Why Congress Moved on Financial Market Reform

From the National Journal--the sports page for professional lobbyists. Its analyses of the substance of public policy are often wanting. Its analyses of the shape of political alliances and the interest groups pressing on the government are unsurpassed.

National Journal: To The Rescue? (07/19/2002)

...In the 1990s, an extraordinary run-up in the stock market increased the incentives for corporate executives to cheat and dulled investors' incentives to notice. The private-sector watchdogs -- accountants and analysts -- found that it paid more to please corporate clients than to safeguard investors, while the public-sector watchdogs found themselves systematically starved for resources. But as long as investors received 15 percent-a-year appreciation in stock values, no one begrudged executives their multimillion-dollar stock-option awards or pressed too hard for explanations about where all this growth came from...

At the beginning of June, the reform movement in Congress seemed moribund.... Paul S. Sarbanes, D-Md., couldn't seem to muster sufficient votes in his own committee to pass a package of auditing reforms.... Having patiently built a persuasive case for reform through a series of hearings, Sarbanes quietly and painstakingly began negotiating for the critical swing votes on his committee. To the surprise of Washington's punditocracy, his bill passed out of committee, 17-4. More striking, Republican Michael Enzi of Wyoming -- a conservative and the Senate's only accountant -- broke ranks with the panel's most senior Republican, Phil Gramm of Texas, and brought five of his Republican colleagues along with him. Just one week later, the political calculus changed even more dramatically, when telecommunications giant WorldCom fired its chief financial officer and announced that it had misreported $3.8 billion in expenses to disguise losses in 2001 and early 2002.... Stock markets that once knew no top now seem to know no bottom. From mid-April to mid-July, the Dow Jones industrial average fell roughly 15 percent, while the already-humbled NASDAQ was off another 22 percent. MSN Money columnist Jim Jubak believes that we have gone from a market decline caused by investors who finally realized stocks were hopelessly overvalued by accepted measures, to a market in which stock prices are falling because investors no longer trust the numbers. "At some point this year, we passed out of the valuation phase and into the fraud phase," ...

ECONOMY
To The Rescue?

By Julie Kosterlitz, National Journal
© National Journal Group Inc.
Friday, July 19, 2002

For the past two decades, the presumption has largely been that the best thing Washington can do for the markets is to get the hell out of the way. And for a time, it did seem that unfettered capitalism was the cure for all that ailed America, and indeed the world. Why would you want to mess with the system that had bested communism by the beginning of the 1990s, powered the U.S. economy past all its industrialized competitors by the mid-1990s, and created a new class of billionaires and 30-something retirees here at home by the late 1990s?

Well, there was that nasty business with the savings and loan industry that left taxpayers holding a $300 billion bag. But that embarrassment happened in the 1980s -- prehistory really, before technology transformed our economy, our way of life, and our expectations about markets and wealth.

In the 1990s, an extraordinary run-up in the stock market increased the incentives for corporate executives to cheat and dulled investors' incentives to notice. The private-sector watchdogs -- accountants and analysts -- found that it paid more to please corporate clients than to safeguard investors, while the public-sector watchdogs found themselves systematically starved for resources. But as long as investors received 15 percent-a-year appreciation in stock values, no one begrudged executives their multimillion-dollar stock-option awards or pressed too hard for explanations about where all this growth came from.

"It's only when the tide goes out that you discover who was swimming naked," says David Malpass, chief international economist for Bear Stearns -- quoting a more ribald variant on an old market aphorism that was coined by company board Vice Chairman E. John Rosenwald Jr.

The more the tide has receded, the more it has seemed as though a veritable nudist camp had sprung up on Wall Street. And at some point, even Washington finally took notice.

At the beginning of June, the reform movement in Congress seemed moribund. The House had passed legislation that activists found sorely wanting, and Senate Banking, Housing, and Urban Affairs Committee Chairman Paul S. Sarbanes, D-Md., couldn't seem to muster sufficient votes in his own committee to pass a package of auditing reforms. No matter that the wreckage of Enron was still smoldering, or that New York Attorney General Eliot Spitzer had turned up some incriminating e-mails that made some of Wall Street's best-known stock analysts out to be two-faced touts.

Many would-be reformers gnashed their teeth and complained that the accounting industry and corporate America had once again bought off Congress.

But they, like everyone else, misjudged both Sarbanes's determination and the tenor of the times. Having patiently built a persuasive case for reform through a series of hearings, Sarbanes quietly and painstakingly began negotiating for the critical swing votes on his committee. To the surprise of Washington's punditocracy, his bill passed out of committee, 17-4. More striking, Republican Michael Enzi of Wyoming -- a conservative and the Senate's only accountant -- broke ranks with the panel's most senior Republican, Phil Gramm of Texas, and brought five of his Republican colleagues along with him.

Just one week later, the political calculus changed even more dramatically, when telecommunications giant WorldCom fired its chief financial officer and announced that it had misreported $3.8 billion in expenses to disguise losses in 2001 and early 2002. Oh, and by the way, it added, the company would be cutting 17,000 jobs.

WorldCom's phantom $4 billion dwarfed the losses from Enron's accounting shenanigans, and the company's troubles were quickly followed by fresh revelations regarding such blue chips as Xerox and Merck. Et tu, Bristol-Myers Squibb?

Stock markets that once knew no top now seem to know no bottom. From mid-April to mid-July, the Dow Jones industrial average fell roughly 15 percent, while the already-humbled NASDAQ was off another 22 percent.

MSN Money columnist Jim Jubak believes that we have gone from a market decline caused by investors who finally realized stocks were hopelessly overvalued by accepted measures, to a market in which stock prices are falling because investors no longer trust the numbers. "At some point this year, we passed out of the valuation phase and into the fraud phase," he wrote on moneycentral.msn.com in early July.

Economists began worrying aloud that the burn on Wall Street could jump the firebreaks and endanger the so-called real economy. And politicians began worrying that the Wall Street vanities bonfire could sear them come November.

Suddenly a government reviled for its gridlock was abuzz with activity. The Senate leadership whisked Sarbanes's measure to the floor just after the Fourth of July recess, and the visible opposition all but melted away. And members began lining up to offer tougher-than-thou amendments.

K Street also changed its tune, or at least some of its lyrics. The Business Roundtable -- which had just weeks earlier asked its Fortune 150 CEO members to personally lobby New York Stock Exchange Chairman Dick Grasso to drop some of the exchange's pending reform proposals -- took out full-page advertisements in major dailies announcing its fervent support for virtually every major reform proposal by members of Congress and the White House.

The frenzy reached a new level beginning the week of July 8. On the Senate floor, Sarbanes's bill was retrofitted from a hearse into a parade float with ever-more-elaborate provisions and with politicians clambering for a visible spot on top. And President Bush attempted to sprint to the head of the parade by delivering a get-tough speech on Wall Street. He gave this speech as debate on the Sarbanes bill began on the Senate floor -- and as the press hordes began re-examining controversies about his conduct and that of other top administration officials during their stints in the boardrooms and executive suites of corporate America.

By mid-July, the Senate had passed the toughened Sarbanes bill 97-0, and the House hastily passed an additional anti-fraud measure 391-28.

But all the sound and fury begs the most basic question: Can Washington restore the public trust in Wall Street?

Bad Apples Versus Rotten Roots
What it takes to "save" Wall Street depends on what you think imperils it.

In Washington, there are two contending theories. One is the "bad apples" doctrine, embraced mainly by conservatives, prosecutors, and industry groups, which posits that Wall Street's woes are principally the doings of individuals -- those executives who crossed the line separating a laudable pursuit of profits from outright fraud.

And the other is the "rotten roots" doctrine, which holds that the problem goes deeper, and that financial conflicts of interest have hopelessly undermined the checks and balances. Auditors, boards of directors, and brokerage houses that were supposed to serve the interests of shareholders became captives of the business executives they were supposed to oversee. Exhibit A for adherents of this view: In 2001, a record 270 public companies restated their financial numbers.

Once the exclusive province of liberals and shareholder activists, the rotten-roots group has claimed a growing set of adherents among free-marketeers -- such as former Federal Reserve Board Chairman Paul Volcker -- and Wall Street and corporate executives fearful of being tarred with the same brush as their more risk-taking brethren.

Each doctrine implies a different set of remedies.

The solution to bad behavior is stiff punishment. It gets wrongdoers out of the corner offices and boardrooms, and gets the attention of the executive mind in the same way that a hanging does. "Conservatives believe that strict punishment is what deters crime," says former Rep. Mickey Edwards, R-Okla., who now teaches at Harvard University's John F. Kennedy School of Government. "So if Ken Lay [of Enron breaks the law], it's not bad to have a headline saying he'll spend 20 years in prison."

This is the solution principally embraced by President Bush. "With strict enforcement and higher ethical standards, we must usher in a new era of integrity in corporate America," he told his audience at the Regent Wall Street Hotel, before calling for creation of a corporate-fraud task force. Bush also proposed doubling the maximum prison term for mail fraud and wire fraud to 10 years, prosecuting document shredding and other forms of obstruction of justice more aggressively, and reforming the Securities and Exchange Commission so it'll be better able to prevent executive looting of companies under investigation.

The bad-apples approach has the advantage of being simple and easily understood by the public. To the extent that Wall Street's woes reflect a crisis in confidence among small investors, or is creating anxiety among consumers, the sight of Ken Lay in handcuffs would surely be more attention-getting than convening some obscure auditing oversight commission.

And this approach could pay political dividends: Satisfying a public desire for retribution -- er, justice -- keeps market failures from spawning class warfare or an anti-business sentiment. Think of it as laying to rest the nagging working-class suspicion that -- as Sen. Zell Miller, D-Ga., put it in introducing an amendment to require corporate CEOs to sign their firms' tax returns -- the big guys got the gold mine and the little guys got the shaft.

Left unattended, a perceived double standard of justice could redound to the particular disadvantage of Republicans -- especially at a time when the party's fortunes rest disproportionately on the popularity of President Bush. As things stand at the moment, opinion polls show voters are slightly more inclined to trust Democrats to solve Wall Street's problems -- a departure from their usual propensity to trust Republicans on matters financial and economic.

But the hang-'em-high approach has its limitations.

For starters, a wide and growing range of observers -- including some conservatives -- believe it wouldn't address the problems underlying the current crisis. That attitude was reflected in the skeptical reaction in news and commentary to Bush's speech. The markets' dramatic slide the day and week of Bush's speech -- the product, naturally of myriad factors -- also suggested that it might take more than an executive hanging to dispel the gloom.

To address systemic problems, reformers would need to remake the system by loosening the ties that now bind boards of directors and auditors too tightly to management, and by giving Wall Street watchdogs more money, power, and independence. Thus, the centerpiece of the original Sarbanes bill featured a new and independent overseer of the auditing profession and new rules to govern the relationship between auditors and the companies they audit.

But this is Washington in an election year -- not a time for doctrinal purity. So why not throw everything you've got at the problem and follow both approaches? That, indeed, is what has been happening in the post-WorldCom world.

As it wended through the Senate, the Sarbanes bill quickly received more bad-apples measures, including Bush's proposed doubling of five-year sentences for mail and wire fraud, as well as some even tougher measures offered by Senate Judiciary Chairman Patrick Leahy, D-Vt. Leahy's provisions would, for example, make it a separate crime to "willfully and knowingly" perpetrate "schemes or artifices to defraud shareholders" and would extend the period in which shareholder lawsuits can be brought.

Meanwhile, Bush, who had scarcely mentioned "auditor oversight" in his Wall Street speech, took pains in an address in Birmingham, Ala., the following week to call for a "strong, independent board" to oversee the accounting industry. And his embattled Securities and Exchange Commission chairman, Harvey Pitt, recently proposed his own version of an independent oversight of the accounting profession, as did the Republican-controlled House back in April. Reformers and Democrats have sharply criticized both proposals' particulars.

But the developments are nevertheless striking, when you recall, for example, that Pitt made his career and fortune representing rogue executives, major accounting firms, and their trade group, and that he inaugurated his term at the SEC by promising, in a now-infamous speech to the accounting industry last year, to make the commission a kinder and gentler place.

The apparent fusion of the two approaches conceals some serious disagreements that could yet cause legislation to unravel. Bush left himself substantial wiggle room in his Birmingham speech when he pledged to work with Congress for a law that "will hold people accountable without stifling the entrepreneurial spirit of America." The accounting industry is sure to fight the tougher provisions of the Senate bill in conference, and the U.S. Chamber of Commerce has served notice it will fight provisions it says will invite abusive shareholder suits. At the same time, Senate Democrats, sensing the political momentum is with them, have been signaling that Sarbanes will refuse to accept any conference agreement he considers too weak.

'A Sense Of Blood Lust'
Even if Washington does achieve harmonic convergence -- will it restore the luster of Wall Street?

Skeptics abound. Many longtime observers of the market believe that over time, it is the markets' own adjustments that will make the most difference.

Suspect companies have already been punished by a merciless drubbing of their stock prices; Arthur Andersen has already been virtually dismantled; and suspected corporate malefactors have become public pariahs. Over time, market observers suggest, small investors will follow the lead of institutional investors and flee the shills at investment houses for the discount brokerage houses and the independent advisers.

And to the extent that rules are needed, many of them are being supplied by private-sector institutions -- such as the New York Stock Exchange, whose Corporate Accountability and Listing Standards Committee (co-chaired by former Rep. Leon Panetta, D-Calif.) drafted a set of widely hailed reforms. The reforms would, among other things, require the majority of corporate board members, and all audit committee members, to be independent. Audit committees would meet more often, and without management, and would have sole authority to hire and oversee the company's auditors. Moreover, the lucrative stock-option grants awarded corporate executives and others would have to be put to a shareholder vote.

The proposals were so well received in Congress and on Wall Street that President Bush cribbed a few of them for his own "get-tough" speech. Some of the proposals also turned up in the Senate legislation.

"Self-correction is probably not only a fact, it's probably going to do most of the work in fixing all these problems," Robert Litan, the Brookings Institution's economic studies director, opined at a recent forum. "There will be a lot of blood on the floor along the way."

A tough, systemic approach, he adds, will on balance do more good than harm. But to the extent that the best balm for nervous investors is a period of scandal-free calm, Litan and others note, the crackdown on white-collar crime could in the short run merely turn up more wrongdoing, thereby spooking investors all the more.

And by the time the scandals fade from the front page, argues Donald Straszheim, a former Merrill Lynch chief economist who now runs an independent investment advisory firm in Santa Monica, Calif., government will likely still be haggling over a response. "Anybody who [cheated] is going to come clean in the next few months," he says. "By the time we get legislation, everybody is going to know the [extent of the] story. This story will be over by Labor Day."

Others are less sanguine about the benefits of more government intervention. Remedies -- especially when crafted in an election year with party control of both houses at stake -- are bound to overreach.

Some fear, for example, that Uncle Sam is becoming a glutton for punishment -- of other people, that is. "There's a sense of blood lust here," said David Becker, who recently left his post as general counsel of the Securities and Exchange Commission and is now a partner in the Washington office of Cleary, Gottlieb, Steen & Hamilton. Treating more securities cases as criminal affairs will make them harder and more costly to prosecute, and this further risks clogging the courts. "Civil remedies can be a safety valve. You settle, get the message out [that the SEC is watching], and move on to the next case," Becker said.

"Securities law is best dealt with from a civil approach, which is better than criminalizing it," says Greg Bruch, a former deputy chief of enforcement at the SEC, now a partner at the law firm of Foley & Lardner. "They're very subtle issues sometimes, not always egregious. Even the most headline-grabbing scandal often involves technical accounting issues, which are hard to explain to a jury," Bruch said, and that makes a conviction unlikely. To increase the chances of a successful conviction, criminal cases are also typically more focused on narrower issues and fewer actors. This focus comes at the expense of illuminating the kind and scope of behavior the government hopes to deter.

L. William Seidman, who chaired the Federal Deposit Insurance Corp. during the Reagan administration and who serves on several corporate boards, fears that the Leahy amendment will have a chilling effect on boards and executives and will stop companies from issuing forward-looking statements about the company's direction and growth prospects that many investors find useful.

Prosecuting people on borderline issues or on technicalities can end up trivializing corporate crime, warned University of Pennsylvania business law professor David Skeel and Harvard criminal law professor William Stuntz in a recent New York Times op-ed column. And prosecutions shift the focus to "what is legal, instead of what is right" -- making corporate honesty a game of cat and mouse rather than a matter of social mores.

Others fear that Congress's systemic reforms may intrude upon the prerogatives of private-sector reformers. "We're very wary" of legislative solutions to corporate-governance problems, says Ken Bertsch, director of governance at TIAA-CREF -- the world's largest private pension system, which manages hundreds of billions of dollars in retirement funds for educators and researchers and is among the leaders of a movement among institutional investors to give tougher scrutiny to corporate governance. "We think they're too inflexible, too potentially intrusive. We still think boards need a fair amount of latitude" and that "the stock exchanges are a more flexible mechanism" for reforming corporate boards.

Congress could, for example, give more power to the audit committees of corporate boards of directors, but then leave most of the substantive decisions to the audit committees. "That's an intelligent approach, where Washington does what it can do: outline the powers of process, not determine the outcomes," said Robert Pozen, a former vice chairman of Fidelity Investments who now teaches at Harvard Law School.

Congress, rather than spelling out the kinds of consulting services accounting firms can provide to the firms they audit, or requiring that lead audit companies rotate every five years, should leave such matters should be left to the audit committees, Pozen says.

A Secret Form Of Currency
For every critic who worries about government overreaching, however, there is another who fears that this round of reforms won't go far enough. After all, Congress during the 1990s made it tougher for shareholders to sue companies and their accountants for securities fraud. Members of Congress also pressured the Securities and Exchange Commission and its private-sector deputy, the Financial Accounting Standards Board, to back down on various efforts to reform accounting-industry practices and accounting principles.

Even now, for all its tough talk, Congress appears unwilling to tackle what many believe is the corrupting effect of lavish stock-option grants to corporate executives.

Stock-option grants entitle the holder to buy stock in the future at an already-fixed price. The options became popular in the 1990s after a decade characterized by lackluster profits and inept management, as a way to reward executives for performance. The more profitable the company, the more company share prices rise and the more valuable the options become.

But over time, stock options have evolved into a secret form of currency that created a parallel economy. This second economy existed largely outside government strictures and allowed executives and corporations to profit at shareholder expense. Exempt from the tax and accounting treatment applied to most employee compensation, options are more valuable, dollar for dollar, to executives and to the company, than cash.

By showering stock options on executives and others, companies can, in essence, make promises that will eventually cost it billions, without any impact on profits. Several studies have suggested that the failure to properly account for stock options has led many large U.S. companies to overstate profits by as much as 50 percent. And because the options are "free" to corporations, companies can and do hand out astonishingly large, options-loaded compensation packages to their executives. But stock options do cost shareholders, because the issuance of more stock dilutes the value of individuals' holdings.

Rather than provide incentives for good management, stock options have provided massive incentives to use creative accounting to drive up stock values for short periods of time. Thanks to changes in SEC regulations in the early 1990s, executives no longer had to hold on to company stock they acquired by exercising the options; instead, they could sell the shares immediately after exercising their option to buy them. This netted an executive millions without tying his or her long-term fortunes to the company's.

In theory, options provide a serious incentive to avoid falling stock prices; in practice, those who watch the value of their options evaporate in a falling market increasingly go before compliant boards to ask that their options be "repriced."

"Stock options have been an incredible gravy train for everybody. When the gains can be that huge in small periods of time, incredibly seductive, no one wants to give that up," says Margaret Blair, a professor at Georgetown University Law Center. "The excessive size and outrageous terms [of stock-option grants] make it, 'Heads I win, tails you lose.' "

Despite the increasing outcry about the pitfalls of stock options, Congress has repeatedly helped corporate America fend off proposed reforms. In 1994, Congress took the extraordinary step of quashing an effort by the Financial Accounting Standards Board -- a private-sector organization deputized by the Securities and Exchange Commission to set standards governing how companies must present their finances -- to require companies to treat stock-option grants as an expense like other compensation costs, such as salaries.

Neither the current string of corporate scandals nor the admonitions of a growing number of eminences grises -- including Federal Reserve Board Chairman Alan Greenspan -- have persuaded Congress, or the Bush administration for that matter, to undertake this reform. Bush made no mention of stock options in his speech, and the House-passed securities bill is silent on the matter. And even as the Senate approved several hard-nosed amendments to the Sarbanes bill in the Senate, the Democratic and Republican leaderships took turns maneuvering to avoid putting stock-option reforms to a vote -- or even requiring FASB to study and vote on the options issue.

"It's going to require the equivalent of the '29 crash to overcome business opposition" to options reforms, John Coffee, a professor of securities law at Columbia University, predicted not long before the Senate dodged options reform in early July.

Shareholder activists and corporate-governance experts also fear that both government and the private sector will miss other opportunities to make corporate managers more responsive to shareholders.

Cato Institute Chairman William Niskanen, who headed President Reagan's Council of Economic Advisers, says that Congress should repeal the 1968 Williams Act, a law he contends helps entrench management by making hostile takeovers more difficult. TIAA-CREF's Bertsch thinks that the Labor Department could be much more aggressive in forcing pension funds to exercise their legal fiduciary responsibilities in scrutinizing management, rather than reflexively voting their shares with management.

The National Association of Corporate Directors would like to see the SEC require the U.S. stock exchanges to adopt a practice instituted in Britain (and later, Canada) after much-publicized corporate-fraud scandals in the early 1990s. There, exchanges endorsed a set of best practices for corporate boards, and then required companies to disclose whether they have adopted them.

Seidman, who was in charge of liquidating the assets of defunct S&Ls during the first Bush administration, likes another British innovation: prohibiting a company's CEO from also chairing its board of directors. "So much concentration of power in one person can lead to abuses," he said.

But many of these ideas have yet to achieve a solid consensus. TIAA-CREF, for example, opposes the idea of banning CEOs from the board chairmanship. "It could be damaging," says Bertsch.

To some, the diversity of views suggests that saving Wall Street will take a much more sweeping effort. "Frankly, the problems are so deep, complicated, systemic, and poorly understood, we need a dispassionate look at what's going on -- a presidential commission like the Kerner Commission," which was established to investigate the causes of racial unrest in the 1960s, says Ira Jackson, director of the Center for Business and Government at Harvard's Kennedy School of Government. "There's no quick fix.... These are systemic issues that are very penetrating. To get the right diagnostic, you need a comprehensive look."

Sure, the blue-ribbon panels of the Conference Board and the Business Roundtable are helpful, Jackson says, "but they don't have the stature and standard of a Kerner-style commission."

That's a tough sell: Washington is a good deal more jaded about the value of presidential commissions than it was three-and-a-half decades ago.

But Jackson contends that the public is not. "If you want to take an uncertain public and turn them cynical, tell them that a couple rifle shots provide solutions," he says.

Unprompted, many experts voice concern that the current spectacle on Wall Street is as much a cultural crisis as it is a legal or financial one. "We have a culture that has glorified the marketplace as arbiters of how people should act," says Cleary, Gottlieb's Becker.

If so, the real task at hand may be not only to restore the nation's faith in Wall Street, but to chasten those who have made an altar of the trader's desk.

Posted by DeLong at July 19, 2002 11:31 AM | Trackback