After the Fall of Harvey Pitt: We Are Still in Bigger Trouble Than We Realize: Archive Entry From Brad DeLong's Webjournal

November 06, 2002

After the Fall of Harvey Pitt: We Are Still in Bigger Trouble Than We Realize

After the Fall of Harvey Pitt: We Are Still in Bigger Trouble than We Realize

J. Bradford DeLong

A First Draft

Harvey Pitt was in bigger trouble than he realized. He is now gone: he submitted his resignation as Chair of the Securities and Exchange Commission [SEC] on the evening of 2002's election day. But his resignation does nothing to get the rest of us out of big trouble.

There is drastic, urgent need for significant and immediate reforms in the way that we regulate our financial markets, and those who staff our executive branch seem to be without a clue. We have a president who regards the mandatory disclosure laws regarding insider sales (to provide outsiders with timely news that insiders think that a stock is overvalued and that it is time to bail out) as things to be broken as casually as one pushes the speedometer needle up to 5 mph above the posted speed limit. We have a vice president who regards firms' requirements to disclose "material" information as extremely elastic. And we have a chair of the Public Company Accounting Oversight Board [PCAOB] who shows no hesitation in firing an accounting firm when it informs him that a company's financial controls are insufficient.

A year and a half ago, almost all of us would have been surprised to be told that financial-market regulatory reform was or would become an important issue. Back when Harvey Pitt was overwhelmingly confirmed as chair of the SEC, it was expected that he would have a quiet life. Under the Bush Administration, it was thought, the SEC would not grow in funding or shift in its mission, but would at most be subject to a few tweaks to make it kinder, gentler, and--with luck--less addicted to pointless red tape. To be sure, there were a couple of tricky issues: (i) Could Generally Accepted Accounting Principles [GAAP] be modified to make headline earnings numbers more meaningful, and if so how? And (ii) Were Arthur Levitt's restrictions on the selective dissemination of corporate news a laudable effort to level the informational playing field or a disaster which made it nearly impossible for anyone to learn anything? But these were two threads needing attention--threads that were barely visible in the apparently-majestic tapestry of American capital markets and their regulation. Almost all of us who have an academic, fiduciary responsibility-based, or personal financial interst in the regulation of America's capital markets looked forward to watching the sleeping dogs lie.

We were badly wrong.

Now it is clear that we need the greatest financial reform in two generations. Our system of corporate control is the mixed private-public system that monitors and disciplines the managers of American capitalism. Our system of corporate control has proved very strong and durable. This very strength has led to overconfidence, and as a result we have failed to protect the system's one weakness: its critical need for high-quality public information about the financial status of America's companies.

But first we need to back up: How did we get into our current mess? In fact, we need to back up further: What, exactly, is our current mess?

America (and also Britain) has, compared to other advanced industrial countries, a peculiar system of corporate governance. In other countries--for the most part and to grossly oversimplify--a key part of the social task of making sure that corporate managers are doing their jobs properly and of figuring out which corporations should grow and which should shrink is delegated to one of two relatively small groups. One group consists of a few large--universal--banks, which vote large blocks of shares, hold large chunks of debt, and can go through its books and operations of client companies with a gimlet eye. (But this system only works when the universal bank remains focused on supervision. And there is no one to watch the banks themselves.) Alternatively, family dynasties of industrial princes hold the whip hand. These family dynasties use elaborate--even inscrutable--structures of pyramidal holding companies and special classes of stock shares to exercise control disproportionate to the share of the capital they have committed. In this system, public shareholders suffer when the industrial princes decide that it is time to divert corporate resources--whether directly in the form of wealth or indirectly in the form of fame--to themselves.

Our system is different. Attempts by small groups--the universal banks and the industrial princes in embryo--to dominate industrial finance in the United States faced serious hurdles as American capitalism developed. The United States saw an antitrust movement in the first half of the twentieth century dedicated as much to breaking up large concentrations of private power as to increasing market competition. The possibility that we might have our corporate managers watched by a few "universal" bankers was foreclosed by the New Deal. Our economy was just too big for even those as rich as the Mellons or the Rockefellers to easily establish a dominant initial position as overseers of corporate managers. And both public and private authorities were not friendly toward the special classes of voting stock that European plutocratic dynasties use to maintain their control.

Thus we have a system that, instead, relies on a surprisingly open market for corporate control. And the prices in this "market" are, essentially, the prices at which one can buy large blocks of stock. Occasionally, a low stock price will prompt a hostile takeover of a company by investors who think they can find managers who will do a better job. More often, the market for corporate control will work indirectly. A steep decline in the stock price will trigger a directors' revolt, for the directors will see the decline as the market's judgment that the management is pursuing misguided policies. Shrewd and on-the-ball managers do not give the directors time to revolt. Instead, the fear of a revolt or a hostile approach induces incumbent managers to take whatever strategic course is favored by the stock market. Although a CEO and her time have some latitude to go against the market's judgment for a while, the market calls the shots in the long run. Indeed, the market calls the shots in the medium run. And back before the mid 1990s it was very common to hear managers complain that the stock market called too many of the shots even in the short run.

But for this to work, the market has to know what it is doing.

Thus the U.S. model rests (or, rather, surfs) on top of a massive torrent of high-quality public information about how our corporations are functioning. Attention is limited. Even the most industrious and sleep-deprived professional investor cannot construct the information base to evaluate de novo which companies need new management or general shaking up. Outsiders simpoly do not have access to enough of the requried information. So we all must rely on what corporations report--and this means that sometimes the reports must be unpleasant. And that means that the information must fit into the straightjacket provided by GAAP, for the wiggle room to avoid unpleasant news must be very limited. And that means that the information that flows out must be trustworthy. And for the past century, to an astonishing degree, it has been. An extraordinary level of trust in the torrent of information guided by GAAP that pours out of American companies has been essential for our system of corporate control to function, and has been a principal factor leading to high levels of investment in America.

This, however, is our system's Achilles heel. When public information stinks, our mechanisms of corporate control break down. When our mechanisms of corporate control break down, fewer will be willing to invest in America: How can anyone dare buy stocks when they fear that the insiders know a lot of things you don't, are laughing at you, and plan to take as much of your money as they can?

If a handful of universal banks or if industrial princes dominated our market for corporate control, it wouldn't matter much if GAAP became a joke and if the numbers stank. They would ahve other, non-public sources of information. They would have private access to books and operations. Their financial (and social) dominance would lead managers to curry favor by telling them the real deal.

A year and a half ago, we had no idea of the damage that the stock-market bubble of the 1990s had done to our collective system of corporate surveillance and supervision. Few would have thought it possible for a firm's officers to try to pump $3 billion out of a public company, as happened at Adelphia. Even those who were most suspicious of WorldCom's acquisition frenzy would never have guessed that it was busy overstating its "EBITDA"--earnings before interest, taxes, depreciation, and amortization, a semi-useful proxy for the difference between the amount of money the corporation is taking in and the amount of money it is paying out. Who would have imagined that Enron could simply not disclose massive financial obligations and its Chief Financial Officer's [CFO's] massive ethical conflicts of interest, and that everyone--outside directors, audit committee members, auditors, the SEC itself, prestigious legal counsel, and others--would simply not notice or would not care?

These three situations exemplify our current mess: sustained dissemination of material errors in statements of financial position into the marketplace. These were big lies, and they had real effects, which are worth examining in detail:

Adelphia's games made it look like a profitable, successful concern even as it paid through the nose for its most recent cable acquisitions. Investors and competitors looking at Adelphia thought, "Aha, look at how profitable it is," and concluded (reasonably) that those recently-acquired cable systems were worth their high prices. Thus (i) investors were spurred to imitate Adelphia and to sink money into acquiring cable customers at high prices too, and (ii) competitors upped their estimates of the worth of a cable customer. Ultimately, somebody may make money via cable: cable customers may be a source of revenue and profit. But much of the belief that they were was based on the sustained dissemination of erroneous information.
WorldCom's accounting tricks, especially from 1999 to 2001, also made its business model appear too successful. Competing executives looked at its numbers and felt pressure from investors to imitate it or be fired, as investors punished companies that could not match WorldCom's success. Was this the source of the entire telecom crash? Certainly not. WorldCom was but one piece of the puzzle. Was it a contributing factor? Certainly. WorldCom was one piece of the puzzle. Billions of dollars of financial capital and a great deal of human capital was wasted--allocated to the wrong industry sectors at the wrong time--as a consequence of the way that WorldCom misrepresented itself. Not all of WorldCom's representations were improper--some was garden-variety puffery--but a lot was.
Finally, Enron's shenanaigans gave the appearance of tremendous profits to be made in the emerging field of energy trading. Pressure to keep up with Enron convinced many energy companies to flock into Enron's business. (And the resulting competition meant that Enron had to defraud harder just to keep its numbers up.) Current stock and bond prices suggest that this was unwise: there was no pot of gold. The companies that decided to copy Enron, and the investors who funded them, bear responsibility for their actions. It is a free country. But Enron's shenanigans made these mistakes in judgment easy to make.

So this is our mess. Real, reputable companies fed the marketplace huge inaccuracies (to put it politely) over an extended period of time--Big lies, lots of them. Such lies enrich the wrong people: insiders who know or suspect the truth and sell their stock while its price is artificially supported by fraud. Such lies enpoor the wrong people: investors who trust that material information about corporate finances will be disclosed in a timely fashion.

Such lies, moreover, inflict two more types of damage. First, they raise the cost of capital to honest firms in the future: stock prices will be depressed and bond interest rates raised by an Ebbers or a Fastow factor. The capital market functions well only when such default, fraud, and risk premia are low, not high.

Second, such lies, while undetected, lead to judgments that put capital in the wrong place. Real investments--not just paper profits--turn out not to be worth what people had reasonably expected. Economic growth slows. The country is a poorer place. The financial markets are, after all, social capital allocation mechanisms: our equivalent of the investment directorate of the late Soviet Union's GOSPLAN. Our financial markets work a lot better than GOSPLAN--but not if the information they are fed and that they act on is made out of garbage.

Had we been smarter, we would have started taking care of this problem three or more years ago. There were signs that things were going wrong. The collapse of the highly-leveraged firm of Long Term Capital Management [LTCM] in the late summer of 1998 was one such sign. The creditors of LTCM had an interest--an overwhelming material interest--in understanding the firm's portfolio and operating procedures: yet they did not. Or consider the extraordinary situation just after 3Com had sold a part of the shares of its subsidiary, Palm: stock prices valued 3Com's Palm shares as worth less than half of what other Palm shares were worth. An investor could buy an equivalent ownership interest in Palm by buying 3Com shares for half the money he would pay for Palm shares. Equivalent ownership interests, trading on the same exchange, possessing similar liquidity characteristics--the financial markets were functioning so poorly that it took more than a season to iron out even the most obvious violation of the law of one price. The violation of this fundamental law was a clear sign that the marginal buyer of technology stocks was stunningly uninformed. And when a lot of stunningly uninformed people show up at the poker table.... So we shoul dnot have been as surprised. But we were. And we are.

Some observers argue that the situation has already taken care of itself: that the market has fixed it. Because there is low trust, the slightest hint of an accounting irregularity will crush a company's stock price. So every accountant and every manager will strive to be squeaky-clean and there is now no problem. Such observers are half right and half wrong. They are right in that hints of accounting irregularities will cause investors to flee in panic. Consider Merck, a company that overstated its revenue and its costs to equal degrees so that the net effect on its profits was zero. Nobody today knows anything about Merck's profits that makes them lower than people thought three months ago. Yet Merck's market value fell by eight percent on the revelation that its accounting was somewhat... unusual.

Once investors presume that numbers are unreliable, the flow of capital through financial markets will not be smooth and capital itself will not be cheap. Moreover, the market for corporate control will not function. Investigating a company and learning anything about its internal operations becomes much more difficult. We need trust.

Trust does not mean that people will be preternaturally honest, that we should take what Wall Street salesmen say at face value, or that only the virtuous will become rich. But trust does mean that we can all be confident that the system has suffiicent checks that large, reputable companies cannot disseminate sustained, material misinformation into the market place. no more big lies.

Are there (relatively) simple things that can be done to create such trust? Yes. Given goodwill, the tasks are not overwhelmingly difficult. Big lies are pretty easy to stop, for they are big. All we really need to do is to take seven simple steps:

First, we need to make public companies change their auditors every few years. Auditors compete on reputation: the auditor with the best reputation gets the most clients, and the former partners of Arthur Anderson will tell you that an accounting firm that has lost its reputation collapses astonishingly quickly. How can we get auditors concerned about whether their actions are putting their reputation at risk? The PCAOB is one social mechanism, but it is not a foolproof one--its staff will, after all, be composed of those rotating to and from accounting-firm partnerships. Knowledge that a hungry competitor--not just the partner down the hall--will be checking the audit in five years searching for mistakes and misjudgments may concentrate the mind better, and is certainly a valuable second bowstring.

Second, professionals who provide information to the market need to stand behind what they say--financially. Current due-diligence standards for underwriters result in due diligence that is... perfunctory. The SEC should pursue underwriters and legal counsel who performed due diligence and chip away at them in the courts. Bring the egregious civil cases, and take them to trial. Put CEOs and Managing Partners on the stand defending their perfunctory efforts at due diligence. The due diligence culture may change.

Third, the SEC needs to work toward a system in which boards of directors are stronger. The easiest mechanism is to separate the post of CEO from that of Chairman. If the Chairman of the Board has an independent reputation to protect, there is one more potentially-effective watcher of the CEO.

Fourth, prohibit loans--all loans, by anybody, not just by the corporation of which they are an officer or director--to corporate officers and directors that are backed by stock. Putting high corporate officials in a position where a stock price decline triggers their personal financial ruin is asking for *real* trouble. Desperate people act desperately. Far more people will lie, cheat, steal, and defraud to avoid loss of high status and wealth than would defraud to gain it in the first place.

Fifth, require *real* disclosure of insiders' financial incentives. This means clear disclosure of CEO pay. This means disclosure of any and all side deals relating to stock. When a CEO collars her stock--finds a bank that will pay him if the stock price falls in exchange for his paying the bank if the stock price rises--she has effectively "sold" the stock as far as the *economic* risks are concerned. But at the moment, we are in a ridiculous situation: the market does not know insiders' real economic exposure because it does not learn about their personal derivative books fast enough.

Sixth, make it clear exactly how the market is allowed to dig for information. Arthur Levitt's "REG FD" tried to level the playing field by prohibiting the selective and non-public disclosure of information. But it is becoming clear that its major function is to shield corporations that want to hide bad news. When some analyst or investor shows up with tough questions, they say, "You're wrong. There's an answer to that. But I can't tell you what it is because of 'REG FD'. The market can do a lot of the heavy lifting that will prevent sustained misinformation when it is given a chance. So make it clear what kinds of information are OK for market participants to ferret out, and then let them do it. This will make it much harder for deceit to fester for a long time.

There is a downside to getting rid of REG FD. It does tilt the playing field more toward Wall Street insiders. But--at least starting from where we are now--helping to prevent sustained misinformation seems more important.

Seventh, the SEC needs to produce some bright-line rules about what is and is not "material." You see, corporations need to disclose things that are "material"--important. Corporations don't need to disclose things that are not "material." And nobody knows what "material" means. The lack of a bright-line definition hamstrings law enforcement. On the one hand, consider Halliburton's well-known failure to reveal an accounting change that boosted its annual income. Halliburton's executives knew that the bald-faced claim that the change was not "material" bought them a level of legal protection. In all probability this protection was a substantial factor in the decision to goose that year's earnings with an unrevealed accounting change. On the other hand, companies refuse to answer analysts' questions on the grounds that they cannot selectively disclose "material" information. We have the worst of both worlds: Call up a company and ask about an unpleasant fact and (surprise!) they won't answer because it would be selective disclosure of "material" information. But when it comes time for the company to file the publicly-available form 10-K... presto! the company's lawyers assure them that the unpleasant fact is not "material" so there is no need to disclose it. Until the SEC takes a bright-line stand on what "material" means, "materiality" will be a barrier to and not a source of information to the market.

Take these seven steps, we believe, and our system of corporate control will once again work relatively well, for it will be able to surf on the torrent of GAAP-guided information about corporate finances that is released every year. This does not mean that our financial system will be perfect. It will still have many flaws... the misuse of 401(k) plans to prop up the value of an employer's stock... the failure of Congress to mandate the diversification of IRAs and 401(k)s... more rapid and accurate public release of changes in corporate insiders' real stock positions... an end to directors and officers who don't take their stock disclosure obligations seriously... and others.

But these other problems are old ones that we have lived with. Our current elephant-in-the-living-room is new. A decade ago, the Federal Reserve did not have to worry in its internal deliberations that investment was depressed because of fears about corporate governance. Now it does.

Will we fix things? The big fear is that we have a president who has the wrong instincts on this set of issues, and who didn't listen to his substantive economic advisers on the tax cut and the government's long-run fiscal balance, didn't listen to them on the steel tariff, and didn't listen to them on the farm bill. We have a Congress that has for a decade been half-bought by those who think they have an interest in muddying the information flow (for what can one make of the argument that options are such a wonderful economic mechanism that is such a wonderful thing for a firm to do to boost shareholder value, and yet nobody must be allowed to easily find out that a firm is issuing them?), and that is half-panicked by the fear that voters whose 401(k)s have fallen in half will someday decide to punish them.

We need a new Chair of the SEC who understands just why her job is so important, and that she has a lot to do.

Posted by DeLong at November 06, 2002 10:41 AM | Trackback

“We have a President who didn't listen to his substantive economic advisers on the tax cut and the government's long-run fiscal balance, he didn't listen to them on the steel tariff, and he didn't listen to them on the farm bill. We have a Congress that has for a decade been half-bought by those who think they have an interest in muddying the information flow...”

I agree with professor DeLong (except for his view on the tax cuts) and it behooves us to light a fire under President Bush. His party now controls both houses of congress. It’s time put up or shut up. The President must deliver the goods. Needless to add, I strongly believe that he will. This guy knows how to get things done.

Posted by: David Thomson on November 6, 2002 12:03 PM

Don't you think it is peculiar that people in charge of billions of dollars would invest in cable because Adelphia was doing it? Shouldn't they have had, you know, analysts who could understand the market and the technology and see if there was any underlying sound business model?

Hows about those mutual fund managers? Didn't they have a fiduciary duty to do more than follow the herd?

You think the problem is the liars. I think the problem is in the structure of investment banking.

Posted by: citizen k on November 6, 2002 12:09 PM

Require directors and officers to own a substantial amount of stock in their company. This should help align their interests with those of stockholders.

"prohibit loans to corporate officers and directors that are backed by stock" Sarbanes-Oxley essentially prohibits all loans to corporate officers.

Reg FD is an interesting question. Which is more iimportant - that all useful information is disclosed to the market, or that all have equal access to information? Efficiency v. fairness?

"the SEC needs to produce some bright-line rules about what is and is not "material""

The trouble with bright line rules is that people find ways around them. Witness the Enron mess - massive off-balance sheet liability was probably ok under the letter of GAAP (if Enron hadn't messed up a few technical details). You need some way of getting at behavior that is technically inside the bright line, but outside the spirit of the rules. Also, it's very very hard to define materiality other than "that which is likely to move the market" or "that which a reasonable investor considers important."

Posted by: richard on November 6, 2002 12:23 PM

"Hows about those mutual fund managers? Didn't they have a fiduciary duty to do more than follow the herd?"

It's difficult to do one's fiduciary duty when you are being lied to. Little can be accomplished unless the future liars know that they will be punished. Oh by the way, isn't Terry McAuliffe a Democrat? What about Bob Rubin's phone calls to assist his Enron buddies? Didn't Senator Joseph Lieberman unwittingly go out of his way to clear the deck for the criminals? Wow, seems like there is a lot of blame to go around.

Posted by: David Thomson on November 6, 2002 12:23 PM

Brad: Good piece. I believe some of your seven points are likely to happen. One quick question:

In the last paragraph of your sixth point, you said, 'There is a downside to getting rid of REG FD. It does tilt the playing field more toward Wall Street insiders. But--at least starting from where we are now--helping to prevent sustained information seems more important.'

I think a word is missing in the final sentence.

Posted by: Kurt Brouwer on November 6, 2002 12:24 PM

You can list 'things to do' but you also need a corporate culture in which non-obfuscation is understood to be a good thing-- even (dare I say it)-- a social good. And this has to be recognized as true even if the facts about your corporation's financial condition might be damaging. Sounds like a tough requirement to me.

Posted by: Matt on November 6, 2002 12:24 PM

Section 402 of the Sarbanes-Oxley Act prohibits public companies from making, arranging or renewing loans to their directors and executive officers, whether or not the loans are secured by company stock. So one of the seven objectives has already been achieved!

Posted by: John Muller on November 6, 2002 01:22 PM

Remember - John Bogle has presented devastating data on the poor returns earned by mutual fund investors during the bull market from 1982 - 2000. We are supposed to be investing for a pleasant retirement, but middle class to moderately wealthy investors who have stayed away from low cost index funds have had a terrible return experience in total. How are we to make investment investor friendly? How are we to make mutual funds investor friendly?

Posted by: on November 6, 2002 01:23 PM

Re:

>>"prohibit loans to corporate officers and directors that are backed by stock" Sarbanes-Oxley essentially prohibits all loans to corporate officers.<<

Section 402a prohibits loans by the corporation of which they are an officer. But it's just as bad for incentives if done by an unrelated bank...

Posted by: Brad DeLong on November 6, 2002 01:58 PM

Brad

The essay is excellent. Please think about showing a bit more clearly why we all have such a stake in business practice reform. I think the issue is lost on too many of us who do not find a ready connection between say the business practices of Enron and power costs to California consumers.

Warren Buffett and John Bogle were complaining about business practices for years, with cursory notice by the press and no apparent notice by economists. What they easily saw, too many sharp sighted economists somehow missed.

Posted by: on November 6, 2002 02:20 PM

Steps 1, 3, 4, and 5 could be undertaken privately. Step 2 could be undertaken privately going forward, although active investigation of old deals wouild be excellent.

Steps 6 and 7 require undoing or revising previous well intentioned regulation. Hmmm, the law of unintended consequences strikes again.

Posted by: Tom Maguire on November 6, 2002 02:37 PM

Forgive the dumb question, but unless a company is itself selling stock, what does the stock market have to do with the allocation of capital? Are stock sales by the companies themselves a major source of investment capital for them? (Not being an economist, I've probably misused some terms, but I hope my question is clear.)

Posted by: on November 6, 2002 03:08 PM

You don't seem to address the role of any of the outside raters in the market failures. In fact, you seem to assume that it was not possible for Goldman, S&P, et al. to discover the problems at the companies you cite. In Worldcom, this can be explained by the fraud that occurred, but the same explanation isn't the case for the other problems that occurred. Will the wake-up call be sufficient? Will the seven reforms you proposed serve to simply solve this problem by themselves? Or do the raters need to be reformed farther, whether it be a Chinese wall or divesting of the research divisions of the investment banks, or simply a large institutional investors like CALPERS taking on research functions?

I certainly can't claim any expertise on these issues, and I may be missing something in your essay, but I think your piece might be stronger if it addressed these issues in some way.

Posted by: Tom Gower on November 6, 2002 03:08 PM

A welcome and eloquent analysis of why dependable information in the public domain is crucial if markets are to efficiently allocate resources. By implication, if not explicitly, it rebuts an old excuse that "insider dealing is a victim-less crime."

An exercise in ranking of the largest national economies according to respective corporate governance practices is available at: http://www.davisglobal.com/publications/lcgi/LCGI2001-execsum.pdf

Posted by: Bob Briant on November 6, 2002 03:46 PM

Brad: You make a compelling case that outright fraud--misrepresentations--should be punished with severe civil and criminal penalties. The SEC should give up its strategic ambiguity with respect to "materiality" and "insider trading".

The rest of your proposed reforms seem more like possible tactics that market participants might voluntarily choose in order to attract investment. If a firm wants to rotate auditors, then if you are right its cost of captial will go down. If it wants to prohibit stock-backed loans to its officers, the same applies. I actually think that the auditor problem stems from the inherent short-run conflict of having the examinee pay the examiner. If the NYSE required all listed firms to pay fees into a pool from which the NYSE paid for auditors, then the incentives would be better aligned for rigorous auditing. My guess is that the market would reward this move by lowering the cost of capital of NYSE firms, which would then pressure other exchanges to go in a similar direction. But there seems no justification for imposing such reforms in a mandatory and uniform manner, since the firms and exchanges internalize almost all the externalities of investor mistrust. In my opinion, reforms of this kind would have happened far more quickly if the false palliatives of security regulation had not lulled investors into a false sense of security and reduced the private benefits of superior rectitude.

Posted by: steven postrel on November 6, 2002 04:25 PM

I don't completely buy the argument that tying an inseider's personal wealth to the value of the company is inherently a bad thing. If there were restriction on the amount of stock an insider could sell over any one period of time, this would seem to be a good thing for shareholders. If the Lays and Fastows (And Bushes too) can't dump the majority of their stock in a short period of time, there would seem to be less incentive to pump up the stock in the first place. In other words, why create a temporary moment of of irrational exuberance if you can't profit by it?

Posted by: John McKinzey on November 6, 2002 04:59 PM

That essay was worthwhile reading for anyone serious about putting our financial markets back in working order. I look forward to seeing it published.

One tweak: you should change "enpoor" to "impoverish."

Posted by: Greg Greene on November 6, 2002 05:50 PM

Irregardless of the misinformation and lack of information put out by the companies, investors do not seem to keeping tabs on their investments as they ought to be.

I am one very small investor who is not keeping tabs on my investments. I have a very small stake in the stock market, through a very large passively managed index fund. I have no idea what companies I have a stake in. My mutual fund manager was chosen by my former employer to manage this fund based on a competive bid--the manager is not doing any research for me. The fund relies on the rest of the investment community to do the research to send the price signals as to which stocks are valuable. There is a free rider problem here. Is it a big one?

Posted by: Elizabeth Weber on November 6, 2002 06:51 PM

Very nicely written, Brad. Isn't one of the big weaknesses of the current regulatory structure its inflexibility in the face of new business models and practices?

How about a more radical FOIA system where investors are allowed to demand more detailed information under limited circumstances (perhaps a percentage of shareholders and the SEC would need to request this information?)? It would be a tough balance to achieve without imposing significant costs on firms, but might add more flexibility to the system. The potential costs of fielding such requests might also induce firms into preemptively disclosing more rather than less.

As for the other debate here, my vote goes for "impoor".

Posted by: david on November 6, 2002 06:53 PM

I'll vote for impoor as well. A lot fewer syllables than impoverish and if you can't neologize, where's the fun in blogging. (For the latin impaired, neologize is "make shit up") For Elizabeth, I think the point Brad was getting at is even your investment professionals were being misled by the Enrons and WorldComs. I was stunned to read that noboby...nobody at the SEC read Enron's filings with any level of diligence. They just filed them. Here's a massive, fast growing, firm that has gotten special permission for mark to market accounting and other unusual treatments and nobody was checking up on them. It must have been that special Senate connection.

Will anybody miss Harvey? Only the accountants he was supposed to be regulating.

Posted by: Dave Roberts on November 6, 2002 07:27 PM

"Section 402a prohibits loans by the corporation of which they are an officer. But it's just as bad for incentives if done by an unrelated bank..."

402 was apparently motivated by a desire to end loans which are disguised compensation. A corporation may make a loan to an officer or director on below market terms, but an unrelated bank would be less likely to do so. If so, how is a loan on market rates worse than a sale of the stock?

Any reduction in the risk of ownership should be disclosed.

Posted by: richard on November 6, 2002 07:30 PM

>>> Forgive the dumb question, but unless a company is itself selling stock, what does the stock market have to do with the allocation of capital? Are stock sales by the companies themselves a major source of investment capital for them? <<<

Public companies do sell their own stock through secondary offerings. Volume over the last decade has ranged from around $32 billion to $120 billion annually. See http://www.marketdata.nasdaq.com/asp/Sec3SEO.asp

Of course public companies borrow from banks and issue debt too. A company's equity value affects its credit capacity much like the value of a home affects the home owner's credit capacity.

Posted by: Jim Glass on November 6, 2002 07:51 PM

A vote for "enpoor". It goes against the grain of language change, where Latin-derived words usually replace Anglo-Saxon derived words. But that's a good thing.

I agree 100% with David Thompson's point that there are plenty of Dems implicated in this too. In fact I've been asking that all day -- why weren't the Dems able to capitalize on Enron.

That is -- unless Thompson's point is just that no one's to blame, we're all in this together, etc. etc. Usually when I see Democratic involvement in Enron brought up it's by Republicans who are trying to absolve their side.

Paul Begala put out a piece listing six ways that the Republicans overrode the Democrats on deregulation, all of which made Enron more likely to happen. Relatively speaking the Republicans are significantly worse.

I couldn't be sure about Thompson's motives from his posts, but he seemed to be crowing a little there. From a citizen's point of view, the fact that both parties are to blame makes things much worse. There should be no comfort there for anyone. It may mean that there will be no recourse and no reform.

This is the kind of thing that send people to Nader, even in full knowledge fo the futility of that move.

Posted by: zizka on November 6, 2002 08:10 PM

I'm not sure about the "gimlet eye" of those Japanese banks.

I have no argument with any of the suggestions, they all look credible to me, but I'll throw in a few extra thoughts.

As others have noted, some of these reforms could be made voluntarily by firms that wish to gain by having credible books in an era that values them more. Much of the reporting "laxity" of the boom years resulted from the simple fact that shareholders saw themselves getting rich and just didn't care as long as they were getting theirs. When people don't care it's hard stopping gray area offenses and "laxity" no matter what rules are set up. It's tough for regulators to fight human nature. When reality returns investors to watching their pennies, there's going to be much tougher gray area enforcement, new rules or not. Liars of course should always have the book thrown at them. But setting enforceable bright line rules through gray areas is easier said than done.

OTOH, there certainly are structural conflicts of interest in the status quo that need to be addressed, that I might put above audit rule changes. One (noted above) is that auditors are paid by CEOs, not investors. Thus CEOs not only tend to get the audit report they desire but, perhaps even more importantly, also control the flow of info to investors. Rotating auditors periodically by fiat doesn't really change this. Baruch Lev of Stern/NYU has recommended instead having auditors be hired and paid by a shareholder/investor committee to align incentives and the flow of info they way they ought to be -- ending the CEO's monopoly on info and showing auditors who they need to please.

A second is having investment analysts paid by the same institutions that sell securities of the analyzed firms to the public -- a blatant conflict with horrible results. Third, and related, is having investment banks value the same businesses they expect to take public. I personally know a case where a premier-name investment bank valued an internet startup with no assets of any worth at $25 million without examining anything, because it was in everybody's interest for the company to be worth a lot. The company died before it ever went public, but its private investors who believed that valuation lost a bundle. The CEO even believed the value given him on his own bogus books! Valuations and selling should be completely segregated.

Also, I have no idea why federal law requires all audit work to be done by partnerships, which are notoriously weak on command and control, and thus on accountability of all things. Whole local partnership offices have been known to go renegade and to blow off commands from HQ, because they always have the power to secede with their lucrative clients. This was a major problem at Andersen and has been in many other cases as well. But no local office of Microsoft every blew off Bill Gates. What's protecting this "partnership" mandate for auditors, so that it's never even questioned, I don't know. That's something I'd look to change too -- on the philosophy that it's better to get structures and incentives right than to pass a lot of regulations.

Posted by: Jim Glass on November 6, 2002 08:23 PM

You wrote: "We need a new Chair of the SEC who understands just why her job is so important, and that she has a lot to do".

Isn't the use of "she" too PC? Wouldn't "he/she" or "his/her" be preferable?

Rest of the piece is fine.

Posted by: Andres Salama on November 6, 2002 09:16 PM

"I couldn't be sure about Thompson's motives from his posts, but he seemed to be crowing a little there. From a citizen's point of view, the fact that both parties are to blame makes things much worse. There should be no comfort there for anyone. It may mean that there will be no recourse and no reform.

This is the kind of thing that send people to Nader, even in full knowledge fo the futility of that move."

I am far more optimistic than you. The Bush administration will almost certainly resolve this mess. Also, my own economic views are something of a combination of Ludwig Von Mises and Ralph Nader. For instance, Nader is right to complain about corporate welfare. Citizens should be wary of the motives of both government bureaucrats and the capitalist class.

Posted by: David Thomson on November 7, 2002 12:52 AM

Enpoored can become a so-called real word. Language is an intrinsically nebulous activity. If enough people employ this new term--then eventually the dictionary editors will respect their wishes. It's as simple as that.

Posted by: David Thomson on November 7, 2002 03:43 AM

David Thomson -- is there any rational reason for optimism here? Bush's own business record at Harken was a mini-version of the overall problem. Pitt was a disaster from the beginning and only got worse, but Bush stuck with him to the bitter end. I am convinced (as I suspect that you aren't, though not necessarily for good reason here either) that the deregulation mania had an enabling effect for the crooks in these cases, and I haven't seen anyone step forward to testify that they have changed their mind about anything.

Posted by: zizka on November 7, 2002 07:40 AM

Another valuable idea to perhaps add to your "materiality" threshold comments is applying the idea to the Cash Flow statement which is currently lacks too many details and allows lumping of items together of, say, "Other net changes to assets and liabilities" followed by a number that constitutes 20% of a companies cash flow from operations. If Enron had had to back out (the numbers are not quite exact but the idea is) $100mm from "Future revenues due to an optical fiber communications jv" out of its Net Income (to arrive at Cash Flow from Operations) this would have raised a lot of questions from investors. (And, yes, Enron did book over $100mm in profits from a still-born jv with another public company.) As the rules stand now, it could net it out against all sorts of other losses and never describe or isolate the actual transaction. In general, the Cash Flow Statement needs to be made a lot more specific. It's much more important than all that phony brouhaha about options expensing.

Posted by: JT on November 7, 2002 08:26 AM

"Deregulation mania" did indeed have "an enabling effect for the crooks.." Many of the changes were not thought out thoroughly. I adamantly oppose an adversarial culture which perceives business people as purely corrupt. However, a little wariness is always best when dealing with our fellow human beings. We should perhaps trust no one--including ourselves.

I am reminded of Joseph P. Kennedy’s efforts to straighten out the stock market mess during the Roosevelt administration. Many thought that his appointment would be akin to having the fox guard the chicken coop. Kennedy surprised just about everyone by doing a fantastic job.

President Bush is an honorable man and he will pick the right people. Ultimately, we will find out in a few months whether I’m a bit too optimistic.

Posted by: David Thomson on November 7, 2002 10:42 AM

Thought-provoking. Here's one: enrich & de-rich (or unrich), in place of enrich & empoor/inpoor/impoor.

Another: a root problem is market failure in the market for securities analysis. Analysts roost in financial megaliths for lack of any other viable niche. Their stock in trade -- like pharma molecules and MP3 samples -- is costly to conceive and cheap to repro ... it's a generic problem of high-info-content goods, and we're literally dying for want of feasible solutions.

Next, material correctness presumes a meaningful standard of meaning. It's not clear that exists in 21st-century accounting. Intangibles, goodwill, notional, speculative, subjective, truly arbitrary appraisals play big roles in
realistic economic valuation of the modern enterprise (where branding and franchise position count more than "hard" asset and liabilities).

Merging these points, suppose we push FASB/IASB accounting standards to the extremes of conservative, verifiable, almost worst-case valuation. Result #1: formal financial statements of many firms will express undervaluation (as their future earnings truly depend substatially on "not real" advantages), but these valuations will be less debatable/fudgeable.

Result #2: this will create richer markets for discovery of "hidden" value -- the gap between strict accounting based on countable items and economic valuation based on goodwill etc.
-- rather than exposing the fictitious values in cooked books. This doesn't solve the whole problem, but it puts ethically compromised S/A's on the right side of the problem, and it leaves the books of account clean.

Posted by: RonK, Seattle on November 7, 2002 12:42 PM

Big Investment Bank puts money into Lying Company. Big Investment Bank, never does spot audits, never complains that auditor is compromised, never demands that the Lying Company audit committee do some actual work, never wonders if the numbers make sense given the fundamental business issues, ...

And the answer is, this is perfectly good due diligence because Lying Company lied? Is that it? You do your fiduciary duty by assuming that human beings don't lie about money?

As for David Thomson: Joe Lieberman is a slimy, pompous, self-righteous, corrupt weasel. His defeat of Republican Lowell Weicker was a sad moment for the State of Connecticut. And having him in charge of the pathetically ineffectual investigations of Cheney's corrupt self-dealing on Energy and the Ernon fiasco was laughable. And I'm a lifelong Democrat. Frankly, Joe reminds me of W too much. Same "I'm religious so it's ok that I lie cheat and take bribes" theory of politics.

Posted by: citizen k on November 7, 2002 01:56 PM

Since I know jack about economics, I'll jump in on the editorial debate: "enpoor" is an extremely elegant antonymic backformation from "enrich." A perfectly cromulent word, as Ms. Krabapple might say, and much better than the alternatives offered.

I'm more concerned about the transgendered CEO who changes sex twice in the course of one sentence ("When a CEO collars her stock--finds a bank that will pay him if the stock price falls in exchange for his paying the bank if the stock price rises--she has effectively "sold" the stock..."). A better choice might be to recast this in third-person plural: "When CEOs collar their stock...." That won't work for the new SEC chair, but considering the role of women whistleblowers in exposing a lot of the crap going on, we could do a lot worse than to put a woman in charge of the SEC.

Posted by: Hard Pressed on November 7, 2002 02:02 PM

Congrats Brad, that was a very thought provoking piece. I have been thinking back to the mid & late 90's and wondering if there were signs missed. I remember back in the day reading an article somewhere "Built to Flip". As I remember it, it talked up idea of starting a new company, (e-commerce mainly), and getting one of the "big boys" to buy it. Take your options, then start another comany and flip it as well. Lost in all that was the idea of building a company on merit instead of hype. Presentation was/is everything. So the "do what you have to do" mantra was seeded.

I dont' like enpoor much, how about disenrich ;)

Also note to Mr Thompson, don't come after me with the "your contempt for capitalism is obvious" garbage.

Posted by: BEM on November 8, 2002 11:58 AM

"Also note to Mr Thompson, don't come after me with the "your contempt for capitalism is obvious" garbage."

Nah, it's only your contempt for the understanding of how capitalism works that is obvious. The main point you overlook is that the capitalist system punishes stupidity. If you goof up--normally you pay a horrible price. A socialist economy invaribly protects the incompetent and this only makes matters far worse. The "built to flip" people have been run out of town. The lesson has been learned for at least this generation.

Posted by: David Thomson on November 8, 2002 03:53 PM

Recommendation #1 -- Auditing is more broken than we realize. Corporates are too big to be audited by small firms, and the ecosystem isn't big enough to support enough big firms to permit relatively frictionless exchanges of audit engagements. It isn't going to work.

Rec. #2 -- Needs development. "Underwriters"? Not sure what you're covering. IPO stage? All financial statements? Auditors? Credit raters? All of the above? Joshua Ronen (NYU/Stern) has suggested an intriguing "financial statement insurance" concept, but has not detailed it sufficiently AFAIK.

Rec #3 -- Generally agree, but (like may other proposed reforms) runs smack into fundamental/ineradicable (Arrow) problems of democracy. Who speaks for shareholders, and how?

Rec #4 -- Good ... but conflicts with many common principal/agent solutions.

Rec #5 -- Excellent ... but can we agree on what is or is not a surrogate for the underlier?

Rec #6 -- At least removes illusions of a level playing field. See also earlier comment.

Rec #7 -- Good. Not easy by any means, but good.

Posted by: RonK, Seattle on November 9, 2002 06:02 PM

Prof. De Long says: "An extraordinary level of trust in the torrent of information guided by GAAP that pours out of American companies has been essential for our system of corporate control to function, and has been a principal factor leading to high levels of investment in America.". This is extraordinarily naif. I do not want to undermine the importance of accounting, but accounting information is only one of the pieces needed in order to evaluate the position and prospects and therefore the value of a company. At the very least you need to know competitive and strategic trends in the industry, management qualities, how the company operates (product lines, costs, etc.) among the other stuff. Corporate accounts are interesting, but are essentially a rear view mirror. Take for instance GE; you can read all their reports and it is still totally unfathomable.You are better off spending time speaking to managers and competitors. Or consider CISCO. Its valuation was absurd at 150 billion and it is still absurd today at 60 billion. The reason is that many lower cost solutions now exist for routers and servers which are CISCO core products (where I suspect all their profits are made). They are facing the same pressure that SUN or Workstation makers faced before. You cannot find any of this in the GAAP accounts or in the Company's propaganda, presentations, etc.

What is my point then. Simply that information and its analysis is a challenging, valuable and expensive exercise. Retail investors relying on "headline figures" or "EPS" or expecting regulators to provide with a "trustworthy" market are fools, cannon fodder or punters or all combined. Disclosure and transparency in accounting are necessary but not at all sufficient conditions for an effective market for corporate control. I would also say that excessive complacency over the last 10 years in "the US capital market" has led to abuses (and corruption) in this country. That is we moved from a "caveat emptor" approach to a blind faith in the system. In respect of corruption, how do you call the practice of "spinning" hot IPO's to managers. If cash were exchanged a lot of people would have ended up in jail, but what was the difference between cash and shares in an IPO which would go up 40% in 2 days? Not to mention the ludicrous notion that research paid by the sell side should not be sell side propaganda!

Posted by: G. Scarampi on November 16, 2002 04:18 PM

Posted by: G. Scarampi on November 16, 2002 04:19 PM