corporation. We will publish these over the next few months, so keep coming back for more!


History's Long Wave of Transparency

Many of the limits on transparency – from principal-agent problems, to the protection of trade secrets, to the complexity that can overwhelm signals with noise, to the war on openness – are increasing or ineradicable. So why do we claim transparency will increase in the near and long term? A quick review of U.S. history suggests that transparency always increases, albeit in a stutter step, crisis-driven pattern.

Sages through the ages have linked knowledge, power, and values. From Virgil, “Of those who improved life by knowledge, and those who are remembered for their services: round the brows of these is a snow-white band,”(1) to Samuel Johnson, “Integrity without knowledge is weak and useless, and knowledge without integrity is dangerous and dreadful,”(2) we have ever been urged that understanding permits wise action.

Yet those in power have not always encouraged the dissemination of knowledge. History chronicles many battles over socially and economically strategic information: a struggle for transparency. Kings and viziers, apostles and priests, sellers and buyers, socialists and capitalists, dictators and democrats, bosses and workers – all depend on whatever information advantages they can muster. Information monopolies, particularly when exploited unfairly, inevitably lead to conflicts with rivals and victims.

This chapter offers a potted history of transparency. It begins with the emergence of transparency technologies in the Western world and then focuses increasingly on the rise of corporate transparency in the U.S.. This book is about transparency for a variety of the firm’s stakeholders – employees, customers, b-web partners, communities, and shareholders. The narrative that follows focuses on the firm’s visibility to just one of these – shareholders. After all, if a company fails to be accountable to its owners, how will care for the interests of anyone else?

Before capitalism, transparency was inherently weak. Tribes relied on cunning and myth. Church and state were intertwined; by and large, they controlled commerce and decreed the boundaries of the knowable and the known. Until the Reformation, most cultural and social revolutions were led or co-opted by rising waves of political-religious autocrats.

Transparency depends on having a way to measure and describe the world, and a medium by which to communicate. The latter arose only some 500 years ago. Paper came into Europe in the 13th century. It facilitated the work of merchants, bureaucrats, preachers and writers. But until Johannes Gutenberg invented the printing press in the early 1450s, publishing was manual work: labor-intensive and slow. Maintaining and disseminating knowledge depended almost entirely on face-to-face interactions. Small elite groups monopolized access to the written word, and many texts were lost. Reference points that we take for granted – like standard maps – did not exist. As late as 1792, France alone had over 250,000 different systems of measurement.

By the turn of the 1500s, Renaissance thinkers had invented investigative tools like the telescope. They also invented the mechanical clock, which set predictable, constant measures of time (though standard time had to wait centuries).
With such tools, Galileo, then Newton could discover and publish laws of nature. The explosion in science and mathematics was accompanied by applied technologies such as musical notation, perspective painting, and bookkeeping. These new technologies captured knowledge as never before. Modern accounting – at its core double-entry bookkeeping – originally invented in the mid-1300s, was popularized in two books by Luca Pacioli around 1500. Accounting was not essential to doing business, but it let the budding capitalist visualize and communicate the state of his business. Pacioli described how transparency builds social capital; “Frequent accounting makes for lasting friendships.”(3)

These developments helped stitch together a much broader economy, more “global” and with more buyers and sellers than ever before. Wide networks demand information, increasing the need for transparency. A serf growing grapes on a twelfth-century French baronial estate inhabited a world where change was slow, prices stable, and relationships highly structured. He could be exploited in several ways, but he knew his boundaries of risk pretty well. Six hundred years later, a pre-Revolutionary renter working the same land – in a more transparent world – faced more imponderables of prices and taxation, but change was still fairly slow and markets relatively local. Today’s small-vineyard owner faces constant price changes from volatile global markets, which unpredictably change the rules from one season to the next and depend on vagaries of geopolitics. Information and complexity feed on each other. Today’s grower knows a lot more; he can instantly check prices and markets around the world and immediately see reviews of his wines in the international press. Yet he has a harder time planning for each season because prices are volatile. Thus, transparency increases over time, in tandem with growing volumes of information, even when firms might wish otherwise.

The Telegraph

While the U.S. economy expanded rapidly from the late 1700s through the 1840s, its tools and forms of business organization were substantially the same as those of Renaissance Europe.(4) Early America was an agrarian society. Businesses were modest in size, based on the family or, if larger, on partnerships. They used double-entry bookkeeping, consignment sales, and letters of credit. Joint stock companies also followed inherited models.

During the latter half of the 19th century, science and technology drove changes in industrial organization, markets, finance – and transparency. The core enabling technologies were steam power and electricity, improvements in machinery, new chemical industrial production methods, and the emerging intellectual arts of invention and technological innovation. Most pertinent to our story were three inventions: the railway, the telegraph and the telephone. We focus on the telegraph though much of what we say applies to the other two.

The telegraph was the first, and in many ways archetypal, communications medium of the industrial world. Like the Internet’s founders, Samuel Morse tapped a U.S. government grant to fund the first telegraph network in 1844. This simple electric medium augured the wonders of today’s global web – interactivity, any-to-any communications, and the collapse of time and space. Within a few decades, the telegraph’s communication and coordinating power allowed modern industries to decimate local and itinerant firms. Financial and commodities markets, transportation, retail industries, newspapers, police work, and personal communications changed almost overnight.

Now and forever, information could move nearly instantaneously. Many telegraph lines used railway rights-of-way.(5) They were also crucial to the growth and operation of this revolutionary transportation network. Telegraph messages enabled railways to run on time and to coordinate people and materials.

Almost immediately, the new medium became a force for change. The British military had for centuries wasted soldiers’ lives and lost battles due to command failures. In 1854, the Times (London) newspaper’s telegraphed reports on the Crimean War described how men perished on the battlefield from hunger and neglect while the wounded languished without physicians or bandages. The newspaper pointedly suggested that “it rests with the Government to make enquiries into the conduct of those who must have so greatly neglected their duty.” The immediacy of this human interest story led Florence Nightingale to go into nursing.(6) She wrote to the war secretary proposing a plan for a private nursing corps. Nightingale went to the Crimea where she invented battlefield nursing. Then she created the modern nursing profession, exposed the horrors of the British home medical system, and laid the foundation for the hospital and public health systems of the 20th century.

The telegraph added more than just immediacy to the news. It spawned wire services, which fundamentally changed the nature of reporting – from the partisan, idiosyncratic style of the local hack to a professional approach that worked in papers of any style or stripe. The new form was objective and spare: nothing but the facts, at least in form if not always in content. Wire services taught the public the structure and value of objective discourse.(7)

The telegraph also spawned mythologies resurrected in the early days of the Internet explosion, as in this 1858 U.S. paean: “How potent a power, then, is the telegraph destined to become in the civilization of the world! …It is impossible that old prejudices and hostilities should longer exist, while such an instrument has been created for an exchange of thought between all the nations of the earth.”(8) A British commentator took a more jaundiced view; “It may be doubted whether any more efficient means could be adopted… to consolidate British power and strengthen British rule.”(9) Indeed, the telegraph quickly became crucial to the imperial center’s visibility and control over its colonial representatives and investments. Perhaps empires could be governable after all.

The telegraph combined with the railway to bring transparency to markets. Before, markets were mostly local and independent of one another. Prices varied from place to place. Middlemen arbitraged these differences: their unique knowledge enabled them to buy cheap in one place and sell dear in another. The telegraph and railway quickly created national commodity and securities markets. In the 1820s, grain prices in Cincinnati lagged eastern markets by two years. By 1840 the lag was four months, and it vanished by the end of the next decade.

The result was profound: farmers’ locus of risk shifted from local buyers to national commodity markets.
Futures markets replaced the arbitrage of pretelegraph itinerant middlemen. These markets reduced price fluctuations and enabled food supply chain participants to manage resources with greater certainty. Space-based speculation declined (arbitrage fails when all participants know the current price), and time-based speculation took off (futures bets work because no one can predict with certainty, and time-value itself is salable).(10) Futures contracts became tradable because reports on weather and other conditions (such as capacity) reached markets long before the goods. All these – and the financial derivatives that followed – resulted from the transparency of the telegraph and its successors.

As with present-day derivatives, the first futures markets created new challenges to transparency. Such instruments had the effect of creating an entirely new financial marketplace with a life of its own. Speculators bought and sold futures, receipts, and other instruments quite independently of the goods to which they referred, and also independently of their grit-fingered producers. The vagaries of these self-contained commodities markets ultimately translated into prices for producers and purchasers, but these terms often bore only a passing relationship to the hog farmer’s cost of production or the consumer’s lust for bacon. As markets rose and fell, some farmers got rich while others lost everything – all because of opaque forces that operated in a mysterious and inaccessible realm.

Transparency breeds complexity, which creates new demands for transparency. It is not a simple linear story of progress but rather one of periodic crises, followed by hard-won (and hard-to-preserve) breakthroughs.

Robber Barons

In the mid-nineteenth century, getting a charter to form a corporation was still a privilege bestowed by the state. The limited liability corporation was a new kind of artifact, a gift to the new breed of entrepreneur. Railway entrepreneurs in search of charters plied politicians with money, shares, and free passes. Between 1850 and 1857 rail companies got 25 million acres of public land for free, as well as millions of dollars in loans from state legislatures. Railway stocks took off, and then collapsed. In this nineteenth-century bubble, many railways went bankrupt and defaulted on their loans (capital expenses for laying track and assembling rolling stock were huge).(11)

Most industries had dozens, even hundreds, of small players and no rules. Competition was ruthless and destructive, labor standards barbaric. The economy swung erratically from boom to bust. Prices soared, banks failed, and depositors were left in the lurch. The telegraph and the press increased transparency, but the world was not an open book for all.
The self-made steamship and railway baron Cornelius Vanderbilt, a primary school dropout, kept his business accounts in his head throughout his life. He trusted no one and built his empire through market cornering and bribery. At his death, reputedly worth $100 million, he was the richest man in the country.

From its early days in the 19th century, the New York Stock Exchange was the financial center of U.S. capitalism. Backroom deals, gambling, fraud, and self-dealing were rampant. Members enjoyed lower trading rates than nonmembers. Share prices were rarely made known to the public or the press. Until Dow-Jones founded the Wall Street Journal in 1889 – where the Dow-Jones Index ran on a daily basis from 1896 – most financial newspapers were paid mouthpieces for stock promoters. This practice ended only after the 1929 crash.

Meanwhile, there was neither meaningful financial regulation nor a central bank. When the Knickerbocker Trust failed in 1907 after a market panic, thousands of depositors lost everything. The bank’s president, Charles Barney, shot himself, and several depositors followed suit. J. P. Morgan led a private sector bailout of other wobbly trust institutions. This ad hoc system functioned, but only at great risk and with meager information available to ordinary investors.

Transparency would only happen as a result of aggressive state intervention. No one knew how much J. P. Morgan was at the center of the banking and commercial world until the 1912 Pujo congressional investigation revealed that he and a dozen partners held 72 interlocking directorships in 47 major corporations. In total, the officers of the Morgan and just three other banks held 341 directorships in 112 corporations, with resources of $22 billion (which exceeded the assessed value of all property in the 22 states and territories west of the Mississippi). In congressional testimony Morgan denied knowledge of his own connections and dealings. Until that moment of “transparency” and even afterward, Morgan and his partners denied the existence of a “money trust.”(12)

In an attempt to bring order to chaos and restore public confidence, Woodrow Wilson formed the Federal Reserve and the antimonopoly Federal Trade Commission. This first great regulatory explosion was a response to new, large-scale corporations and financial webs, themselves made possible by the telephone and telegraph. Yet they were insufficient to tame the business cycle.

It took the worst business collapse in modern history – the Great Depression – to force transparency into the underlying world of money and securities. The Securities Act of 1933 was the first piece of national securities legislation passed by Congress.(13) During the previous two decades, some 20 states had passed a patchwork of so-called blue-sky laws to regulate the issuance of securities, but these were rife with loopholes. U.S. financial markets, in both banking and securities, operated pretty much free of regulation and visibility until Franklin Roosevelt stepped in.

Arguably, the 1929 crash was just another 1800s style panic in a bigger, more complex, and interdependent 20th century world. Wall Street machinations – many of which the Internet bubble of the 1990s revisited – caused the crash:

• Stocks replaced bank savings for over a million Americans.

• Bankers used deposits to lend money to stockbrokers and accepted stocks as collateral.

• The boom in banking and share prices drove a false “wealth effect” along with inflation and high interest rates.

The Depression had everything to do with transparency, in several dimensions.

First was the collapse of investment-bank houses of cards – hundreds of interlinked holding companies and investment trusts with little or no substance behind them.

Goldman Sachs, for example, floated the Shenandoah Corporation in 1929. A third of Shenandoah’s assets was stock in another investment trust, Goldman Sachs Trading Corporation. In due course, Goldman Sachs created another and larger trust, the Blue Ridge Corporation, and 80 percent of its capital was stock in the Shenandoah Corporation. Such speculative monuments of the New Era became its necropolis. Their own stock was exposed as worthless when trade slumped.(14)

Deposit banks were a second kind of house of cards; as they collapsed, millions lost their personal savings. This turned out to be another by-product of opacity. Some bankers had used depositors’ money to personally speculate on risky and fraudulent deals. Others simply stole depositors’ money outright (this did not apply to the major New York and Chicago banks, but was widespread elsewhere). A vicious spiral ensued when millions of depositors panicked and withdrew their money.

Then after the crash some bankers, notably Albert Wiggin of Chase National, used their inside positions in Wall Street’s bailout attempt to make millions from short selling. Wiggin used Canadian companies to hide profits and avoid paying taxes. Word got out. This scandal was among the main reasons why banks and stock markets lost public support for a generation.(15)

All this contributed to mass fear that extended well beyond 600,000 active investors to millions of families who had fallen into debt for the first time in their lives. A deflationary spiral ensued. Many closed their wallets, pushing the prices of goods, services, and shares down and unemployment up. Consumer spending dropped by 10 percent in 1930.

The New Rules

Finally the government stepped in and forced the United States’ financial system to open itself to greater scrutiny and regulation. Transparency was central to the first piece of national securities legislation ever passed by Congress. Franklin Delano Roosevelt submitted the Securities Act of 1933 right after he took office, saying:

The Federal Government cannot and should not take any action which might be construed as approving or guaranteeing that newly issued securities are sound in the sense that their value will be maintained or that the properties which they represent will earn a profit…There is however an obligation upon us to insist that every issue to be sold in interstate commerce shall be accompanied by full publicity and information.(16)

The act required sellers to register new securities – and supporting information – with the Federal Trade Commission. Issuers of foreign bonds (also the subject of various fraudulent schemes) were required to do the same. Wall Street dispatched John Foster Dulles (who later became Dwight Eisenhower’s secretary of state) to fight the law, to no avail.

The Glass-Steagall Act went even further, dismantling the structural basis of self-dealing in the Robber Baron era. The act separated commercial from investment banking. Every bank had to choose one or the other activity. J. P. Morgan Company, the commercial bank, begrudgingly spun out Morgan Stanley Company as a bond and stock business. Now, bank depositors could trust that the preservation of their accounts no longer depended on stock fluctuations.

Next Roosevelt decided to police the stock market itself. The Securities Exchange Act of 1934 created the Securities and Exchange Commission: for the first time, investment bankers were accountable to a government agency. Again transparency was central. Any company or investment banker who made a false filing with the SEC would face prosecution. All publicly traded companies would henceforth be required to register and provide quarterly and annual financial reports. To gain the right to register newly issued shares of other companies, investment banks would also have to provide financial information about themselves. This was revolutionary, since most companies – from the house of Morgan on down – had never published annual reports. Joseph P. Kennedy, trusted by Wall Street, was Roosevelt’s brilliant first choice as SEC chair. Despite this choice, the SEC Act ended any prospect for good relations between Roosevelt and the Street.

Roosevelt lost other battles. But his legal framework established an enduring bridgehead for transparency in U.S. capitalism. Although Wall Street and corporate executives howled and skirted rules, the foundation held. It changed the structure and day-to day operations of industry, mostly for the better – for all parties.

Separation of Ownership from Control

Adam Smith described the capitalism of the invisible hand: individual entrepreneurs, pursuing their own self-interest, create goods and services that meet the needs of customers with growing efficiency, creating benefit for all. This description was true enough in his time. But by the New Deal, the invisible hand had given way to an institutional model that was far more complex. Instead of individual capitalists with modest businesses, gigantic corporations dominated entire industries and integrated a wide range of functions under a single umbrella. And the shareholders of these businesses were typically in the dark.

Consider one example. In 1881, James Bonsack patented a machine which soon thereafter could produce 120,000 cigarettes per day. The most-skilled manual workers produced 3,000 cigarettes a day; Bonsack’s machine reduced production costs by 85 percent. Fifteen such machines would easily saturate the entire U.S. market. James B. Duke was the first to put this machine to work. He acted quickly to create a vertically integrated purchasing, manufacturing, advertising, sales, and distribution organization to capitalize on the machine’s capability. Within a few years, his firm, the American Tobacco Company, had all the core characteristics of a managerial, multidepartment, twentieth-century firm. Duke built a large-scale industrial corporation from scratch, because he had no choice if he wanted to capitalize on the potential of Bonsack’s cigarette machine. The choice was simple: grow fast or lose out to competitors.

Duke and others like him did not personally have enough capital to fund the growth of his business. Well in advance of receiving product sales revenue that would cover all his costs, he had to acquire land, build facilities, hire and pay employees, buy equipment and materials, advertise, distribute, and so on. Aspiring capitalists raised money by selling shares of their companies to others – initially, perhaps, on a private basis, then via public markets like Wall Street.
These “limited liability” corporations, made possible when the courts first allowed owners and employees to be free of personal liability for their firms’ actions, are central to modern capitalism – and unlike anything that Adam Smith imagined. Since the corporation has a separate existence unto itself, it is solely liable for its debts and obligations. Its investors and shareholders stand to gain from the firm’s success, but their personal risk is limited to the amount of capital they have invested (which in a worst case scenario such as bankruptcy, they may lose).

Limited liability, granted by society, is a good deal for investors. Arguably, in exchange for the privilege of limited liability, firms as instruments of their shareholders can or should be accountable to society for their actions. In other words firms, should be transparent, not cause harm, do good, and so on, as consideration for the “gift” of limited liability (not to mention other considerations such as an education system that delivers skilled workers, laws that facilitate commerce and the interests of specific corporations and industries, financial assistance, and so on). While a democratic state is the product of the coming together of “natural” individual citizens, the firm is an artifact that exists at the pleasure of the state. As a minimum, since the firm’s very existence and legal “personhood” depends on the state’s laws and licenses, the state has a right to regulate: to define the terms by which the firm gains and continues in its right to exist.

A related big change from Adam Smith’s theory was the separation of ownership from control. This began with the capitalization of railways in the nineteenth century and became dominant across most industries by the 1920s. Adolf A. Berle and Gardiner C. Means first analyzed this change in 1933.(17) As joint stock companies grew and investors traded shares with one another, the stock market took on a life of its own. Thousands, then hundreds of thousands of individuals bought shares. By and large, no individual owned even 1 percent of any one company. As a result, shareholders as a class became weak, while managers inside the firm took control. Berle and Means nailed the resulting risk for shareholders: “The controlling group … can serve their own pockets better by profiting at the expense of the company than by making profits for it.”(18)

Since few firms bothered to publish financial reports before 1933, shareholders lacked the most basic information about the companies they owned. Even Berle and Means, after years of research, reported that due to the “difficulty of obtaining information on industrial companies, they could not vouch for the accuracy of their data on the ownership structures of the country’s 200 largest publicly traded corporations.”(19) Accurate information on most companies was just not available: “An outsider cannot estimate, and the insider frequently does not know, which of the various elements, if any, is dominant.”(20)

New integrated multiunit firms like AT&T, General Motors, and Standard Oil were exceedingly complex, generating an ever-growing need for coordination, well-defined organizational hierarchies, and professional management.(21) Few of the entrepreneurs who started companies knew how to run them. Frederick Taylor and others promoted scientific management, “a complete mental revolution.” Managers and workers should “push shoulder to shoulder in the same direction” to generate profits so great that there’s no quarrel over how to divide them up. “Exact scientific investigation and knowledge” ought to replace the individual judgment and opinions of workers and bosses.(22)

Taylor’s “exact scientific investigation and knowledge” founded the cult of management science – a mystique that sought to put managers on a par with professionals like physicians, engineers, and scientific researchers. Management has always mixed art with science, yet the ideal of scientific management reinforced the self-assigned right of executives to run firms with minimal accountability toward shareholders or, for that matter, other stakeholders (with the occasional exception of customers). It also legitimized opacity: like other “scientific” professionals, managers purportedly have specialized knowledge that is beyond the ken of the average layperson, not to mention the average employee. On the positive side, the cult of scientific management produced a mindset of professionalism – almost like a religious calling. Integrity and modest personal gain were hallmarks of the sincere post-World War II professional manager.

This system has prevailed ever since, though it is now, in certain respects, in crisis. Top-down management by the numbers is finally giving way, but not everywhere.

Peter Drucker dryly observed in 1954 that scientific management “may well be the most powerful as well as the most lasting contribution America has made to Western thought since the Federalist Papers.” Then he attacked its cardinal tenets, including assembly line one-motion/one-job production and the “divorce of planning from doing.” These practices, he said, reflect “a dubious and dangerous philosophical concept of an elite which has a monopoly on esoteric knowledge entitling it to manipulate the unwashed peasantry.”(23) (Only recently has this message reached most business schools.)

In theory, the managers of the 1950s and 1960s cared about shareholders; after all, they measured their success in rising share prices. But the practicalities of shareholder accountability were absent. Drucker, again, was prescient – this time in 1974. He worried that boards have become “a fiction.” They are “either simply management committees [i.e., controlled by inside directors], or they are ineffectual.”(24) He listed three causes which ring true today: the dispersion of share ownership (the fundamental cause), the separation of ownership and control (the result), and the fact that top management doesn’t want a truly effective board:

An effective board asks inconvenient questions. An effective board demands top-management performance and removes top executives who do not perform adequately – this is its duty. An effective board insists on being informed before the event – this is its legal responsibility. An effective board will not unquestioningly accept the recommendations of top management but will want to know why… An effective board, in other words, insists on being effective. And this, to most top managements, appears to be a restraint, a limitation, an interference with “management prerogatives,” and altogether a threat.(25)

Shareholders who took issue with any of this could only “vote with their feet” and sell their shares. Management tightly choreographed annual meetings and shareholder ballots. The typical shareholder didn’t care, since he (typically male at the time) was but one of millions of unrelated small-holding speculators. He didn’t want to be bothered about corporate governance. As long as his shares went up, he was happy. Opacity was A-OK.
Reality Check

The rise of the baby boom generation in the 1960s, changes in society, culture, and politics; and an accumulation of shocks prepared the ground for a new assault on opacity in business.

• The Civil Rights movement challenged discrimination, first in public services, then inevitably in the workplace. As this tale unfolded, myths of equality and invisible persecutions were stripped naked.

• The Soviet Union’s 1957 Sputnik, the first space satellite, frightened the United States into wondering whether the Soviet Union – and its industrial technologies – might not prevail.

• Executives of several large companies, such as GE and Westinghouse, were found to have conspired to raise prices. They had covered their tracks by meeting in hunting lodges, using code names and making calls from public telephone booths. Their CEOs claimed in court they didn’t know what their vice presidents were doing. The VPs went to jail and business began to operate under a cloud. Presidents Kennedy and Johnson passed new regulations and staffed enforcement agencies with business critics.

• The 1963 Kennedy assassination tore away a patina of civility; if the most dashing national leader of the century was vulnerable, so was every other person and institution.

• Vietnam divided the nation and weakened trust in government.

In the 1970s, U.S. management practices were shaken by stagflation and the stunning rise of Japanese competitors (despite books on “the Japanese way,” it was impossible for western firms to emulate Japan’s complex webs of interrelationships, not least because of their opacity). Their credibility again falling into disarray, U.S. firms paid dearly for their lack of transparency and accountability in the corporate raids of the 1980s and the “business reengineering” craze at the turn to the 1990s. Driving these events were two additional structural shifts. First was a new industrial revolution: a demanding, innovation-centric economy made possible by information and communications technologies. Second was the rise of investor capitalism: shareholders, including institutional investors and market players (such as the corporate raiders of the 1980s and the venture capitalists of the 1990s), challenged the separation of ownership and control.

Suddenly, anti-bureaucratic management, innovation, and core-competency focus – expressed and inspired by books like In Search of Excellence – began their ascent.(26) One illustration: analysts in the media and the computer industry worried that data processing departments were losing control over employees who were stealthily buying PCs with departmental budgets. The PC revolution put a new kind of tool for transparency in the hands of ordinary people, whether they thought of themselves as shareholders, employees, customers, community members, or all of these at once.

The merger and acquisition (M&A) boom of the 1980s was a forced shakeout of the excess capacity and bureaucratic inefficiencies in the old managerial capitalist order. There were 35,000 M&A transactions between 1976 and 1990, with a total value of $2.6 trillion (1992 dollars).(27) Many described the boom – along with some huge payouts that went with it – as a greedy maneuver by corporate barbarians who sucked innovation and investment out of the economy, degraded the country’s competitiveness, and destroyed the lives of hundreds of thousands of terminated employees. Critics attacked exotic techniques like leveraged buyouts and junk bonds, which eliminated size as a barrier against takeover and let nonestablishment foxes into the corporate chicken coop. Certainly, corporate raiders made tons of money while loyal employees lost jobs, paying dearly for a situation few of them created.

But underlying all the fire and fury, investors were finally doing more than voting with their feet. Corporate raiders and institutional investors reasserted the right of shareholders to have a say in the fate of the firm. Business visibility increased dramatically, as players’ failings, inefficiencies, maneuvers, and self-dealings were scrutinized as never before.

Such events changed the course of history for many companies during the 1980s. Many analysts argue that the M&A boom was a necessary purge. Excess capacity was eliminated, corporations slimmed down, and companies that were trying to do too many things at once got broken up into more-focused units. “On average, selling-firm shareholders in all M&A transactions in the period 1976 to1990 were paid premiums over market value of 41%, and total M&A transactions generated $750 billion in gains to target firms’ shareholders… it appears that most of these gains represent increases in efficiency,” reports Michael Jenson.(29)

But a new consensus urged that the continuous bloodletting had to stop. It was, to put it mildly, “too disruptive.” By the early 1990s the M&A boom was over. The corporate and fiduciary communities reached a new consensus: accountability to investors, and particularly long-term investors like pension funds, would be better served through ongoing oversight by management and directors within the firm and by institutional investors outside the firm. Corporate governance activities rather than battles over corporate control would become the norm. But in the exuberance of the dotcom boom, the expected oversight did not happen, result: the 2002 corporate governance crisis.

But first in the early 1990s came business reengineering, fueled by another recession. Whether inspired or traumatized by popular management theory and the corporate raiders, executives in effect raided their own companies. They “delayered” middle management, downsized the front lines, and reengineered business processes (many of which had never been “engineered” in the first place).

In a spirit of better late than never, boards of directors moved in on some serious executive failures. GM’s board fired CEO Robert Stempel in 1992 after the company reported losses of $6.2 billion in 1990 and 1991. IBM replaced John Akers with Lou Gerstner after $2.8 billion in losses in 1991 and more red ink in 1992. Eastman Kodak followed suit. In these and other cases the problems had been visible for years – in GM’s case for over 20, in IBM’s for over 10. Transparency means more than making things visible; it also means taking action on what you see.

The Internet bubble, for all its folly, permanently regeared the economy. Most important for our story (as described in Chapter 1), the Internet is a transparency medium without peer in human history. The bubble also bounced the world out of recession, shocked companies out of their process-reengineering narcissism, brought globalization to life, and launched a productivity boom that has no end in sight.

US Steel provides an example of how the game changed. Founded by Andrew Carnegie and taken public by J.P. Morgan, U.S. Steel was a crown jewel of U.S. industrial capitalism. By the 1980s it was under assault from efficient Japanese steel manufacturers. It had too many plants, and too many inefficient plans. Sensing that the company was vulnerable, CEO David roderick diversified by buying Marathon Oil in 1981. Nevertheless, by mid decade U.S. Steel's shares had fallen below its breakup value (the price its indivitual components would fetch if they were sold separately), well below what it had paid for Marathon.(28)

In 1984 Roderick used a proxy statement to push through anti-takeover resolutions, including staggered board elections and a rule that any takeover required approval by two-thirds of the shareholders. This is a perfect example of a maneuver designed to preserve the separation between ownership and control. Such measures strenthen the hands of management against the interests of shareholders who might make money from the sale of the company. Note that, if owning share in a company is an investment in its future value, a sale is one great way to enjoy this benefit. Tying the company upby requiring a two-thirds majority, as Roderick did, is bad for shareholders who stand to gain from a sale.

The following year Roderick announced plans to buy another oil company, Texas Oil and Gas. He planned to achieve this by issuing 133 million new shares, which would more than double the number to 255 million. As a result, several institutional investors - pension and retirement funds holding several million U.S. Steel shares - rose up in arms. Roderick managed to push the deal through, at an excessive price, just as natural gas prices peaked and just before they collapsed.

In 1986, slumping energy prices drove U.S. Steel's oil and gas profits down to $42 million (from $1.6 billion in 1985). The new Texas Oil and Gas subsidiary posted a $31 million loss. Corporate raider Carl Icahn decided to acquire the company and sell off its assets one by one. He started buying now-cheap USX (as U.S Steel had renamed itself) stock. He soon amassed 9.8 percent of the company's equity and made an offer on the rest of it. Roderick threw up a series of defenses and managed to stave Icahn off. In 1989 Icahn returned. Brandishing 13.1 percent of USX shares, he went after the new CEO, Charles Corry. Icahn forced a shareholder vote on a motion to break the company into two "pure plays," steel and energy, artguing that they had greater market value separately than together. Several big institutional investors supported him; new style activists lined up against USX's industrial age management. Corry fought back and defeated Icahn's motion. Then a year later hne presented a resolution of his own to split the company's shares into separate steel and energy trading stocks. with Icahn's endorsement it passed by a large margin. USX had finally bowed to the wishes of its owners.

The Corporate Governance Crisis of 2002

The Internet bubble lubricated the corporate governance crisis of 2002, most visibly in the case of Enron, by diverting attention from old-fashioned standards of profitability and governance amid hype about “new rules for a new economy.” But crooked dealings at accounting firms, multibillion dollar writedowns at over 150 companies, and conflicts of interest at securities firms can’t be blamed on the Internet.

In April 2003, ten Wall Street firms agreed to split penalties totaling $1.4 billion, a relatively painless outcome considering how they vaporized the integrity of core processes at the heart of market capitalism. For corrupt practices like publishing falsely favorable analyst reports, sending clients advance copies of analyst reports, and using shares of hot initial public offerings to virtually bribe CEOs of client firms, the brokerages avoided admissions of guilt while their executives escaped criminal prosecution. Some forth percent of the fines were mitigated by tax deductibility or insurance. And, as The Economist observed, the entire amount is equivalent to a few days’ collective profits and a tiny percentage of what the firms earned during the boom.(30) The two entities that should have been policing these firms – the New York Stock Exchange and the National Association of Securities Dealers – also escaped censure. Investors’ civil suits are now bound to follow.
Ultimately, the bubble merely exacerbated the perennial principal-agent problem, that is, the separation of ownership from control. When there is personal gain at stake, many “agents” (corporate executives) tune their values to rationalize malfeasance.

We’ve seen such problems before, most spectacularly in the events surrounding the 1929 crash – houses of cards; misstatements of financials; self dealing by overpaid executives; stock promoters with conflicts of interest; boards of directors that fail to blow the whistle whether due to cronyism, conflicts of interest, or sheer laziness; and all in the atmosphere of an overheated market where expectations outpaced reality.

But there were some encouraging differences. At no time was the integrity of the banking system questioned or at risk. Even the brokerage industry, with a proven industry-wide conflict of interest between research and underwriting, was not fundamentally undermined: it lost more to the overall decline of the stock market and the rise of online trading (another Internet-based transparency phenomenon) than to the conflict of interest scandal.

Also, transparency proved to be a constructive force. Whistleblowers came forward against Enron, Andersen, WorldCom, and others. The media delivered the story. Institutional investors like CalPERS pressured Congress to act and tightened up their own operating guidelines. Investors pulled out of the market; this resulted in a massive value collapse and sent a clear signal that visible change was a matter of urgency. Many companies began to rethink and revise their governance.

As in the 1930s, the government stepped in with new laws (though we are not convinced it will follow through). The Sarbanes-Oxley Act moved quickly through Congress and came into effect July 30, 2002. Like Roosevelt’s 1933 Securities Act, the focus of Sarbanes-Oxley is to strengthen transparency. Key provisions among the act’s many new rules are:

• A firm’s CEO and chief financial officer must both sign written statements certifying that their company’s quarterly and annual financial reports meet reporting rules and fairly present, in all material respects, its financial condition and the results of its operations.

• A new board will set and enforce the quality and ethics standards of audits, with the authority to impose stiff financial penalties.

• Accountants are prohibited from providing nonaudit services to audit clients.

• Board committees of independent directors rather than company executives will appoint external auditors.

• The Securities and Exchange Commission is mandated to address securities analyst conflicts of interest.

• The kind of evidence destruction that Andersen did at Enron can lead to a prison sentence of up to 20 years, and defrauding shareholders 25 years.

• Employees who blow the whistle on securities violations gain protection.

Institutional investors demanded new kinds of transparency in this crisis – and they also found ways for transparency to contribute to their portfolio growth. The crisis in corporate governance drove them to adopt a much more public profile.

In 2002 the California Public Employees' Retirement System (CalPERS), the $143 billion benefits fund for state workers and other public sector employees and the largest of its kind, moved into the headlines. It had been badly stung by a distinct lack of transparency: Pacific Corporate Group, which advised CalPERS to put more than $750 million into Enron, also was getting rich fees from the Texas energy trader for snagging investors. CalPERS moved to eliminate such conflicts of interest by requiring its financial advisers to disclose financial ties with the firms whose securities they recommended. And, in late 2002, CalPERS invested $200 million to become a partner in a turnaround fund that targets underperforming Japanese companies. The fund is forecasting a 30 percent rate of return by acquiring sclerotic conglomerates, selling off their parts, and improving their corporate governance – a strategy that hearkens back to the glory days of 1980s M&A.

CalPERS was also instrumental to the passage of the proxy voting rules for mutual funds that we described in Chapter 1 – a critical piece of the puzzle for improving corporate accountability to shareholders.

The Role of Regulation
Transparency strengthens market forces, theoretically reducing the need for regulatory enforcement. But the history of the past century shows that the transparency-driven surge of powerful market forces is not sufficient to change corporate behavior. As a matter of economic necessity, many firms may embrace norms of candor and integrity that exceed minimum legal requirements. But free riders will take advantage of the system as long as the legal umbrella protects them; and many, as we’ve seen, are quite willing to break the law.

Thus, free markets depend on strong governments. Public interests are greater than the sum of all private interests. And open market economies depend on clear rules, rigorously enforced.

Well-performing capital markets capture the wisdom of millions of investors, but this only works when investors have complete and accurate information on each firm’s financial health. This begins with trustworthy audited financial reports. External auditors were among the measures the U.S. government put in place after the 1929 stock market crash. But even then questions arose as to whether external accounting firms could be trusted. In 1933 a member of Congress asked Col. A. H. Carter, senior partner of Deloitte Haskins & Sells: who will audit the accountants? "Our conscience," Colonel Carter replied.(31) More than sixty-five years later, this premise sent Arthur Andersen up in smoke.

The protections in Sarbanes-Oxley are long overdue; if anything, they don’t go far enough. Some business groups fought even these mild measures. U.S. Chamber of Commerce president Thomas Donohue published a letter that accused Senator Paul Sarbanes of a "knee-jerk, politically charged reaction" to the Enron scandal and claimed that accounting reforms were a threat to "informed market decision-making." Not all groups were equally shortsighted. The Business Roundtable called for Sarbanes-Oxley’s swift implementation, saying the “legislation will help investors, employees and companies by restoring investor confidence.”

Rules also help a market economy by preventing unethical companies from externalizing costs onto other market participants. Example: the Prestige oil tanker sank off the Spanish coast November 2002, resulting in a human and economic disaster beyond that caused by the Exxon Valdez. The Prestige immediately disgorged 20,000 tons of fuel oil (half the amount spilled by the Valdez) and sank with another 60,000 tons still on board. Oil from the tanker contaminated beaches and shut down a $1.5 billion fishing industry that employed 120,000 people along the Spanish Galician coast. The oil then moved east to the Asturian and Cantabrian coasts. Oil stains were reported in the Basque province of Guipuzcoa. By early January 2003, cowpie-size globs began washing up on the shores of southwestern France, closing the area's famed oyster beds and tourist beaches. With a massive store of oil still in the sunken tanker, no one knows when this disaster will end.(32)

The Prestige was a regulatory basket case. It was, like the Valdez, a single-hulled tanker, a construction well known to create far greater risk of spill than a two-hulled ship; the U.S. banned single hulled tankers from its waters after the Valdez spill, but the European Union had failed to follow suit. The boat was chartered by the Swiss-based subsidiary of a Russian conglomerate registered in the Bahamas, owned by a Greek through Liberia, and given a certificate of seaworthiness by the U.S.. When the ship refueled, it stood off the port of Gibraltar to avoid the risk of inspection. Every aspect of its operations was calculated to avoid tax, ownership obligations and regulatory scrutiny.(33)

Such examples explain why societal expectations for improved corporate behavior result in pressures to regulate. The post-Enron environment has increased support for legislation in the U.S.: in July 2002, two thirds of Americans agreed that the free market economy works best when strongly regulated.

Government regulation can also create a level playing field for competition: many industries depend on patent laws to reward innovation and discourage free riders.

Regulation can itself be a double-edged sword. Disclosure rules could protect firms that externalize environmental costs. Business and social critic Amy Cortese notes: “With their confidence shaken in corporate bookkeeping and the market's omniscience, investors are starting to look for other possible ‘off balance sheet’ land mines, including the hidden risks that could be associated with global climate change…. (and) company officers could be held accountable for failing to protect their companies from climate-related risk.”(34) Rules for disclosing such risks could, by implicitly factoring them into the stock price, keep these shareholder lawsuits at bay.

But all this only proves that mandating disclosure is not enough; it may also be necessary to regulate behavior. Laws like the Environmental Protection Act don’t just expose – they restrict polluters’ behavior.

Regulation alone won’t produce open enterprises that always do the right thing. And legal compliance is merely the lowest common denominator. What really counts is leadership with integrity, beyond compliance.

A sea change is finally happening in corporate governance in the relationship between ownership and control. Shareholders are steadily acquiring the ability to scrutinize the ompanies whose share they hold, and the governmetn is helping to ensure that third-party overseers - auditors and regulatory agencies - are themselves held accountable. In short, the crisis helped to bring about an increase in transparency. Nevrtheless, after a century and a half of shareholder capitalism, the jury is still out on the theory that investor oversight can work.

Today's stakeholders expect a new kind of integrity.



(1) Virgil, The Aenid of Virgil (19 BC)

(2) Samuel Johnson, The History of Rasselas, Prince of Abissinia (1759)

(3) Alfred W. Crosby, The Measure of Reality: Quantification of Western Europe, 1250 – 1600 (Cambridge: Cambridge University Press, 1997), 216.

(4) Dr. Alfred Dupont Chandler Jr., The Visible Hand: The Managerial Revolution in American Business (Cambridge, MA: Belknap, Harvard University Press, 1977).

(5) As the telegraph moved information faster than a messenger, the railway moved people and goods faster than a horse or a boat. Both, of course, were also cheaper than what they replaced. Another footnote: telegraph operators, of course, chattered personal messages to one another in the unheralded origin of instant messaging.

(6) Marshall McLuhan, Understanding Media: The Extensions of Man (New York: McGraw-Hill, 1964), 223.

(7) James W. Carey, Communication As Culture: Essays on Media and Society (Winchester, MA: Unwin Hyman, 1989), 210-211.

(8) Charles S. Briggs and Augustus Maverick, The Story of the Telegraph and a History of the Great Atlantic Cable (Rudd & Carleton, 1858), cited in Carey, 208.

(9) William P. Andrews, Memoirs on the Euphrates Valley Route (William Allen, 1857), cited in Carey, 209

(10) Market insiders seek to protect and extend their arbitrage opportunities. For example, in 1894 the New York Stock Exchange banned telephones on the trading floor to create a 30-second time advantage over Boston traders.

(11) Howard Zinn, People’s History of the United States: 1492 – Present (20th Anniversary Edition) (New York: Harper Perennial, 1999), 220.

(12) Charles R. Geisst, Wall Street: A History (New York: Oxford University Press, 1997), 131.

(13) Ibid, 228.

(14) Harold Evans, The American Century (New York: Alfred A. Knopf, 1998), 223.

(15) Geisst, 192.

(16) Ibid, 228.

(17) Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property (New York: MacMillan Company, 1933)

(18) Ibid, 114.

(19) Ibid, 48

(20) Ibid, 84

(21) Chandler, The Visible Hand, 6-9.

(22) Excerpted in Michael T. Matteson and John M. Ivanevich (eds.), Management Classics, 2nd ed. (Santa Monica, CA: Goodyear Publishing Company, 1981), 6-8.

(23) Peter F. Drucker, The Practice of Management (New York: Harper & Row, 1954), 284.

(24) Peter F. Drucker, Management: Tasks, Responsibilities, Practices (New York, Harper & Row, 1973), 628.

(25) Ibid, 629.

(26) Thomas J. Peters & Robert H. Waterman Jr, In Search of Excellence: Lessons from America's Best-Run Companies (New York: Harper Collins, 1982)

(27) Michael C. Jensen, A Theory of the Firm: Goernance, Residual Claims, and Organizational Forms (Boston: Harvard University Press, 2001), 21.

(28) Nitin Nohria, David Dyer, and Frederick Dalzell, Changing Fortunes: Remaking the Industrial Corporation (New York: John Wiley & Sons, 2002), 172-175

(29) Jensen, A Theory of the Firm, 22.

(30) “Unsettling,” The Economist, May 3, 2003.

(31) “Clay Feet: Could Capitalists Actually Bring Down Capitalism?” New York Times, June 30, 2002

(32) “Spanish Coast Seethes at Incessant Tide of Oil,” USA Today, January 13, 2001.

(33) “Comment: Capitalism Must Put Its House In Order: The Prestige Disaster is Yet Another Example of How Unregulated Business Practices Can have a Calamitous Effect,” The Observer, November 24, 2002.

(34) Amy Cortese, “As the Earth Warms, Will Companies Pay?” New York Times, August 18, 2002

(Updated December 3, 2003)
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