Icarus in the Boardroom: The Fundamental Flaws in Corporate America and Where They Came From.

• Author: Griffith, Sean J.
• Position: Book review

ICARUS IN THE BOARDROOM: THE FUNDAMENTAL FLAWS IN CORPORATE AMERICA AND WHERE THEY CAME FROM. By David Skeel. Oxford and New York: Oxford University Press. 2005. Pp. vii, 250. $25.

TABLE OF CONTENTS INTRODUCTION I. A HISTORY OF BUSINESS SCANDAL II. INSURANCE AGAINST RISK-TAKERS III. A NETWORK OF CONSTRAINT A. Takeover Jurisprudence B. Icarus Effect Jurisprudence CONCLUSION INTRODUCTION

Everyone loves a good scandal. Scandals sell papers. (1) They focus public attention and galvanize public opinion. (2) They also divert and entertain. (3)

The recent corporate scandals are no exception. (4) Coming, as they did, in the midst of an economic downturn, they focused public attention on corporate governance and galvanized public opinion in favor of reform. (5) They also did not fail to entertain. (6)

But perhaps most importantly, scandals are rhetorically useful. They provide politicians with ammunition to attack their opponents and assure commentators of a wealth of material over which to disagree. Here again, the recent corporate scandals did not disappoint. Democrats and Republicans in Congress sought to blame the mess on each other, (7) the President pledged to get tough, (8) and the New York State Attorney General built a gubernatorial campaign out of combating corporate evil-doers. (9) Articles on corporate reform appeared regularly in newspapers and law reviews, (10) and prominent legal academics testified in Washington. (11)

Now, several years later, it remains unclear what we ought to make of all of this. Is there a lasting lesson buried amid the noise, or did we simply give in to cognitive biases causing us to rely excessively on narrative as opposed to statistical data and to weight bad news over good? (12) What, if anything, can we learn from the corporate scandals that we did not know before? And how should they shape the thinking of corporate leaders and policymakers going forward? These are the questions that Professor David Skeel of the University of Pennsylvania Law School addresses in Icarus in the Boardroom: The Fundamental Flaws in Corporate America and Where They Came From (hereinafter Icarus in the Boardroom).

Icarus in the Boardroom is a historical analysis of corporate calamity that takes us to the beginning of the industrial era to study the periodic episodes of scandal that have roiled American business and stirred the federal government to action. (13) It is an extremely colorful account, peppered with an array of cultural references and fascinating anecdotes. (14) Indeed, because it is a trade book, aimed at an audience beyond the narrow confines of academia, Icarus in the Boardroom gives Skeel considerable room to display his wit and talent for creating lively prose, yet it is an unmistakably serious work of legal scholarship. Starting with the emergence of the corporate form and moving through the rise of the large corporation, Skeel provides a nuanced, historical account of the problems of corporate governance and offers an innovative set of proposals to address them.

This Review describes Skeel's account of corporate scandal and evaluates his policy recommendations. It argues that although Icarus in the Boardroom provides a compelling history of corporate scandal, the book's focus on federal responses to scandal--from the enactment of the Interstate Commerce Act to the Sarbanes-Oxley Act--misses an important part of the story. As corporate law scholars have long pointed out, corporations exist within a network of constraints, based in part on law and in part on markets, norms, and other non-legal sanctions. (15) Because it omits any sustained discussion of the reaction of these other sources of constraint, focusing instead on the federal reaction, Icarus in the Boardroom is largely incomplete as a history of scandal and reaction. A comprehensive account requires a more thorough treatment of other corporate constraints, beginning--this Review argues--with state corporate law. State courts have long engaged the problem of productive versus destructive risk that motivates Skeel's analysis. Moreover, this Review argues, the flexibility and interpretive suppleness of state corporate law jurisprudence may be better suited to respond to the problems Skeel identifies than a central, typically federal, regulator.

Part I of this Review describes Skeel's account of corporate scandal, focusing on the central theme of excessive risk-taking. Part II examines Skeel's most original policy proposal--the creation of an investor insurance scheme to protect against excessive risk. Although the proposal takes up only a few pages of the book, it targets the books' core concern--the risk of corporate fraud. In evaluating the proposed investor insurance regime, this Review raises a set of objections based on cost and administrability and argues that an insurance regime would be duplicative of existing mechanisms that effectively spread the risk of financial fraud. Part III then discusses the broader environment of constraint and emphasizes the responsiveness of state courts to corporate crises. It argues that state judges have every incentive to respond to periods of scandal and that state law jurisprudence has evolved a set of highly flexible mechanisms for increasing or decreasing the legal oversight of corporate governance. Icarus in the Boardroom, in other words, emphasizes Icarus, but the perspective is Daedalean. This Review, by contrast, emphasizes the ability of existing institutions to respond to the problems Skeel identifies, resisting the impulse to tinker with the system and federalize ever-greater amounts of corporate governance.

1. A HISTORY OF BUSINESS SCANDAL

   The phrase "corporate scandal" has been applied to a variety of frauds and failures, most recently including accounting fraud at Enron and World Com, (16) looting at Tyco and Adelphia, (17) and corruption among Wall Street investment banks. (18) Going back a bit, a list of major business scandals might also include the savings and loan crisis (pp. 132-34), the Erie Railroad scandal (pp. 33-36), and the tulip and South Sea bubbles (pp. 15-16). Although acknowledging the possible breadth of its central theme, the narrative of Icarus in the Boardroom focuses on four central characters: Jay Cooke, Samuel Insull, Ken Lay, and Bernie Ebbers. (19) What these men have in common is their form of failure. The rise and fall of each traces the pattern of what Skeel describes as "Icarus Effect" failures (p. 7).

   An Icarus Effect failure is one in which three core causal factors contribute to a financial collapse. The three factors identified by Skeel are (A) "excessive or fraudulent" risk-taking; (B) competition, both between and within firms, and (C) the "increasing size and complexity" of business organizations (pp. 5-6). The relative importance of each of the three factors is given away by the decision to name the tendency and the book itself after Icarus, the figure from Greek mythology who flew too close to the sun on waxen wings. When the heat of the sun melted the wax, Icarus was sent plunging to his death because, as Skeel interprets the tale, he "thought less and less about risk, and more and more about the majesty of his powers" (pp. 4-5). Icarus Effect failures, in other words, are a result of risk-taking run amok. The fundamental flaw in corporate America, Skeel argues, is the encouragement and facilitation of excessive risk.

   Ken Lay at Enron and Bernie Ebbers at WorldCom are modern exemplars of the Icarus Effect. Each emerged as a consummate risk-taker by surviving round after round of "probationary crucibles." (20) Here Skeel draws upon current scholarship in the field of industrial organization describing executive promotion as an ongoing tournament that rewards short-term success and discourages loyalty (pp. 170-72). The result of this structure, as described by Professor Donald Langevoort, is that tournament survival traits "such as over-optimism, an inflated sense of self-efficacy and a deep capacity for ethical self-deception ... are disproportionately represented in executive suites." (21) Enron was a paradigmatic example of the corporate crucible. As described by Langevoort:

   Enron was filled with people who [were] optimistic, aggressive, and focused. The culture quickly identified itself as special and uniquely competent, believing that special skill rather than luck (or just being first) was responsible for the early victories. That self-definition then set a standard for how up-and-coming people acted out their roles: Enron was a place for winners. With this--and the stock market's positive feedback-the company's aspiration level rose. This aspiration level required a high level of risk-taking by the firm .... [T]he compensation and promotion structure at Enron ... harshly penalized the laggards at the firm, which, on average, tends to lead to herding behavior (risk aversion). To counteract this, the company had to magnify the reward structure considerably for those who ended up as stellar performers--a winner-take-all kind of tournament. (22) The same survival traits that this Darwinian process selects in corporate managers--over-confidence and a taste for risk--can lead them into a spiral of bad decisions and ever-greater risks once their luck begins to fail. (23) Put this together with the cult of the charismatic CEO and a compensation structure rewarding consistent short-term success and you begin to get at the core of what Kenny and Bernie did. Theirs, Skeel argues, were Icarus Effect failures, caused by the incentives in modern corporations pushing managers to take ever-greater risks.

   Ebbers's and Lay's forefathers in fraud were Jay Cooke and Samuel Insull. Skeel credits Cooke, a Philadelphia banker who rose to prominence in the early 1860s, with leading the United States into its first Icarus Effect scandal. Cooke was a bond salesman who pioneered a new distribution technique by marketing issues to the small...