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Solving Business Problems: Ethics Versus Education By Nikhil P. Varaiya March/April 2003 (Financial Executive International) The current mood of American business may be one of despair -- resulting from the dot-com meltdown, the fall from grace of icons like Jack Welch and the scandals at Enron Corp., Tyco International, Ltd., Global Crossing Holdings Ltd., ImClone Systems Inc. and others. While business is accused of being short on ethics and long on fraud and greed, business schools, we are told, may have a solution to this malaise: students must be exposed to accounting ethics. It's said that students should be required to learn how to detect accounting fraud, and ethics should be included in every business school course. Indeed, the school of management at a major university in Southern California will be offering a course dedicated entirely to the collapse of Enron.
While ethics training may be part of the solution, the other part involves a deeper understanding of what drives business.
Indeed, the ethical breaches of the Enrons are symptoms of deeper causes and, as such, warrant deeper scrutiny. These scandals resulted from managements that sought to meet hubristic investor expectations of ever-rising share prices, auditors who failed to perform due diligence as required by their obligations to shareholders, analysts who sacrificed integrity to earn significant investment banking business for their companies and boards of directors that were deficient in the exercise of their oversight responsibilities.
All of these parties -- management, auditors, analysts, and board members -- knew what was ethical and what was unethical.
Even given the current climate, the U.S. economy is the envy of the world. Since the early '80s, its enormous success in innovation, business formation and quality job creation has been a model for other democratic governments that wish to create conditions for similar success in their economies. This success has its origins in the flexibility of American business in responding rapidly to change, the smooth functioning and transparency of its capital markets and its effective legal and regulatory framework.
Business Success Drivers
The long-run sustainability of a business requires that its revenues exceed all costs, including the cost of capital invested in the business, ensuring that it earns economic profits. Businesses that generate economic profitability and growth will over the long-term reward their shareholders with handsome returns. Such is the track record of Microsoft Corp., Wal-Mart Stores Inc., Procter & Gamble Co., IBM Corp., Intel Corp. and others. This performance is the result of managements that have effectively implemented solutions to three key strategic questions: Which customer markets should the firm serve? How should the firm compete in its served markets? How will the firm finance the capital needed to compete effectively in its served markets?
Effective competition occurs along two dimensions: How does the firm's cost structure, and its product or service offering, stack up against its rivals; and given its relative cost and offering position, how does the firm set its product price relative to its rivals' prices? These questions, which comprise a firm's business strategy, must be addressed by all firms, whether start-ups or established companies.
The recent dot-com meltdown resulted from the sudden recognition by investors that most of the ventures were unlikely to compete effectively in their product markets and generate economic profits. The meteoric share price increases exhibited by the sector resulted from beliefs held by investors that the companies' tremendous revenue growth would translate into earnings growth. However, earnings seldom transpired. The same story was repeated in the telecommunications sector, where shareholder and debt holder losses dwarfed those in the dot-com meltdown. Shares of firms in these sectors at their peaks exhibited price to earnings ratios in the 40-50 range, and price to sales ratios in the 5-10 range. In effect, such prices implied that these companies were expected to show significant and continued earnings growth over the next 30-50 years!
The rise and fall of firms in both the dot-com and telecommunications sectors is evidence that product markets in the U.S. are very competitive, and that new start-ups funded by hubristic investors and touted by willing analysts but without distinctive competitive advantages would fail to be profitable. Reluctantly, but surely, the capital markets came to the same conclusion, and the result has been the tremendous loss in shareholder values over the past three years.
Role of Business Education
While it is certainly important to expose business school students to ethical issues, first and foremost, the debacle at Enron reflected the failure of its business strategy -- the inability of its operations to generate sufficient operating earnings to service its debt. Enron filed for bankruptcy on Dec. 2, 2001. BNP Paribas bond analyst Daniel Scotto was reported to have advised his clients around August 2001 to sell Enron securities because Enron's profit margins -- as he was quoted in The Wall Street Journal -- "were flattening out and starting to decline. This wasn't a company with hard assets; it was built on paper and highly leveraged." Enron's management then resorted to hide its debt by shifting it off the parent company's balance sheet through a complex web of limited partnerships, a strategy neither its auditors nor its board of directors questioned. The board was remiss in its financial responsibility, failing to exhibit an understanding of the finance and economics of Enron's business. Wall Street analysts (with very few exceptions) were willing accomplices. They, too, did not critically evaluate Enron's business, but, instead, continued to make strong "buy" recommendations, even when Enron's share price reflected ever-rising earnings expectations that could not be supported by the economics of its business.
While the demand for a renewed emphasis on teaching business ethics is warranted, both business students and boards of directors can be better served by a renewed focus on a thorough understanding of the drivers of business success.
Successful management requires effective implementation of the solutions to the strategic questions stated above. Recall the early 1980s, when both the business press and business educators were extolling the virtues of Japanese management and institutions (such as the keiretsu system of cross-shareholdings between firms, lenders and suppliers) and predicting the competitive demise of U.S. corporations. The inflexibility of the very same system of Japanese management and institutions is now identified as a root cause of the poor performance of the Japanese economy over the last 15 years.
While corporate America is now at a crossroads, it has also shown its ability to adapt to external changes. When threatened by the Japanese quality initiatives of the '70s, U.S. corporations adopted the quality management methods pioneered by Japanese companies and succeeded in meeting Japan's challenge (even in the automobile industry).
Corporate America is once again vigorously debating critical issues such as stock option accounting, auditor and analyst independence, pay-for-performance issues in management compensation and effective governance by corporate boards. If history is a guide, U.S. business will once again need to rise to the challenges -- which makes an even stronger case that while issues change, an understanding of the drivers of business is key for mitigating each individual situation.
NIKHIL P. VARAIYA is Professor and Chair, Department of Finance, at San Diego State University, where he teaches courses in competitive analysis and entrepreneurial finance. He is past President of the San Diego Chapter of FEI and presently serves as its Vice President of Professional Development.
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Return to FEI's column
2003 Financial Executives International. Reprinted with permission.
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