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A Season of ScandalNovember, 2002 Seven Business School professors analyze the conditions that precipitated the latest maelstrom in corporate America.BY ANDREA HAMILTON
IT JUST GOES FROM bad to worse. Scandal after scandal unfolds in the heart of corporate America: Management and accountants in cahoots to cook the books. Stock analysts promoting weak companies based on their firms’ desire to secure lucrative underwriting business. Already overpaid executives cashing out huge options packages after running their companies into the ground, leaving their employees and shareholders with the now empty bag. “CEO resigns under fire; Company faces SEC scrutiny” is the standing headline du jour; just insert new names and faces. Securities and Exchange Commission investigations are multiplying against companies accused of overly aggressive “creative accounting.” Earnings restatements, once the penultimate corporate shame, are becoming distressingly common: 270 restatements last year, compared with an average 49 per year from 1990 through 1997. Congressional hearings, shareholder lawsuits, indictments, and guilty pleas are piling up like trash on pick-up day. The business pages warn of a crisis of capitalism, as investor confidence collapses and the capital markets potentially dry up. If Queen Elizabeth were describing Wall Street, she might proclaim 2002 Annus Horribulis. Is this the darkest hour in American capitalism? Far from it. More like, here we go again. Remember the savings and loan scandals of the 1980s? Michael Milken and junk bonds? Or Teapot Dome in the 1920s? There is a long and depressingly familiar history of scandals on Wall Street—it’s largely a matter of same story, different date. Stanford Business School faculty research shows that many of the current problems, from aggressive accounting and managed earnings to analysts’ conflicts of interest, are anything but new. Says Roderick Kramer, professor of organizational behavior, “Much of this was well known by experts, but now it’s public knowledge.” THE BIG DIFFERENCE IS that today what happens on Wall Street also hits Main Street. More than half of American households are invested in the stock market compared with a small fraction of that 20 years ago. The fact is, the humble retail investor wasn’t the only one who got burned in the post-Enron meltdown. Pension funds and other institutional investors were equally fooled by cheating management, acquiescent accountants, and overly rosy research reports. These are professionals who should have known what to look out for. “There is an element of this that is behavioral,” says Harrison Hong, associate professor of finance. “In the wake of the market’s collapse, people have become much more systematic about scrutinizing the numbers than when the market was booming. These are the same numbers as before. But people were not reading the right things into them,” he says. Whereas CEOs selling millions of shares of stock was considered normal when the market was booming, investors now are viewing such sales as potential signs of corporate malfeasance. Hong doesn’t buy the claim that the current mess is a complete anomaly. Accountants, CEOs, and analysts were all part of a system that couldn’t police itself. But Hong says investors have to shoulder some of the blame. “We have to ask: Why did people get so excited about these stocks? People were fed numbers they chose to believe, but they should have known conflicts of interest existed.” In the short term, the market’s decline will take care of the problem, Hong says. “A lot of the incentives of these guys had to do with the market being so hyperinflated and the huge potential payoff involved. If the market is flat, there is no such incentive.” Longer term, however, he stresses the need for major rethinking of checks and balances and discounts the notion that accountants or others can regulate themselves. In theory, investors would police the numbers themselves, but in reality, they can’t. “Nobody could understand Enron, not analysts or anyone else. But still they trusted Enron’s management,” he points out. “As long as things are going well, people will believe anything.” A recurring question—and potential lawsuit—as each new scandal erupts is whether there was outright fraud or merely gross negligence on the part of senior management. Executives are quick to sidestep the blame, claiming either that their underlings misled them or that they assumed everything was ok when their auditors signed off. But in the view of Kramer, that distinction is almost irrelevant going forward. “It doesn’t matter whether it was intentional or not. People are most mad about the consequences,” he says. “Ignorance is no excuse.” The end result is the same: a loss of trust by investors in the truthfulness of the financial information they receive and in the institutions supposedly in place to prevent such fraud and abuses. Kramer outlines two kinds of trust that are relevant to understanding a way out of the current crisis. One is competence-based: “Should we trust you because we have evidence you are competent?”—an accountant, for example. “The second is intentions-based trust. We look at your motives. We have good reason to think you have benign motives and have our best interest at heart; you will look after us.” The problem occurs, says Kramer, when we can’t believe the people who should be competent. What happens when a Big Five accounting firm misses a $3.7 billion error? “One reason people have a false sense of security is precisely because we have gatekeeper institutions, like independent auditors. These institutions should detect breaches of trust—but they failed us.” Rebuilding that trust involves building up effective deterrents by making it costly to cheat. “We can trust the system to deter, if there are deterrents to unethical conduct. Ronald Reagan called it ‘trust but verify.’” But, Kramer adds, it is also costly to have a deterrent system with the necessary monitoring in place to detect breaches. “People thought trust was cost-free. We had accounting firms, and people thought that was enough. But we need monitoring of these firms” and more qualified people at the sec working on cases, he notes. Arthur Andersen’s conviction this spring for its role in the Enron debacle was a wake-up call that auditors, ostensibly one of the principal gatekeepers in the American financial system, are also fallible. Whether they actively helped companies “manage earnings” or just looked the other way as company managers cooked their books, or whether their audits, as designed, were unable to detect fraud, accountants no longer can plead ignorance as a defense. “Rest assured, the accounting profession is watching closely,” says former Andersen partner and accounting professor Mary Barth. “This was one of the premier firms that just got blown up.” |
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