July 3, 2002
How many lies remain to be uncovered in corporate reporting? That was what investors wondered as they sold stocks upon hearing yet one more massive cover-up of corporate performance.
The list of whys is getting long. Why are these frauds happening? Why is corporate leadership motivated to hide deteriorating performance from their shareholders? Why are their accountants not informing corporate boards that something is amiss? Why are corporate boards failing to uncover the frauds?
Apparently, there was no arcane structure of partnerships that overwhelmed the understanding of analysts of Worldcom, as there was at Enron. According to the press reports, Worldcom shifted expenses into capital accounts so that much smaller costs of providing services could be recorded. The result was reported profits that had not occurred.
Clearly, some expense items and capital expenditures must have been dramatically different from historical performance when these frauds were made. Why did no one notice? (This group includes members of the board, auditors, and analysts. I also think loan officers at lead banks also bear some responsibility for failing to inform boards of possible irregularities and the damage that might be done to future banking services.)
Yes, they are the usual suspects, except for the bank loan officers, but that is what is so bothersome. Are all the informational checks and balances faulty that should lead to relatively useful investment information? If we cannot rely upon investment information, can the markets appropriately allocate capital?
There is more at stake than the balances of our 401k's, although those balances also have economic implications. If our stock prices are wrong because the information is wrong, then resources are being allocated inappropriately. More funds may become available to a company who successfully hides its problems.
Stock market prices that are manipulated through accounting irregularities might allow mergers that would not be viable without an inflated stock price. Corporate managers clearly receive more bonuses and higher values for their stock options from such manipulations. Undetected cheating provides substantial gains.
Unfortunately, we are now learning that cheating, when uncovered, can have implications far beyond the investors in companies that engage in such practices.
First, virtually all securities have some suspicion cast upon them. Falling stock prices reduce the value of enterprises. As a result, less capital may be invested, international investors may withdraw funds and create a currency crisis, and investors may feel poor enough to slow their consumer spending.
Second, banks lose capital that supports their depositor claims. Although our banks certainly can handle the magnitude of the losses that may be incurred to date from fraud, serious bank dislocations could develop if fraud becomes widespread. At a minimum, banks are increasing their lending scrutiny. Fear of default may prevent expansionary monetary policy from flowing to legitimate corporate opportunities.
Third, special burdens are suffered by companies in the same investment sector or with some of the same characteristics as the fraudulent company. Those CEOs who dominate their boards and treat their companies as their own and not their shareholders, may find that their companies also are targeted, even if they have done nothing wrong.
Some companies have suffered lower bond rates, and therefore must face higher interest payments, because they are similar enterprises to those with reported irregularities--even if there is no history of problems and no deterioration, other than the higher interest rates, in their business fundamentals.
Unfortunately, I cannot say that we have uncovered most of the culprits. Only time and diligent SEC investigation will determine how widespread the problems are.
One hopes that accountants now know that failing to inform boards could lead to much more than lost fees. Boards need to realize that they are defenders of the shareholders and not apologists for the managers. Hopefully, all will work together. If they do not, the board must take responsibility to remove managers or at least to resign if such changes are too difficult to achieve.
Any fraud against shareholders should immediately nullify any employment agreement with any manager. Some due process needs to be developed, but no one should profit by cheating their shareholders.
All auditors need to develop a relationship with audit committees that are independent of management. Merely requiring that members of the audit committee are independent, as the exchanges do, is not enough.
In any event, measures are required to restore confidence in corporate reporting and governance. I would hope that every board starts asking tough questions of management and of their auditors the next time they are scheduled to meet, if not before.