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Capital Punishment
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| By James K.
Glassman |
03/14/2002
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| Testimony by James
K. Glassman before a hearing of the U.S. House Committee on
Financial Services on H.R. 3763, "The Corporate and Auditing
Accountability, Responsibility and Transparency Act of 2002" on
March 13.
The Enron scandal is primarily a story of
executives and auditors deceiving investors about the true state of
a business. The question that the legislation before you addresses
is how to protect investors against such deception.
"The
Corporate and Auditing Accountability, Responsibility and
Transparency Act of 2002" (H.R. 3763) makes several changes in
current law: mainly, to increase oversight over auditors, to ensure
the independence of auditors by barring activities that pose
conflicts of interest, and to increase transparency of transactions.
In the current overheated atmosphere, the bill is admirably
levelheaded and restrained, especially in comparison with the
"Comprehensive Investor Protection Act" (CIPA). Still, some of H.R.
3763's provisions are troubling. Rather than protecting investors,
these provisions may harm them.
In fact, investors do a
remarkable job protecting themselves, mainly through a simple system
of rewards and punishments. Investors reward good corporate citizens
with higher stock prices, and they punish miscreants with lower.
Investors have their own unwritten set of rules, and when companies
violate them, the retribution is swift and often extreme. Those
rules center on trust - essential for the operations of all capital
markets. Investors do not tolerate lying in any form. In Enron's
case, as soon as it became clear that the firm had deceived them,
investors entered a verdict of guilty and applied capital
punishment.
They didn't wait for a trial; they didn't wait
for an SEC investigation. If you lie to us, investors said, then
you're dead. They dumped Enron's stock, and a company with a market
capitalization of $60 billion in early 2001 and $30 billion as
recently as the fall of 2001 became practically worthless by the end
of the year.
This is precisely the response we should want
from investors: brutality. Similarly, clients of Arthur Andersen,
Enron's accounting firm, did not wait for an indictment or a
government report. Delta Air Lines, Merck & Co. and Freddie Mac,
among others, fired Andersen as their auditor. On March 11, the
Wall Street Journal reported that employees were leaving a
sinking ship and that another firm was trying to buy Andersen. While
Andersen has had problems in the past, it is safe to say that the
Enron episode alone stands a good chance of destroying the
88-year-old firm entirely. That's discipline.
Enron and Andersen
executives face possible criminal penalties as well. But even if
they did everything by the letter of the law - and GAAP accounting -
investors and clients would have exacted severe punishment.
In the face of such a ferocious reaction, one wonders why
Congress is considering, in 10 committees and at least 32 bills, new
laws. Congress has played an important role in exposing the details
of the scandal to the public and in calling the participants to
account publicly. This committee deserves particular praise.
Voltaire once said, "In this country it is a good thing to kill an
admiral from time to time to encourage the others." That is, to
encourage the others to behave. The Enron case has definitely
encouraged better behavior. Many companies have reacted quickly with
more disclosure than the law now requires, the most recent example
being General Electric. Firms foolish enough to believe that they
could deceive investors and get away with it are now on notice.
Firms with questionable balance sheets and income statements have
suffered sharp price declines since the Enron scandal broke. If
investors and analysts had been dozing before, they are wide-awake
now.
The market incentives for responsible corporate
governance and accurate accounting are powerful. With more than
8,000 publicly traded companies from which to choose, why should
investors buy shares in those that aren't forthcoming? A recent
study by Paul Gompers, Joy Ishii and Andrew Merrick, published by
the National Bureau of Economic Research, found that "a portfolio
strategy based on purchasing shares in companies with the strongest
investor protections and selling short those firms with the greatest
management power earned an abnormal return of [that is, beat the
broad market by] 8.5 percent a year."
In addition, short
sellers have an enormous incentive to expose corporate wrongdoing.
If they are right, they can make millions of dollars. Bethany McLean
of Fortune broke the story of Enron's deception after she was
tipped off by James Chanos, who heads Kynikos, an investment firm
that specializes in selling stocks short - that is, betting that
they will fall.
After the Enron scandal entered full public
consciousness in December, the media carried stories claiming that,
as a result, investors were losing faith in the stock market in
general. Instead, while investors have become more vigilant, they
have not responded by dumping shares across the board. In fact, in
January 2002, according to the Investment Company Institute,
investors added $19.6 billion more than they took out - the largest
such net gain in many months.
Investors have done the right
thing. They have continued to buy stocks, but they have exacted
terrible retribution against Enron and against other firms suspected
of deceiving them. Now, Congress wants to enter the picture with
additional remedies….
What Should Not Be Done?
Auditor Independence
H.R. 3763 would bar
accounting firms from providing the same publicly traded corporate
client with both external audit services and either
financial-information system design or implementation services or
internal audit services. The CIPA, introduced by the ranking member
of this committee, also forbids a long list of activities, including
appraisal or valuation, "expert services" and just about anything
else.
But the enthusiasm for these "independence" rules is
misguided. The Securities and Exchange Commission failed to achieve
enactment of such regulations in 2000 "primarily because of a lack
of evidence demonstrating that providing non-audit services does, in
fact, compromise auditor independence," wrote Zoe-Vonna Palmrose,
professor of auditing at the University of Southern California, and
Ralph S. Saul, a former director of the SEC's division of trading
and markets, president of the American Stock Exchange and chairman
of CIGNA Corp, in an extensive article in Regulation. The SEC
began examining this issue in the late 1950s, and, since then, "the
question of whether non-audit services compromise audit firm
independence or cloud the appearance of independence has been
studied and investigated by numerous government and self-regulatory
commissions and committees. None of the studies recommended the
separation of auditing from consulting." The SEC, in its latest
attempt, "produced no empirical evidence of abuse." Indeed, one
study found that in 25 percent of cases, the provision of both audit
and non-audit services "had a positive impact on the effectiveness
of the audits."
But the Commission was apparently not so
worried about empirical evidence. The SEC's response in a June 2000
statement was that "studies cannot always confirm what common sense
makes clear."
Nor has clear evidence established yet of a
link between auditor independence question and the deception
practiced at Enron. On the contrary. The theory put forth by
advocates of "independence" rules is that companies use the high
fees involved in contracts for non-audit services in order to bribe
accounting firms to produce deceptive audits that favor the company.
The average company among the 30 Dow Jones Industrials paid its
auditor three times as much for non-audit as for audit work. Enron,
however, paid Andersen $25 million for audit work and $27 million
for non-audit. The audit payments were exceeded by only one Dow
company (Citigroup) while the non-audit payments were exceeded by
13. The ratio of non-audit to audit work for Enron was lower than
that of all but three of the 30 Dow companies.
It is true
that investors should be concerned about the audit-bias problem.
After all, the company that pays the auditors wants to put the best
face on its financial results, while the auditing firm is supposed
to be presenting the material fairly. That's a real-life conflict,
and reducing it is the reason audit committees were invented and the
reason that investors take financial statements so seriously. But
why should forbidding non-audit work solve the problem? After all,
it is just as easy to bribe accountants directly: just pump up the
fees for audit work. Instead of $10 million for a typical
large-company audit, why not slip the accountants an extra $5
million?
While evildoers lurk in the corporate world as well
outside it, the main reason that such respected companies as
McDonald's, General Motors, DuPont and ExxonMobil use the same firms
for both audit and non-audit work is not that this combination
provides some kind of nefarious leverage but because a technology
revolution has occurred in the infrastructure of American businesses
- one that has greatly benefited the economy, as Federal Reserve
Chairman Alan Greenspan noted in his testimony before this committee
on Feb. 27. A thorough audit requires a thorough knowledge of the
information-technology systems of a complex global corporation, and
often the auditing firm is in the best position to provide such
non-auditing services. Clearly, having one firm do both jobs lowers
overall costs, and forcing companies to divide the job is
economically inefficient. It will add expenses, lower profits and,
inevitably, lower stock prices. That hurts investors; it doesn't
help them.
But will auditor independence increase investor
confidence, lowering risk aversion and boosting stock values in the
long run? That's a dubious proposition. If the conflict is so
threatening to investors, then why, at least before Enron, did
companies that separate the functions not advertise to shareholders
and potential shareholders that they were free of conflicts?
The Congress and the SEC should not substitute their
judgment of who should provide accounting services for the judgment
of the companies that actually buy those services. Similarly, as
Palmrose and Saul note, "There is not just one model for organizing
accounting firms, and … each firm, not the SEC, should be able to
define the particular model for that firm."
Auditor
Oversight
The legislation proposes a public regulatory
organization (PRO) to oversee the accounting profession. As I stated
earlier, the discipline provided by investors, clients and
suppliers, as well as current criminal and civil laws and SEC
regulations, offer adequate protections currently. The constitution
of a particular board is not the problem. Why should the accounting
profession be subject to a PRO when the professions of the law,
journalism and politics are not? Misbehavior by professionals in
these arenas can be at least as destructive as misbehavior by
accountants.
But if an oversight board is created, the
guidelines offered in H.R. 3763 are far superior to those in CIPA,
which says, in effect, that the SEC and the General Accounting
Office (which, I don't have to remind you, is a congressional
agency) should run the accounting industry.
Increasing
the Complexity of Accounting Rules
Government officials
need to understand that the complex nature of American corporations
means that every loophole cannot be plugged, every possible
deception and distortion cannot be remedied with a new rule. In this
regard, the Europeans, believe it or not, have a better approach
than do the Americans. In a recent interview in the Financial
Times, Frits Bolkestein, the European Commission's commissioner
for internal markets, stated, "Having rules is a good thing, but
having rigid rules is perhaps not the best thing. You must give an
accountant a certain latitude to use his judgment. It's not merely a
question of ticking boxes."
The Economist recently
put it well: "There are two main approaches to rule-setting. One is
to define precisely how to deal with each and any situation. The
other is to spell out rough principles and let auditors decide how
to apply them. America has typically gone for precise rules rather
than broad principles… If the rule says that above 10 percent an
item should be shown, then those with something to hide go for 9.9
percent."
Harvey Pitt, the SEC commissioner, has said that
"the current system of disclosure is designed to avoid liability,
not to inform anybody." I read 10-K and 10-Q statements all the
time. I understand this stuff, but I yearn for a plain-English
explanation of what is going on within a company. The answer is not
more numbers and legalese but more leeway for auditors and corporate
executives to explain the true health of a company. That requires
two things: 1) a loosening of current rules, and 2) strict
accountability by companies and auditors. I strongly agree with
President Bush's call to make CEOs personally responsible for the
financial statements of their companies. Another point in the
President's plan "to improve corporate responsibility and protect
America's shareholders" was, "The authors of accounting standards
must be responsive to the needs of investors." Absolutely. But this
means giving them more flexibility, not less. Andersen should have
been able to tell shareholders, "The books of Enron are consistent
with GAAP, but shareholders should be aware of the hundreds of
off-balance-sheet entities that carry heavy liabilities."
What Should Be Done?
Real-Time Disclosure
I strongly agree with Section 4 of H.R. 3763, which requires
that officers and directors disclose sales of company stock to the
SEC before the end of the business day after the transaction and
made available to the public by the SEC on the day after that. I
would go further, requiring contemporaneous information (that is,
within an hour) to be released directly to the public on both sales
and purchases. News of such sales and purchases is important
information that could signal the true state of corporate health.
Investors need to know it in minutes, not in 40 days.
Improper Influence on Conduct of Audits
Section 3 of H.R. 3763 correctly states that it should be
unlawful for corporate officers to "improperly influence"
accountants into "rendering…financial statements materially
misleading."
Blackout Periods and Restrictions on Selling
Company Stock
Section 5 states that, if participants in
a 401(k) are prohibited during a transition period from selling
their company stock, then officers and directors who own company
stock outside the plan should be prohibited from selling as well.
This is a fair, confidence-building measure. In addition, I favor a
ban on any restriction on the transfer of company stock by employees
within a 401(k) plan. Enron employees, for example, could not
transfer company stock (given to them by Enron) until age 50. A
simple rule should be that every asset in a 401(k) plan must be a
marketable security or mutual fund. No lettered or restricted stock,
period.
End Double-Taxation of Dividends
Cash
dividends are the clearest, most transparent evidence of corporate
profits. An investor who sees dividends increasing every year can,
properly, have confidence in a company. But dividends are taxed
twice - both at the corporate and the personal level - and, mainly
as a result, fewer public companies now pay dividends than ever in
history and dividends represent a smaller and smaller proportion of
total earnings. Ending double taxation of dividends would increase
payouts and vastly increase investor confidence. I realize that this
matter goes beyond the committee's jurisdiction, but it is probably
the single most important legislative step that can be taken to
protect shareholders.
Treat Options as Expenses
Currently, accounting rules do not treat as immediate
expenses most options granted to employees. Therefore, companies
have an incentive to pay executives with options, even if such
compensation does not make economic sense. Options often provide the
wrong incentives for executive behavior, pushing them to boost
profits in the short run, by whatever means. But, more important,
options are a real expense - they are things of value given as
compensation by the shareholders - and they should be treated that
way.
Peripheral Issues
Analyst Conflicts of
Interest
H.R. 3763 calls for a study of "matters
involving equity research analyst conflicts of interest." The CIPA
goes much farther, requiring, for example, that "analyst
compensation not be based on investment banking revenue" and that
criteria be established to ensure that "analyst compensation be
principally based on the quality of the equity analyst's research."
In my testimony last year before this committee's
subcommittee on capital market, insurance and government-sponsored
enterprises, I stated, "There is little doubt that conflicts of
interest pervade the securities industry." In fact, they pervade
life - even journalism. For example, a study by the Roper Center of
139 Washington bureau chiefs in 1992 found that 89 percent said that
they voted for Bill Clinton and just 7 percent for George Bush. Yet
I doubt that a single one of these journalists would admit to bias
in reporting - and most would probably be correct. Analysts are torn
by conflicts, just as politicians and journalists and mothers and
fathers are, but ultimately their judgments about companies are out
there for the public to assess. An analyst who recommends bad stocks
in an effort to sell investment banking services will be an analyst
who will ultimately lose his job.
A study of 360,000
recommendations by 4,340 analysts over a 10-year period by Brad
Barber of the University of California at Davis and other
economists, published in the April 2001 issue of The Journal of
Finance, found that analysts' top stock selections beat the
market benchmark by a remarkable 4.1 percentage points annually and
their lowest-ranked selections trailed the market by 4.9 percentage
points.
A further public airing and more studies of this
issue would not be fruitless, but blaming the stock-market decline
or the collapse of Enron on stock analysts is inaccurate and
misleading. It wasn't just analysts who were wrong on Enron. Large
institutions, with skilled research staffs, including Fidelity and
Janus, the giant mutual fund houses, had invested heavily in Enron
stock as well.
Repealing Litigation Reform
On
Dec. 22, 1995, the Senate joined the House in overriding President
Clinton's veto of the Private Securities Litigation Reform Act of
1995. The vote in the House was 319-100; in the Senate, 68-30. The
bill scaled back the excesses involved in often-frivolous securities
fraud cases brought by a small group of politically generous
plaintiffs lawyers. "California's high-tech industries, in
particular, have suffered from lawsuits aimed more at squeezing out
settlements than righting wrongs," said The Fresno Bee in an
editorial at the time. The law took such steps as barring
"professional plaintiffs" from being named in more than five
class-action lawsuits in a three-year period and requiring
plaintiffs to cite the concrete facts of each allegation of
fraudulent behavior. Lawsuits to recover damages for securities
fraud have continued since 1996, but the law redressed a severe
imbalance and it undoubtedly helped high technology prosper and the
U.S. economy expand.
Now, some in Congress have decided that
these moderate reforms were responsible for the Enron excesses. If
only plaintiffs' attorneys could have sued Enron, it would have
brought the company back to the straight and narrow. In fact, of
course, attorneys could have sued Enron earlier, and they are
certainly suing Enron and its auditor, Arthur Andersen today.
Repealing this reform would not protect shareholders; it would hurt
them by forcing their companies to make payments of tribute and
distracting executives who should be focusing on managing their
firms.
I was not aware that a CalPERS representative would
be on this panel today, but CalPERS provides an example of the role
that investors must play in preventing abuses. For market discipline
to work, investors must act responsibly. Unfortunately, this is not
always the case. The New York Times reported on Feb. 5 that
while CalPERS, the giant California public pension fund, was altered
to the abuses at Enron in December of 2000 -- nine months before the
company itself surprised investors with announcements of write-offs
-- executives "did not confront Enron's board" or "publicize its
concerns." Instead, CalPERS continued to profit from dubious
partnerships like JEDI. Instead of concocting extensive new laws,
this committee should use its bully pulpit to exhort accountants,
corporations and pension funds to act responsibly. That did not
happen in the CalPERS case.
Conclusion
In
times of scandal, emotions run high, and the urge to rush in with
legislative remedies is understandable. But it should be resisted.
Parts of H.R. 3763 are admirable, but the bill goes too far in
trying to substitute the economic judgment of regulators for that of
investors, clients and managers. Ultimately, legislation of this
sort diminishes earnings and depletes corporate value - a loss not
just to executives but, in a nation in which half of all households
own stock, to small investors as well. Market discipline and current
criminal and civil laws provide powerful remedies and protections
against another Enron already.
As a financial columnist,
what bothers me most about this legislation - and, far more, what
bothers me about CIPA -- is that it sends the wrong signal to
investors. When stocks decline, the underlying logic of this
legislation goes, someone must be doing something illegal or
immoral. Analysts and accountants are the current targets. This is
absolutely the wrong message to send investors. They need to
understand that the stock market is a risky place and that they
themselves are responsible, in the end, for their own investments.
Yes, the market provides the threat of punishment, but bad things
still happen to the best of investors, and he only protection is
diversification.
For that reason, my focus as a remedy would
not be to change accounting rules but to educate investors. We don't
want to scare them out of the market - and so far they have not been
scared. We want instead to get more of them into the market. The
best way to do that is to inform them of the true risks and rewards
of investing.
Thank you.
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