REVIEW ARTICLE LffiS AND CAPITALISM Denis Collins Why We Lie: The Evolutionary Roots of Deception and the Unconscious Mind David Livingstone Smith New York: St. Martin's Press, 2004; 256 pages, $24.95 h.c. , ISBN 0-312-31039- 0 The Battle for the Soul of Capitalism John C. Bogle New Haven, Conn.: Yale University Press, 2005; 288 pages, $25.00 h.c, ISBN 0-300-10990- 3 Capitalism and Morality The moral foundadon of capitalism holds that the wealth of a nadon is enhanced (udhtarianism) by providing individuals with the freedom and hberty to do what comes natural, pursuing their own self-interests (egoism). When alignment between individual interests and general welfare is achieved, even if unintendonally achieved, minimum patemalistic govemmental oversight and intervendon is needed. Honesty and promise keeping are other essendal moral values in capitalism. Managers promise to investfinancial resources wisely on behalf of owners, to provide a pardcular product or service for customers, to meet a particular payment schedule for suppliers, and to pay a pardcular salary to employees. When these promises are broken or acdvides misrepresented, inefficiencies, lawsuits, and govemment reguladons are the result. Honesty is essendal because, according to David Livingstone Smith's book Why We Lie: The Evolutionary Roots of Deception and the Unconscious Mind, lying is also natural to the human condidon. We tend to lie when it is in our self-interest © 2007. Business Ethics Quarterly, Volume 17, Issue 3. ISSN 1052-150X. pp. 563-572 BUSINESS ETHICS QUARTERLY to do so—"of course I didn't take the last cookie"—or to reduce the suffering of others—"of course you look wonderful." Trained in protestant theology, Adam Smith was well aware of the human proclivity to deceive and lie when he theorized about the benefits of an economy based on freedom to pursue one's self-interests. He maintained that, although there are infinite opportunides to act immorally, most of the dme we choose to act morally. We do not act on all of our impulses, pardcularly the immoral ones. Our conscience, belief in God, concem about moral agents observing us, and ability to be reasoned with place limits on our behaviors. When these mechanisms fail, then a system of jusdce must punish the wrongdoer to protect the public from our most egregious immoral actions (Smith 1759/1976). This brings us full circle. Since most business people do not want to be regulated by government, it is in their self-interest to behave morally in economic affairs. Over dme, laws have been constmcted and modified to reinforce this point. Corporate executives have a legally binding duty not only to maximize shareholder interests, which forces an alignment between managerial and owner interests, but also to convey honest informadon about the company to shareholders. As backup, a host of watchdogs, including auditors, lawyers, boards of directors, research analysts, media, and regulators, have a professional and legal duty to make sure sucb honest information is forthcoming. Mutual-fund founder John Bogle's book. The Battle for the Soul of Capitalism, argues that this system of watchdogs failed during the 1990s, culminating in the Enron debacle. Execudve misrepresentations regarding a company's financial performance were passively, and sometimes actively, reinforced by watchdogs pursuing their own economic self-interests. Bogle's descriptively compelling insider analysis could have been strengthened by Livingstone Smith's deeper understanding of the human psyche. The Human Propensity to Lie Livingstone Smith's Why We Lie combines Charles Darwin and Sigmund Freud, situating the survival of the fittest mentality in our unconscious mind. Humans deceive each other, and themselves, because it enhances their likelihood of survival. According to Livingstone Smith, a philosopher/evolutionary psychologist at the University of New England, we tend to lie in circumstances in which telling the tmth is likely to generate a lot of psychological, physical, or economic pain. Sometimes this is a conscious decision, we choose to lie. At other times it is unconscious, our brains are simply operating on automatic pilot. Over time, conscious deceptions and lies may evolve into unconscious ones. Deceit is normal and natural, Livingstone Smith argues, not a function of moral failure. This is tme for bacteria, plants, and animals, as well as us humans. Viruses deceive our immune systems, mirror orchids impersonate the smell of female wasps REVIEW ARTICLE to achieve pollination, and animals misrepresent where precious food is hidden. Camouflage, hiding one's real presence, is a basic survival skill in the nonhuman world. Hawks take on the appearance of turkey vultures to capture their prey. Stripe patterns and colors make the zebra nearly invisible to its predators. As demonstrated by these examples, Livingstone Smith relies on a very broad definidon of lying: "[Lying] is any form of behavior the function of which is to provide others with false information or to deprive them of true informadon" (14). Among human beings, deceit and lies generate many favorable outcomes. We lie about our weight, salaries, family histories, alcohol consumption, and career aspirations in order to impress others. A Hobbesian war-of-all-against-all would break out if our prejudices, hadeds and lusts were not censored. Civil society would collapse if others knew the terrible things we sometimes think about them. We leam to hide our tme feelings for the sake of future interactions and communal peace. Lying is particularly salient in the madng process, the author argues. Men and women nonverbally deceive each other regarding their natural beauty—covering their perceived imperfections with make-up, deodorants, breast implants, and hairpieces. Lustful fantasies are suppressed when making polite conversation with a sexually atdacdve person. Verbally, individuals lie about their marital infidelides, and over- or under-estimate their sexual conquests based on whatever will make a bigger impression on the person they want to impress. Livingstone Smith provides some stadsdcs to support his analysis. Social science researchers report that, on average, people tell three lies during a ten minute conversadon. In terms of those sitting in our classrooms: • Undergraduates lie to their mothers every other conversadon; • 92 percent of college students have lied to a current or previous sexual partner; • One in three job applicants hes when seeking employment. Parents contribute to their child's proclivity to lie. Attributing the origin of gifts to Santa Claus and the Easter Bunny teaches children that lying is morally permissible in some circumstances. Parents tell children to express gradtude for a gift they hate, and repeat stories where deceivers, such as Trojans hiding in a wooden horse, claimed victory over their enemies. Older children and teens leam how to bluff and hide their emofions when playing poker, and how to fake an injury for the good of a sports team that has used up all of its dme-outs. Some parents teach their children that lying and cheadng are necessary to get ahead in life. We claim selective persecution if caught lying or cheating because everyone seems to be doing it. After all, doesn't every driver speed, every company "cook the books" a little, every ballplayer take some performance-enhancing sdmulant, every polidcian take advantage of public office for personal gain, every spouse cheat on his/her partner? BUSINESS ETHICS QUARTERLY Being able to hide our lies, and to detect who is lying to us, is a compedtive advantage in modem society. Livingstone Smith refers to this as mastering the Pinocchio effect. You want everyone's nose to grow when they lie, except your own. The most successful military strategists and poker players have perfected these skills. They closely observe an opponent's facial expressions, bodily movements, perspiration, and speech tempo to detect lies, while controlling their own. The book's second half is less relevant to business ethicists. Livingstone Smith explores the stmcture of the unconscious mind and how it allows individuals to deceive themselves. The author admits that this stream of analysis is psychological conjecture and I wondered about the legal implications of such claims. If lying is an unconscious activity, then how accountable is former Enron CEO Ken Lay for lying about $7 billion in hidden losses, something he denied doing right up undl his fatal heart attack? Livingstone Smith's analysis could be strengthened with a compedng values explanation. When faced with an ethical dilemma, people choose between two compedng values. One can be honest and suffer the consequences, or lie and achieve more desirable consequences. Unlike the zebra, we choose our camouflage. In business during the 1990s, that camouflage took the form of accounting schemes. Managerial Capitalism Managers play with other people's money, notably those of investors and bankers, who demand an honest accoundng. Protecdve layers consisdng of auditors, lawyers, boards of directors, research analysts, and regulators fill the principal-agent gap to ensure that the tmth is being told about company operadons. According to Bogle, this system of checks and balances has significant problems. He wams that "we have come perilously close to accepting a system of dictatorship in corporate America, a system in which the power of the CEO seems virtually unfettered" (29-30). Bogle knows that of which he speaks, having worked in the financial industry for more than half a century and served on many blue-ribbon committees. He is a staunch pro-capitalist Republican sounding the bell, not a distant wild-eyed andcapitaHst revolutionary. The book's dtle. The Battle for the Soul of Capitalism, alludes to two versions of capitalism—owner capitalism and managerial capitalism. The latest round of business scandals, epitomized by Enron, demonstrated that managerial self-interest, not owner self-interests, lies at the heart of capitalism. Corporate execudves maximize their financial interests at the expense of owners, and, with cooperation from the chief financial officers and chief accounting officers, lie about it. The results of a 1998 Business Week survey cited by Bogle emphasize this reality. Conducted at the height of the dot.com mania, 67 percent of 160 CFOs attending the annual Business Week CFO fomm reported being pressured by other executives to REVIEW ARTICLE misrepresent corporate results. Twelve percent of the CFOs agreed to do so, while 55 percent resisted the request. How did this situafion come about? Bogle grounds his analysis in Adolph Berle and Gardiner Means's classic book from the 1930s, The Modem Corporation and Private Property. For centuries, the owner and manager tended to be the same person or worked side-by-side. As capitalism evolved, ownership became more dispersed and owners could not monitor closely the managers hired to represent their interests. In order to protect their jobs, managers lie or not tell the owners the whole truth when things go wrong. The size of the split between owner and managerial interests reached Grand Canyon proportions by the end of the 1900s. One of the biggest culprits was the issuance of execudve stock options, which was meant to align managerial interests more closely with those of the owners. However, this principal-agent problem soludon made managers even more powerful because they can buy and sell company stock based on inside knowledge of company operadons before other owners. New laws were created to prevent this from happening. But execudves found creadve ways around these and other laws by co-opdng each watchdog, as described below. CEOs Capture the Board of Directors Highly qualified CEOs are a rare commodity. The position demands demendous knowledge, experience, and polidcal savvy. One bad decision by a CEO can min a previously well-mn company. The board of directors oversees the CEO on behalf of the shareholders, providing sdategic advice as needed. CEOs like to be in charge and either serve as Chairman of the Board, or have a very sdong voice in choosing the Chairman of the Board. Board members, many of whom are CEOs or high level execudves within their own companies, are often recommended with the CEO's approval. If a board member is too intmsive, a highly valued CEO will request that the board member be replaced under threat of obtaining employment elsewhere. Executive compensadon is merely one example of how the board of directors takes management's view rather than that of the stockholders they legally represent. The Board's compensadon committee employs a consultant to determine CEO salary, bonuses, and benefits. Then the pursuit of financial self-interest takes over. • Compensation Consultant Einancial Self-interest: o If the relatively high compensadon package pleases the CEO, the consultant's contract will be renewed, o If the reladvely high compensadon package pleases individual Board members, they might employ the consultant for their own company. • Board Member Financial Self-interest: o If the reladvely high compensation package pleases the CEO, the Board members who recommended the consultant will be asked to serve another term. BUSINESS ETHICS QUARTERLY o The CEO's relatively high compensadon package will serve as a new benchmark for their own salary determinations. What sorts of perverted compensadon agreements are reached as a result of this system? During economic downtums, executive stock options, which had inidally been issued to align managerial interests with owner interests, are recalculated to reflect lower stock prices to keep executives from changing companies. If one CEO is granted a favorable loan condition or a unique perk, then all CEOs feel endtled to similar benefits. Since compensation consultants and committees benchmark a CEOs salary to other CEOs, rather than to the average employee, salary rados of the average CEO to that of the average employee increased from 42:1 in 1980 to 531:1 in 2004. CEOs Capture the Auditors If the board of directors is failing in its responsibilides to adequately represent shareholder interests, there is always the auditor. However, the auditors are hired by the Board. Going against the Board and CEO is tantamount to client suicide. Auditors seek to please, not antagonize, the CEO in hopes of contract renewal. With the approval of their auditors, executives overestimate assets and underestimate liabilities (particularly in accoundng for the value of executive stock options), so that company stock becomes more appealing to potential investors. Auditors have also been known to ignore the executive pracdce of hiding excess revenue in reserves, and then dipping into these reserves when revenue totals need to be propped up. Corporate execudves align auditor interests with managerial interests, rather than owner interests, through consulting contracts. In 2000, Arthur Andersen received $23 million in auditing fees and $29 million in consulting fees from Enron. KPMG eamed $3.9 million in audidng fees and $62.3 million for other services from Motorola, and $23.9 million in audidng fees and $79.7 million for other services from GE. For KPMG, losing an auditing contract could mean losing three to fifteen dmes that amount in other services. Is this view too cynical given the professional obligations of auditors? Bogle suggests that the recent high profile accounting scandals are just the tip of the iceberg. Under the glare of media scmtiny, more than 1,500 companies restated their previous auditor-approved eamings between 2000 and 2004, seven times the number that did so between 1990 and 1994. Auditors were either knowingly letting execudves aggressively manage eamings, or managers had become experts at hiding accoundng manipuladons from understaffed audidng firms. CEOs Capture the Investment Community. Certainly the financial community would expose any lies about a company's financial performance. Companies with sound management practices can more REVIEW ARTICLE reliably repay their loans, and financial institudons could more reliably esdmate the economic value of the pension funds they manage. In addidon, financial institutions have demendous economic power over corporations. Whereas stock owners of a particular company might be too dispersed to organize against managerial self-interests, stock ownership in general is rather concendated. The 100 largestfinancial institudons own 52 percent of all stock, with private and public pension plans alone accoundng for 26 percent. The mutual fund industry has grown from $2 hillion in 1950 to $8 trillion in 2005 and represents more than 100 million shareholders. But rather than corporadons and financial institudons keeping each other in check, they protect each other. Rule number one in management, be the manager employed by a corporation or financial institution, is to never bite the hand that feeds you. CEOs and their proxies offerfinancial insdtution execudves the following deal: We will borrow money from you and let you manage our pension funds so that you can meet your monthly revenue goals if you, in turn, tell everyone to buy our stock. Financial insdtutions offer corporate executives the following deal: We will round up investors to fund your initial public offerings (IPOs) and expansion plans and tell everyone to buy your stock if you, in tum, borrow money from us and let us manage your pension funds. Corporate andfinancial insdtution managers were playing the same tune from different sides of the same instmment. Anyfinancial institudon that publicly exposes corporate mismanagement risks losing as a client not only the corporadon being exposed, but also the companies of the CEOs on the exposed corporadon's board of directors. In addition, CEOs of other companies, not wandng to be similarly exposed, will employ a compedtor. As a result, brokerage firms rarely recommend pubhcly that investors sell a pardcular company's stock. During thefirst-quarter of 2001, with a recession well underway, the typical brokerage firm made 1,028 stock recommendadons, of which only seven were sell. Figure 1, which I created based on Bogle's analysis, diagrams how the relationship between corporations and financial institutions led to the 1990s stock market bubble. An intricate network of financial incendves and lies led to highly overvalued stock. But wouldn'tfinancial insdtutions be able to sell more loans for future corporate expansion, eam better long-term retums on their stock investments, and attract more investors if they honestly assessed corporate financial performance? Theoredcally, yes; but pracdcally, no. Bogle maintains that financial insdtutions have changed their conceptual framework from long-term stock ownership to short- term stock rental. Even though low turnover funds consistently outperform high tumover funds and research analysts were not publicly issuing sell recommendadons, mutual fund daders sold just about everything in the fund on a yearly basis. The annual mutual fund tumover rate (how much of the fund's stocks were sold in BUSINESS ETHICS QUARTERLY Brokerage Rrm's Investment Bankers and Research Analysts Go on Sales Call Offering to Company Signs Brokerage Firm A) Raise money for corporate Agreement with Purchases d^t and nfiergers and Brokerage Firm for Company's Stock acqui^tions its Services B) Sell equity C) Provide favorable research reports — , Brokerage Rrm Sells the Higher Priced Stock for a Large Proflt Research Analysts Brokers Likelihood of a Compar^y Leaks Hostile Takeover 3ood Financial News Pubnsh Favorable Recommend cf Company Is to Brokerage Flim's Rapoits "Buy" to Investors Reduced Resear<:h Analyst Company's CEO d Top Managars Cash Out their Stock Options Figure 1. The Making of a Stock Market Bubble a given year) averaged a steady 15 percent for decades and then took off during the mid-1980s, reaching more than 100 percent by the late 1990s. Once again, just follow the money trail for an explanation why. Traders have a short-termfinancial incendve to sell, not hold, a stock because they eam commissions based on the number of transacdons. Financial insdtudons focus on the company's daily stock price and bet on whether it will go up or down the next day, week, or month, instead of making investment decisions based on the discounted value of a company's future cashflow, which would be a long-term approach. Following the money trail also helps to explain the lack of vigilance by mutual fund managers. A fund manager's compensation is based on the size of the fund's assets, not thefinancial retums of the fund itself. As a result, fund managers focus on short-term growth opportunities. Fund managers also engage in their own web of lies on behalf of their favorite customers. Several major mutual fund management companies have been indicted for market timing violations (readjusdng end of day sales based on whether the stock went up or down ovemight), selling low quality funds that had higher commissions, selling their own funds to customers without telling them, and offering better commissions and future business to small brokerage firms that favored their fund over that of competitors. Similar to corporate execudves, these fund managers pursued their financial self-interests at the expense of transparent transactions. REVIEW ARTICLE CEOs Capture Lawyers, Regulators, and Journalists Lawyers, Hke auditors, are hired by the corporadon. If they wish to keep the corporadon as a client, the law firm must work in cooperadon with the corporate execudves, not against them. Regulators face different pressures. Part of the regulatory failure during the 1990s came from corporate lobbyists pressuring polidcians to keep regulators at bay. In addidon, regulatory bodies were underfunded and understaffed. In their cost-cutdng efforts, newspapers have reduced the number of invesdgadve joumalists and are more prone to publishing corporate public relafions announcements as news items. Bogle side-steps the issue of corporate condol of the media and the increasing importance of adverdsing for newspaper survival during this period of redacdon. What should be done about the power offinancial self-interests to override conscience and other moral restraint mechanisms? Bogle quotes Descartes witty summary of human nature from three-and-a-half centuries ago: "A man is incapable of comprehending any argument that interferes with his revenue." Not much has changed. As a conservadve. Bogle's first response is a call to retum to tradifion, despite Descartes's quote. This includes a retum to the high moral principles of the Founding Fathers (minus their views on slavery), a retum to an ownership society (rather than a managerial one), and a retum to virtue ethics. From a policy perspecdve. Bogle calls for a Nadonal Commission to implement the pracdcal recommendadons offered throughout his book. He favors separadng the roles of CEO and chairman of the board, prohibifing auditors from conducfing any consuldng work, increasing board independence, linking CEO pay to company performance rather than the pay of other CEOs, and full disclosure accoundng, among a host of other reforms. Bogle wants the owners of the world to unite andflex their muscle by becoming more informed and exercising their vodngrights. Will these changes occur? Auditor conflict of interest has been noted for about a century, yet auditors are still being paid by their client rather than from an independent body. If the pace of change remains slow, at some point the dam will burst and rapid repairs will be needed, such as Sarbanes-Oxley, to enhance market and corporate credibility. Arthur Levitt, Bogle's friend and former SEC Chairman, covered similar ground in his expose Take on the Street. Levitt surmises that if capitalism is viewed as a nine inning ballgame, we are in the top of the third inning. Livingstone Smith's analysis suggests that the relief pitcher's arsenal will have to include a psychological understanding of lying and its role in human nature. Changing mles is good for a quick fix, but permanentfixtures require additional work on the conscience and other moral restraints. Fortifying extemal checks and balances must be accompanied by a fortificadon of intemal checks and balances. BUSINESS ETHICS QUARTERLY References Berle, Adolf A., and Gardiner C. Means. 1932/2002. The Modem Corporation and Private Property. New Bmnswick, N.J.: Transaction. Levitt, Arthur, and Paula Dwyer. 2002. Take on the Street: What Wall Street and Corporate America Don't Want You to Know. New York: Pantheon Books. Smith, Adam. 1759/1976. The Theory of Moral Sentiments. Indianapolis: Liberty Classics.