The premise is simple:
Hard-working entrepreneur wants to sell stock to help her business grow. She lines up a group of experts for her company’s board, which ensures that management acts in the best interest of shareholders, and finds an investment banker.
Savvy investor believes in the company, and buys in when shares are offered.
Wall Street analysts research the company and give clients the unvarnished lowdown. Entrepreneur tallies up her revenue and costs, announces company’s profits. Independent auditor checks the books. If things are going badly, company fesses up. If entrepreneur is selling shares, investors know about it.
Someday, the savvy investor decides to sell. Efficient stock market gets him the best available price, down to the penny.
At least that’s the ideal.
Two backbones, of course, are supposed to be fairness and transparency–no sweetheart deals, no cutting corners, honesty, integrity, prompt disclosure.
But as millions of investors have learned from the multibillion-dollar debacles at Enron, WorldCom, Merrill Lynch and Chicago-based Andersen, it doesn’t necessarily work that way.
Those high-profile disasters aside, some common practices–and some rare and less costly, but uncovered by regulators nonetheless–are also ominous:
– The entrepreneur may well round up a group of current and former company insiders and old friends for the board–and still meet independence rules. Investors may never know the true scope of their connections.
– Investment bankers may be promising favorable analyst coverage–or threatening to provide none if the firm goes elsewhere. The savvy investor is unlikely to get shares at the offering price; investment bankers dole them out strategically to help their business, or for a portion of the profits. Later, the analysts might tell you the shares are a “buy,” even if they don’t have facts to support the rating.
– The entrepreneur’s chief financial officer helps guide the analysts to earnings estimates, then has countless ways to beat that number–some perfectly acceptable under accounting rules, some dubious and some absolutely fraudulent, and all largely invisible to even the most diligent footnote-reader.
– The CFO may be chummy with the auditor–maybe because that’s where he used to work. Same goes for the chairman of the board committee that oversees the auditor.
– The broker may route the investor’s sell order to a firm that promises it the biggest kickback, not necessarily the one that has the best price.
– Even if the investor sticks with mutual funds, the manager could be using the fund to goose personal investments.
Too harsh? Of course. The business community has countless people who are ethical, honest and conscientious. But that’s small consolation to wounded and wronged investors who have seen portfolios shrivel and, even in cases of outright fraud, often recover a mere fraction of their losses.
The series of scandals that have rocked corporate America this year reflect, at their core, a failure in the ethic of transparency that made U.S. markets the global investment of choice.
Defenders stress that the worst abuses have come at the hands of the few bad apples. But sentiment has just as quickly coalesced around the idea that something has to be done–fast–to improve transparency and restore faith in the integrity of American business.
As the president put it in his much-anticipated speech:
“There must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, on unselfish performance; without them it cannot live.”
The president was Franklin D. Roosevelt. The speech was his first inaugural address in 1933, several months before the creation of the Securities and Exchange Commission.
`Challenging circumstances’
To some, it’s time again for more bold steps.
“These are very challenging circumstances,” said James Owers, a finance professor at Georgia State University and an expert on corporate reporting and restatements. “It requires actions equivalent to the trust-busting of Theodore Roosevelt or the formation of the SEC.”
Few doubt that Americans’ faith has been shaken to the core. Indeed, a recent survey for the Tribune found that only 4 percent of respondents said they had “a lot” of trust in major companies’ financial reports, while 53 percent said they had “little” or “none.”
Congress, the major stock exchanges, the SEC and companies themselves already have taken steps to shore up confidence: They’re moving forward with plans for a new accounting oversight board, harsher and swifter punishment for dishonest or incompetent executives and directors, and measures for enhanced board, auditor and analyst independence.
Now what?
Accounting regulators may require companies to account for stock options as an expense, or more firms may do it voluntarily. More big institutional shareholders and mutual funds are demanding to be heard on various governance issues. And shareholder pressure can temper the worst excesses of executive compensation.
Although quibbling over the details continues, many ideas now in the works have won wide support. Whether they will be enough to restore investor confidence is an open question.
University of California at Berkeley professor Terrance Odean, a noted expert on investor psychology, said media coverage of corporate scandals has an outsized effect on investors, often trumping any rational analysis of risk.
“What investors are asking themselves is … how prevalent is this stuff–how probable is it that the company I own has a problem like this?” he said.
“You’re willing to take the risk that the business plan doesn’t work. You don’t want to take the risk that you’re going to be defrauded of your money.”
Change from within
While much of the attention has been focused on rules and regulations, many experts say the most profound changes can only come from within.
David Kelsey, CFO at Saddle Brook, N.J.-based packaging products giant Sealed Air Corp.–a recognized leader in corporate governance–said it’s largely a matter of corporate culture. His company believes management integrity and stressing its code of conduct with employees pays off in more productivity, stronger sales and healthier margins.
“There is a role for regulation and guidelines, but clearly they’re not enough to solve the problem,” Kelsey said.
He warns that requiring more disclosure doesn’t necessarily solve the problem, or translate into improved transparency.
“I don’t bother to read the annual reports and proxies of the companies I hold shares in,” he said. “Even the companies that try to write in plain English–it’s too much and it doesn’t give a good flavor of what to expect in the coming year.”
Some experts say a more systemic change is also required.
PricewaterhouseCoopers Chief Executive Samuel DiPiazza co-wrote a book, “Building Public Trust,” that stressed the need for transparency, accountability and integrity.
But others fear the search for solutions may go too far. Deloitte Research chief economist Carl Steidtmann urges companies to “embrace transparency” and create a chief governance officer position to oversee it, but he doesn’t believe the system is necessarily broken.
In fact, the Enron and WorldCom situations illustrate that it works, he said. “The market is, in a sense, imposing a discipline that will force companies to engage in a much greater level of transparency than they were before,” he said.
Many experts, including Steidtmann, say it’s impossible to prevent all malfeasance.
Robert Borosage–a former issues adviser to Rev. Jesse Jackson and co-director of the progressive Campaign for America’s Future–advocates analyst and auditor independence, among other changes, but said rules are not enough. He said too many specific guidelines merely provide “a detailed map” for crafty wrongdoers.
Ultimately, he and other experts agree, confidence is easier to shatter than to repair.
“Trust isn’t something you manufacture overnight,” Steidtmann said. “It’s a process that’s going to take time.”
Standard ideas don’t go far enough? Try these
OK, it’s bad out there. What to do? Most of the standard ideas–more-independent boards, more auditor and analyst independence, better accounting oversight, more funding for securities cops–are in the works or have been batted around for a long time.
So what’s left? Here are some of the bolder proposals:
-Tax returns: SEC and IRS reporting rules are different. Companies like to impress Wall Street with big profits, but pay taxes on smaller profits–so some suggest requiring companies to release tax returns to let investors compare and contrast. Alan Greenspan says it’ll never fly because of the corporate secrets involved, but the idea is backed by some conservative commentators.
– Auditors: Looking to promote independence from the company? Have the stock exchanges pick the auditor.
– National incorporation standard: Supporter Robert Borosage of the Campaign for America’s Future calls this a “dramatic” step that would prevent firms from cherry-picking the states with the most favorable incorporation rules.
– IPOs: Remember those eye-popping first-day returns? Give everyone a shot at them, rather than allowing investment bankers to reserve shares for select clients. A few offerings have been via Dutch auction–let anybody bid, dole out the shares to the highest offers. Make it the standard.
– Chairmen/CEOs: Former Fed Chairman/would-be Andersen rescuer Paul Volcker and others point to Europe, where separating these two top corporate jobs is typical. The theory is that the CEO needs a true, independent boss. Opponents of mandatory separation say combining the titles provides a sense of direction and control.
– Reporting: Patrick Dorsey, director of stock analysis at Chicago-based Morningstar, believes companies shouldn’t be allowed to report quarterly earnings unless they also provide a balance sheet and cash flow statement. They’re vital tools for knowledgeable investors.
–Andrew Countryman
