Posted on 06/21/2002 7:05:12 AM PDT by Stand Watch Listen
Not since the 1900s has faith in corporate America been so strained. The skepticism that started with last December's bankruptcy filing by Enron has hardened with each subsequent revelation of corporate wrongdoing or shading of the truth. Investors are baying for blood, angered by the graft (or convenient laxity) that's being revealed in corporate boardrooms stocked with chieftains earning astronomical sums.
Auditing irregularities that weren't picked up by audit committees, or were ignored or even encouraged by accounting firms, also are drawing the ire of investors and regulators. Currently, all of the "Big Five" auditors either are in court or under investigation, and proposals are being pressed for audit committees to be more independent and aggressive (see sidebar, "Accounting Cases Crowd the Docket," below).
Nor have Wall Street and its finance houses come under such scrutiny before and, with guilty pleas, financial restatements and conflict-of-interest probes by the Securities and Exchange Commission (SEC) piling up apace, the questions remain as to how the system is going to be fixed and who will fix it.
Corporate bosses argue that the calls for structural reform and the dozens of post-Enron investigations that have been launched by the SEC and an increasing number of state attorneys generally amount to a witch-hunt — the business equivalent of Salem, Mass.
"Guilt is assumed, and a financial restatement, say, is seen not as a sign of a clearing of the air and of getting it right but the indication of something dirtier being covered up," the chief financial officer of one Fortune 500 company complains.
Recently, Joseph Nacchio, chief executive officer of Qwest Communications — one of the 64 firms currently under investigation by the SEC for questionable accounting — bewailed the "corporate McCarthyism" that has gripped America. He fears that before a catharsis is reached there is going to be considerable damage — and more than was necessary to clean up.
Others, including some state attorneys general such as New York's Eliot Spitzer, maintain that there is now no alternative but to cleanse the system rigorously and that failure to do so merely will prolong the lack of faith by investors, both foreign and domestic, in American capitalism.
That view is supported by some economists and even free-market advocates such as Larry Kudlow, who has been highly critical of the performance to date of SEC Chairman Harvey Pitt. Kudlow argues that Pitt hasn't been in tune with "investors who see conflict-of-interest problems as endemic to dishonest accounting." And he maintains that Pitt quickly should have endorsed the reform proposals pressed by former Federal Reserve chairman Paul Volcker when Volcker fashioned a restructuring plan for the troubled auditing firm Arthur Andersen. Kudlow believes that Pitt wasted an opportunity when he didn't follow Volcker's example and advance a reform requiring all auditors to cease consulting for clients they audit.
Shareholder-rights advocates and pension-fund managers see Pitt as operating the mechanism of their frustrations and responsible for the general slow pace of change and the lack of fixes (see sidebar, "SEC Chairman Pitt Is Caught Between Opposing Reform Camps," below). But he is just one cog in the wheel of regulation and self-regulation that some argue needs to be recast if the public's faith in corporate America and Wall Street is to be revived.
And a revival (or at least speedy reassurance) is needed. Few experts doubt that the stock market would be higher if questions about the integrity of the financial system had subsided. Despite a series of upbeat economic reports on the state of the "real" economy, the market has been unable to shake off the doldrums. Every time good economic news is reported, the market is set back reeling by the emergence of a new wave of allegations of corporate malfeasance or the announcement of yet another probe into questionable accounting practices.
Take June 3, for example, a day when the Institute for Supply Management announced that U.S. manufacturing increased in May at the fastest pace in more than two years. That kind of news should have prompted a good day for Wall Street. Instead, stocks declined as investor confidence was weakened further by the resignation of Tyco International Chairman Dennis Kozlowski, who stepped down when he became the target of a criminal investigation into whether he evaded New York state sales taxes.
The fallout from the crisis appears to be widening. The recent slide in the value of the dollar against the euro, yen and other major currencies also is thought to be partly the result of the tarnishing of Wall Street and doubts about the ethics and financial reporting of corporate America. "I think the depreciation of the dollar will continue because of the growing distrust toward the U.S. financial system," said Jeong Young Sik, a senior analyst at the Samsung Economic Research Institute in South Korea.
Realizing that betrayed investors as a voting bloc could affect the congressional elections in November, and eager to escape blame, both major political parties are competing to fashion post-Enron reforms. But little so far has been accomplished — or not as much as some pension-fund managers and shareholder advocates argue is needed.
In mid-April, the House approved pension-reform legislation designed to shield workers from the kind of retirement-plan losses Enron employees suffered. But on May 24 an auditing-reform effort sponsored by Senate Banking Committee Chairman Paul Sarbanes (D-Md.) was derailed when opponents of reform proposed 123 sabotage amendments to his bill.
Sarbanes wants a regulatory board that would be independent of the accounting profession and have the power to compel testimony and impose serious fines. The auditors are determined to remain self-regulatory and favor an earlier bill passed by the House that proposes a new accounting board made up of five members, only one of whom would have to be independent of the auditing profession. The board envisaged by the House would have no powers to compel testimony.
The General Accounting Office (GAO), the official investigative watchdog of Congress, has backed Sarbanes and recommended that the Bush administration create a body to regulate accounting firms. The body the GAO favors would be housed in the SEC but would remain independently funded and managed. The entity would have the authority to set standards for the accounting industry.
House lawmakers who approved a shake-up of the auditing profession in late April insist their bill is tough enough — that it would provide stricter oversight and require broader financial disclosure. They cite, for example, the bar on accounting firms providing certain consulting services to audit clients. "We have taken action. We have stood up to Wall Street," declared Rep. Richard Baker (R-La.), who cosponsored the bill with House Financial Services Committee Chairman Michael Oxley (R-Ohio).
But advocates for tougher supervision of the auditing profession maintain that the accounting industry has had plenty of time to clean house and that the House bill deals with the problems exposed by the collapse of Enron and the recent spate of dubious accounting in a superficial way. Federal supervision now is in order, they say. These critics believe the House is letting the auditors off the hook, arguing that every time reform is in the offing the accounting industry wages a well-funded lobbying campaign. That is exactly what happened when former SEC chairman Arthur Leavitt was arguing for a ban to be imposed on accountants to prevent them from offering consulting services to audit clients.
The auditing profession certainly has considerable clout on Capitol Hill, much of it bolstered by hefty campaign donations. During the last election cycle the auditing industry spent $12.3 million on lobbying, and gave nearly $15 million to congressional candidates and the national political parties, the Center for Responsive Politics has reported.
Sarbanes plans to try again to move his measure; he well may be assisted by mounting investor and public frustration at the continuing revelations of conflict-of-interest auditing. As Sarbanes' bill was pecked to death the front pages of U.S. newspapers were full of reports concerning the alleged financial shenanigans of the Rigas family, the founders and controlling shareholders of Adelphia Communications, a cable-media conglomerate poised to file for bankruptcy after having been used by the family as a piggy bank (see sidebar, "Accounting Cases Crowd the Docket," below).
It is public outrage that the reformers are banking on to force change. The longer-term danger here is that a stampede of regulations could damage the market and restrain economic growth. But there also is the danger that nothing much will be done, that the parties will trip each other up or that clashing political philosophies will prevent Congress from coming to grips with reforms that do need to be introduced.
According to Oxley: "It's easy to do something extreme. We can easily smother American businesses with red tape, we can punish those who have done nothing wrong and we can damage the capital markets and the economy in the process."
Business is worried, too, about heavy-handed regulation becoming the result of the clamor for reform, fearing that the baby will be thrown out with the bathwater. In a bid to guide the legislative debate about corporate-governance issues, the Business Roundtable, an influential group of top U.S. business executives, recommended new procedures in mid-May to make corporate audit committees more aggressive in monitoring the work done by outside accountants.
While some of its recommendations are not as radical as other ideas being touted on Capitol Hill, the Business Roundtable called for audit committees to be completely made up of outside board members with no ties to the company or management. Under the proposals, audit committees would take over responsibility for evaluating the performance of outside accountants on an annual basis — something now largely done by corporate managements.
Also, the Business Roundtable backs a ban on outside accountants doing internal audit and consulting work, but is reluctant to adopt rules that might prevent accountants from conducting important "nonaudit work." Furthermore, with an eye to growing public outrage at the huge compensation packages of top executives, the group is urging businesses to come up with pay packages. But it is opposing a New York Stock Exchange proposal requiring stockholders to vote on stock-option schemes for corporate executives and employees.
The slow pace of reform and change has left a vacuum, encouraging others to step in to appeal to populist sentiments. Convinced that federal regulators in Washington are too ready to roll over when it comes to big business and are being too slow to come to grips with the current crisis of confidence in the financial system, state attorneys general are taking an increasing lead in investor-protection issues. They also are forging ahead in pursuing corporate and Wall Street wrongdoers.
The $100 million settlement in May by Merrill Lynch of a conflict-of-interest case brought against the brokerage by New York Attorney General Spitzer could well serve as a model for other cases he and his counterparts in other states plan to bring against brokerages for misleading investors with biased research. The settlement included Merrill agreeing to separate analysts' pay from investment-banking deals and promising to ensure that analyst research is not tainted by the brokerage's investment-banking interests.
With this case and others, some Wall Street observers believe that Spitzer has done more to bring about change than all the debates on Capitol Hill and the promises of reform there. The Merrill Lynch settlement has emboldened the states to push harder and grab a larger piece of the action — now under way is a 40-state probe into conflicts of interest between the research and investment-banking divisions of brokerage firms.
The fear among the brokerages, shared by SEC Chairman Pitt and some lawmakers, is that the intervention at the state level will lead to a hodgepodge of state regulations being introduced, thereby confusing enforcement and leading to legal chaos. But with Congress being slow on the uptake it hardly is surprising that others are leaping in to make themselves more powerful.
Accounting Cases Crowd the Docket
Arthur Andersen, on trial for obstruction of justice relating to the destruction of Enron documents, isn't the only "Big Five" accounting firm facing legal problems. The remaining four also are mired in civil lawsuits and federal probes.
They had hoped to stave off reforms, or at least to soften them, and are lobbying hard for the industry to remain essentially self-regulatory, a position supported by Securities and Exchange Commission (SEC) Chairman Harvey Pitt.
But pressure is building on Capitol Hill for the federal government to step in and impose new and more-stringent regulations on auditors. And with each revelation of dubious behavior by the accounting firms, it is going to be harder for them to resist the calls for intervention by Washington, despite the campaign donations with which the "big four" have been lavish this year.
Here's a brief list of why the "big four" are under investigation as Insight goes to press:
- Ernst & Young is under pressure from the SEC to return auditing fees paid to it by PeopleSoft between 1994 and 2000. According to the SEC, Ernst & Young violated auditor-independence rules. The SEC also is probing Ernst & Young audits of other firms, including PNC Financial Services.
- Deloitte & Touche in late May braced for a wave of lawsuits from disgruntled shareholders of the troubled local phone and cable-TV company Adelphia Communications following revelations of accounting irregularities and the start of an SEC probe. Deloitte & Touche apparently had failed to inform Adelphia's audit committee that the Rigas family, Adelphia's founders and major shareholders, was using the company's credit lines to buy Adelphia stock. Deloitte was the auditor for both Adelphia and for Rigas-controlled entities.
- PricewaterhouseCoopers still is under SEC investigation for its audits of client MicroStrategy.
- KPMG denies any wrongdoing in failing to identify bookkeeping efforts by Xerox to inflate revenue. KPMG has agreed to avoid making future investments in audit clients following the SEC's decision that it violated auditor-independence rules with its $25 million investment in the AIM mutual fund.
SEC Chairman Pitt Is Caught Between Opposing Reform Camps
Securities and Exchange Commission (SEC) Chairman Harvey Pitt is under mounting pressure from investors and Democrats to transform himself into the kind of regulatory tough cop that Arthur Leavitt was as chairman.
Pitt's critics on Capitol Hill argue that his background as a lawyer who previously represented many of the big accounting and brokerage firms hardly suits him for the reform task that lies ahead. They maintain that he has proved far too cautious to propose structural changes that will shake up Wall Street and the auditing industry.
The result, they say, is a leadership vacuum that has left state attorneys general, among others, to step in and attempt to set the agenda. Pitt's frequent refrain that "not every problem requires a new statute or a new rule" infuriates those who are demanding government intervention to clean up Wall Street.
But despite President George W. Bush's call in March for the SEC chairman to "take action," as well as his announcement that "reform should improve investor confidence and help our economy to flourish and grow," Pitt appears to be adopting the approach that the White House really wants.
While the Bush administration backs the idea of tough sanctions against senior corporate officials who violate their fiduciary duties — even to the point of confiscating their bonuses and stock-option profits — it is nervous about sweeping legislative changes being introduced to help restore the faith of investors. Administration officials favor self-policing arrangements that are more in tune with the freewheeling spirit of American capitalism. "If we can solve much of the problem without new legislation, so much the better," says presidential political adviser Karl Rove.
Certainly the GOP's big financial backers hope that will be the case. They fear a stampede of regulations that could bog down the U.S. economy and impede its bounce back from recession. The SEC chairman is relying on stronger enforcement, increased penalties for corporate misdeeds and quicker and clearer financial disclosure. On the enforcement side, Pitt has been no laggard — he has doubled the number of probes the SEC normally undertakes at any one time. Some SEC insiders argue that he has, in fact, been tougher on enforcement than Leavitt.
Furthermore, Pitt has pushed his "two-strikes-and-you're-out" proposal for corporate bosses who infringe the rules. He also has lobbied Capitol Hill for more SEC funding, arguing that he needs pay parity to recruit top lawyers and accountants.
Pension-fund managers and shareholder-rights advocates aren't so sure that this is enough to restore investor confidence and prevent misdeeds in the future. They argue that Pitt too often has just been dragged along on the reform front. They cite his regulation plan for auditors and the rules he proposed for analysts to limit their contacts with investment-bank colleagues. Pitt himself has acknowledged that more-stringent standards may be required.
In April, the SEC chairman handed his critics a perfect weapon to beat him with when he met privately with KPMG Chairman Eugene O'Kelly, who later said that the two had discussed the SEC's probe of KPMG's questionable audits of Xerox. Pitt says they didn't, but foes insist the meeting was improper and another sign of the chairman's chumminess with the industry he's meant to regulate.
Jamie Dettmer is a senior editor for Insight.
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