Putting Integrity into Finance: A Positive Approach (PDF of Keynote Slides)

Abstract:     
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Finance theory and practice are incomplete without an integrated theory of integrity. Following Erhard, Jensen and Zaffron (2007) I define integrity without reference to morals, values, religion, or ethics. Something is in integrity if it is whole, complete and sound. Integrity is closely related to workability because an entity or system that is out of integrity will not be whole, complete and sound. Workability is the bridge to value. The farther out of integrity the less well any given entity will work.

The positive proposition that increasing the integrity of a firm will contribute to increasing its value is no different in kind from the positive proposition that the net present value investment rule will lead to value creation. The theory thus implies that integrity is a necessary, but not sufficient condition for the maximization of long-term value. The theory is testable and refutable.

I illustrate the application of this concept in finance by considering several examples:

1. The implicitly held proposition that firm's managers owe fiduciary responsibility to current shareholders only (excluding current and future bondholders and future shareholders). This leads to the widely held recommendation/belief that the appropriate action for a firm whose equity is substantially overvalued is to sell new equity and pay out the proceeds to current shareholders or to acquire a less overvalued firm through an equity transaction. Both of these policies will create a system in which future shareholders find that they have been taken in the transaction. Policies that expropriate wealth from future shareholders or bondholders cannot contribute to the creation of long-term value. Interestingly, U.S. disclosure laws provide some obligations for managers to take into account the interests of future bond and stockholders.

2. I discuss the extensive empirical evidence on the puzzling low-integrity value-destroying equilibrium between managers and capital markets and argue that understanding how this equilibrium continues to exist is a major challenge for our profession.

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PDF file of Keynote slides for speech first presented on the occasion of the presentation of the LECG Lifetime Achievement Award in Recognition of his Contributions to the Field of Financial Economics to Michael C. Jensen at the meetings of the American Finance Association, Boston, MA, Jan. 6, 2006; also presented to the Centre for Corporate Governance, London Business School, London, UK, Jan. 19, 2006; the Center for Corporate Governance, LeBow College of Business, Drexel University, Philadelphia, PA, March 1, 2006; Journal of Corporate Finance Conference on Private Equity, LBOs, and Corporate Governance, Rensselaer Polytechnic Institute, Troy, NY, April 21, 2006; CFO Forum, U. of Washington Business School, Seattle, WA, May 17, 2006, JOIMs Fall 2006 Conference, Boston, MA, Sept. 2006, Zicklin Center for Corporate Integrity, Baruch College, NYC, Oct. 2006; State Street Global Markets 7th Annual Research retreat, Boston, MA March 1, 2007: Society of Quantitative Analysts (SQA) Society, Fuzzy Day Conference, NY, NY, June 18, 2007; Smith Breeden Associates¿ Investment Research Seminar, Pinehurst, NC, Oct. 4, 2007; Tuck School of Business, Corporate Governance Workshop for Large Institutional Investors, Oct. 8, 2007; Deutsche Asset Management, Global Quantitative Investor Strategies: The Art of Alpha and Beta, NY, NY, Oct. 17, 2007; Financial Management Association, Orlando, FL, Oct. 18, 2007; DeAM European Investor Conference -- Alternative Sources of Alpha: The Art of Alpha and Beta, Berlin, Germany, Nov. 7, 2007; U. of South Florida and Society of Financial Analysts Conference on The Relationship of Value to Governance, Tampa, FL, Feb. 1; London Business School Private Equity Institute Seminar, April 14, 2008; Mays Business School, Texas A&M U. Feb. 10, 2009; and Keynote Address, Financial Intermediation Research Society (FIRS), Prague, Czech Republic, May 29, 2009.

Keywords: Integrity, Lies, Lying, Managing Earnings, Smoothing Earnings, Collusion, Development, Disclosure Strategy, Fiduciary Responsibility, Financial Reporting, Accounting Errors, Fraud

JEL Classifications: G10, G12, G14, D82

Working Paper Series