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A Case for Integrity

March 03, 2006

If only Enron's stock had not surged so high, the company might still be around.

While having a high share price might seem to be a blessing for a CEO, it is next to impossible to preserve a company's long-term value once a firm becomes wildly overvalued, Michael Jensen, an emeritus professor of finance at Harvard, warned during a March 1 appearance at Drexel University’s LeBow College of Business.

Using Enron to make his point, Jensen told the crowd of 125-plus that the notorious energy trading firm was a viable company that succumbed to intense pressure to prop up an unjustified share price. "By defending the $30-or-$45 billion in excess value" through means for which its officials are now on trial "they destroyed the company," Jensen said.

Jensen's lecture, "Putting Integrity into Finance Theory and Practice: A Positive Approach," was organized by the LeBow College Center for Corporate Governance, a think tank opened this year to promote awareness and discussion of governance issues by industry, academics and students.

Considered by many to be the father of the academic study of corporate governance, Jensen argued that integrity is a necessary condition in maintaining the long-term value of any firm, as well as a workable financial system.

Unfortunately, Jensen said, executives routinely use inflated earnings for ill-advised mergers like that between AOL and Time Warner, which wind up destroying value. Another practice he criticized was manipulating earnings or timing expenses in deceptive ways to meet compensation targets or earnings forecasts - a practice he bluntly called "lying." Jensen blamed those practices on the way executives are typically compensated, coupled with the intense pressure they are under to meet analysts' expectations for fear of taking a pounding on Wall Street.

Any CEO gutsy enough to tell a board the company's stock price is too high and should come down is liable to be shown the door, Jensen said. Meanwhile, the desire to meet financial benchmarks set by compensation committees, or to live up to earnings forecasts, often lead managers to make strategic decisions with other goals in mind than the long-term outlook of the company. Jensen said the use of stock options as compensation, which makes share price even more of a concern for managers, exacerbates the problem.

Jensen told a story from a company on which he sat on the board. During a time when it was touch-and-go whether the CEO would meet a fourth quarter target and trigger his bonus, the company announced that it would raise prices in the first quarter of the new year. This key strategic decision, Jensen said, was timed to increase the likelihood the CEO would get his bonus by prompting customers to order more goods during the fourth quarter, prior to the price increase. When it became clear the target would still not be met, Jensen said, management started loading expenses into the fourth quarter in order to make it easier for financial targets to be met in future quarters. Decisions were clearly being made with other things in mind than the company's long-term interests, Jensen said.

Jensen stressed that this practice is routine, and cited an academic study in which 78 percent of 401 CFO’s who were surveyed said their company was willing to sacrifice value to "smooth earnings."

Jensen said this is a tremendous drain on productivity, which he predicted would double if organizations operated in a more forthright manner and made decisions with their long-term good in mind. One way to encourage that practice, he said, is to rearrange compensation packages so that executives are rewarded for taking actions to preserve a company's value for the long term.

In introducing Jensen, Professor Ralph Walkling, director of the Center for Corporate Governance and Stratakis Chair in Corporate Governance and Accountability at LeBow College, explained that this first academic lecture organized by the Center was in keeping with its goal to help satisfy the “dramatic need for impartial, objective evidence” when discussing corporate governance.