Lessons Learned

What are some of the lessons that have been learned? In no particular order 10 come to mind.

The first lesson is the realization that financial incentives, such as stock options, can create both good and bad behavior. We witnessed throughout the 1990s how incentives fostered innovation, economic expansion, building of plants, and the accompanying creation of jobs. Yet, at the same time, when left to their own devices, some people believed the incentives created an environment in which the end came to justify the means, even if that end could ultimately inflict tremendous personal and economic damage to thousands of others. And what of all that wealth the stock options supposedly created for technology investors when the NASDAQ raced to 5200? Where is it today and what have those options done in recent years to create value for shareholders?

Second, in major systemic market breakdowns, including that accompanying the depression of the 1930s, the bear market of the 1970s, as well as the bubble of the 1990s, many observed that the whole orchard of market participants is not rotten to the core. Yet at the same time, such widespread failures are not the result of a few bad apples either. Rather they tend to be the result of a few bad actors that initially crossed over the line of ethical conduct. This created an uneven and sometimes lucrative playing field, and others followed.

The third lesson is that the capital markets may be efficient in the longer run, but in the short term, they can be highly ineffective. For example, securities markets can react very quickly to new information about the value of securities—often anticipating new facts before they are made public. At the same time, the price of the security should reflect all available information to participants in the markets. Due in large part to improvements in technology, information has become easy—and inexpensive—to obtain and process. However, evidence shows that stock prices react with substantial volatility immediately following significant announcements that impact the company. Such short-term price fluctuations do not reflect the underlying fundamentals of the value of the stock and do not demonstrate an efficient market.

Fourth, the lack of timely, high-quality transparency with respect to what is creating or destroying value greatly contributes to inefficient markets. This is especially true when the shortcoming is used to mask real economic conditions and performance of companies. While there is a cost to transparency, especially to those who are responsible for providing it, the lack of transparency can have a much greater cost (and benefit) to those who use the information to make informed decisions. Without transparency, investors, creditors, and regulators cannot make reasoned decisions and, ultimately, make wrong decisions, leading to poor allocation of capital. Ultimately, that has always led to national or international economic consequences. The importance of transparency also applies to accounting and financial disclosure standards. We have learned that standards that are the result of compromises to meet the needs of preparers—to the detriment of the ultimate customers, investors, and creditors—are neither principle-based nor reflective of the true economics of the business.

Markets can discipline market participants, but only if the market can measure and hold those responsible accountable. Therefore, the fifth lesson is that one successfully manages only what one can measure. In order for the market to measure accountability for each and every market participant, be it public companies, investment funds, stock exchanges, or regulators, there must be high-quality disclosures of financial performance and those indicators that are critical to the success of the enterprise. Without these disclosures on a comparable, consistent, and timely basis, the market cannot provide discipline in an effective and efficient manner. As a result, management fails to measure in terms of economic reality that which must be managed; operational issues that need fixing in the business fail to get fixed; the numbers get managed by management as a way of fixing the problem; and in the end, to the surprise of many, the business implodes and is no longer capable of being fixed by management and fails.

Sixth, in order to provide oversight and counterbalances to financial incentives that may create a negative incentive for some, the necessary role of gatekeepers has been created. Independent auditors have been empowered to provide a third party perspective of the financial statements and accompanying disclosures. The legal professionals provide their expert opinion on the legality of transactions and filings with regulators and investors. And investment bankers are required to perform a level of due diligence as a sort of sanity check, if you will, with respect to their undertakings. Yet the very financial incentives that create the need for these gatekeepers can also compromise their ability to perform their function. The ethics of these market participants are not without challenges and potential for breakdown, which in turn can have disastrous effects well beyond market participants.

The seventh lesson may well be the most critical and important lesson one can learn when it comes to capital markets. It is the simple and yet powerful and self-evident concept of independence. Independence is vital and critical to the success of any functioning market system. When the independence of corporate boards, gatekeepers, stock exchanges, analysts, investment bankers, accounting standard setters, or regulators is compromised, at best a weak link in the chain is created. But all too often, the markets deflate as if a balloon pricked by a sharp pin.

Often it has been argued that market participants, such as the major auditing or Wall Street investment banking firms, are not willing to compromise their reputations and independence in exchange for fees. Yet that is exactly what occurred during the bubble as names like Merrill Lynch, JPMorgan Chase, CitiGroup, Putnam, Janus, and each of the Big Five accounting firms became household names tarnished by repeated negative exposure in the media.

In addition, members of the accounting profession have referred to there being a lack of empirical evidence demonstrating that the large consulting fees they took—US$2.69 for each dollar of audit fees in 2000—impacted their judgments. Yet time and time again at the Securities and Exchange Commission (SEC), situations such as at Waste Management were observed, where the auditors found the problems, and then failed to report them, instead choosing to give the company a clean bill of health. As Paul Volcker once said at a round-table discussion, “You do not need studies to figure this one out.” Yet defining independence is a struggle as financial incentives push some to fight for weaker independence regulations, while others push for unquestionable rules. However, it is in the mind and ethics of the decision maker that the answer will ultimately rest. Only time will provide the ultimate proof.

The next lesson is that politics and transparency are like oil and water. They don’t mix. When politicians, whose political machines are “well oiled” by special interests, place special interests ahead of transparency for investors in the form of full and fair disclosure, trouble is just around the corner. Such actions are like a film of sludge covering what would otherwise be transparent, clear like a glass of fresh water. It is beyond question that some politicians in the United States directly contributed to the systemic breakdown that permitted the bubble in our markets toward the end of the 1990s.

The ninth lesson is that capital markets are not “self-healing.” The very real existence of inherent financial conflicts, a lack of independence, and political interference prevent and inhibit capital markets from taking self-correcting actions. In the United States, businesses, auditors, analysts, corporate boards, and others had been urged to adopt best practices, sometimes for decades. For example, the organization of Financial Executives International had for many years urged its members to report on internal controls, consistent with recommendations of highly respected commissions arising from debacles in the 1970s and 1980s. These same executives had been urged to address the shortcomings of their “pro forma” earnings releases that included everything but the bad stuff. During 2000, the SEC urged and pushed the profession, along with a panel of experts led by the former chairman of Pricewaterhouse, to adopt more effective and stringent oversight. And of course, our own Financial Accounting Standards Board (FASB) had been working on a project that would have solved the accounting for special purpose entities such as existed at Enron for over two decades.

Yet none of these solutions came to fruition. Instead, one out of every 10 public companies in the United States has had to restate its financial statements after shortcomings in their internal controls were exposed, the off-balance sheet transactions of companies such as Enron and Parmalat surprised investors, and investors were misled by earnings numbers that were more representative of Grimm’s fairy tales than economic truth. Billion dollar errors in financial statements have become a recurring rather than an extraordinary event.

The final lesson is that when there is a lack of enforcement of rules, be it those regarding conduct on Wall Street or the major international stock markets, the independence of gatekeepers or corporate boards, the transparency of financial disclosures, or the ethics of management, there are in fact and substance no such rules. Time and time again, rules have been ignored when management believed the benefits of such behavior outweighed the costs associated with ethical and proper conduct. It has been like a speeding car whose driver had seen the sign, “Next policeman—500 miles.” And with trade becoming more global with each new day, perhaps the sign might more appropriately say, “Next policeman an ocean away.”

To date, in some countries, change has and continues to occur. Here in the United States, public sentiment, illustrated clearly in polls, led politicians to pass what has affectionately become known as Sarbanes-Oxley. Change is also occurring internationally as we have seen new rules and regulations passed and/or proposed in countries such as Italy, England, Germany, Canada, and Australia. We have seen the Organization for Economic Cooperation and Development adopt new measures, and likewise, the International Accounting Standards Board has also adopted new measures, such as those requiring expensing of all forms of compensation. The International Organization of Security Regulators has also been working hard to facilitate greater coordination among its members, including in the field of enforcement.

But whether these measures and steps taken ultimately receive a passing grade will depend on whether, in time, they resolve the matrix of inherent financial conflicts, lack of independence, lack of transparency, and accountability by bringing them clearly into the sunlight through high-quality disclosures. Just as people like financial rewards, they also tend to guard their reputations with zeal. Quite often, they act with more ethical behavior when the risk of getting caught with one’s picture plastered on the front page of a major national or international newspaper increases. As the weekly newspaper in Aspen, Colorado succinctly touts, “If you don’t want it printed, don’t let it happen.”

To that end, the discussion will next address some of the factors required for a passing grade. These factors focus on the issues of independence, accountability, adequate controls and oversight, and effective enforcement of those who chose to break the law.

Changes to Prevent Future Busts

First, in the area of corporate governance, boards need to govern with investors clearly in mind. To that end, corporate boards need to become more independent of the CEOs they oversee. The days of the “good old boys’ club” of board members needs to become as much a relic of the past as the dotcoms and the horse and buggy. That is not to say professional board members are required. But we do need experienced, knowledgeable members who ask tough questions, and when the answer isn’t satisfactory, they ask them again and again until the answer is complete. To help accomplish this, corporate boards should be 75 percent or more independent, and the roles of the chairman and CEO should be separated. Such practices have become more commonplace elsewhere than in the United States and I think we need to follow the lead of others. As for mutual funds, as the Securities and Exchange Commission has proposed, the chairman of the board should always be independent of the fund complex whose fees come from the investor funds.

Second, to help ensure greater accountability of executives, the executives should have to formally acknowledge their accountability for the truth, the whole truth, and nothing but the truth when they provide information to the owners and creditors of a business.

Third, accountability should be established and the progress measured through greater transparency in disclosures to a greater extent than is currently done. We should eliminate gimmicks that exist in current international and national accounting standards that permit lease and other forms of financings to remain off-balance sheet. Changes in the value of financial portfolios, liabilities, and instruments should all be reflected without compromise in the financial statements. The international and national accounting standard setters need to adopt a rule that, notwithstanding their existing standards, if material information is necessary to an understanding of a business, and that information is not required by a particular rule, then that information must still be disclosed. Key performance indicators, which provide investors, creditors, and regulators greater visibility into the future value creation or destruction for a business, should also become a standard part of any disclosure regime.

Some argue for the creation of differing levels of transparency for businesses or countries based on their size or degree of development. Yet neither of those two criteria have anything to do with the ability of investors to make reasoned, informed decisions about how to best allocate their capital to maximize their returns. And while I do agree a small business may be less complex than a large multinational conglomerate, it should nonetheless be very transparent with respect to its disclosures. For example, if it has financial instruments, leases, or pension plans, it should disclose those and their economic impact on the business in a truthful, meaningful fashion. To waive such a requirement is to take the first step away from a principles-based approach toward a complex set of rules based on exemptions, waivers, and a lack of reality.

Companies and countries that provide transparent disclosures, which serve investors in their quest to maximize returns, will increasingly be able to attract capital at an increasingly attractive price. It is just such a system that allows investors over the long run to maximize their returns and reduce their losses, thereby increasing their trust and confidence.

Fourth, an alignment and linking of executives’ pay to their performance on behalf of investors must be done over the long run. In all likelihood, this means changing the mix of some forms of compensation, such as decreasing the use of stock options and increasing the use of restricted stock that vests over time and, in some cases, after retirement. It also means measuring performance not on a quarter-by-quarter basis, but by how each of those quarters builds on the longterm strategy of the business. Likewise, if we are to hold executives responsible for their performance over the long run, then investors must also change how they perceive and measure performance. In particular, portfolio managers at institutional investors should also adjust their compensation schemes to compensate them for their performance over the long run.

Fifth, we need to reduce the financial conflicts inherent in a robust capital market system by increasing the independence of the gatekeepers and overseers. As previously discussed, corporate boards need to become more independent. Likewise, auditors whose reputations have been bloodied and bludgeoned by the disclosure of one financial fraud after another need to become more independent. After all, if auditors cannot find billion-dollar errors as existed at WorldCom, Parmalat, and Qwest, or report a serious deficiency to investors and regulators when it is reportably found, such as at Tyco, Waste Management, or Adelphia, what is reasonable to expect them to be able to find and report? Perhaps the need for periodic mandatory rotation of auditors has come.

Restoration of the public’s trust in the auditing profession and firms will be accomplished only if they are prohibited from providing services that conflict with their independence, both in fact and appearance. It is common sense: an auditor of a company who audits his or her own work, who acts as an advocate for the company or executives they are responsible for testing, who acts in any capacity as an employee or management, or who has a financial interest or business dealing with the company will have their independence seriously challenged by just about any reasonably prudent investor. To that end, auditors should be prohibited from engaging in such acts. While some have proposed letting the auditors themselves decide if there is a threat to their independence and then put in place safeguards, experience in recent years demonstrates that this type of approach has failed. The auditors seldom see a threat, seeing dollars instead, and before long their job is over, but the company’s problems are just beginning.

Yet independence should not be just a lesson for auditors. The objectivity of other gatekeepers such as financial analysts and the legal profession need to be enhanced and strengthened as well. In the United States, 10 investment banks were the subject of a large legal and financial settlement with the SEC and the Attorney General of the State of New York. However, that settlement only applied to those 10 firms, not the thousands of others that have been left to continue their past practices. The reality is that, with the financial rewards being as large as they are, systems involving ethics and regulations need to be put in place and then strictly enforced to ensure analysts do their homework, and then provide independent and timely research to investors. This is an area where much work remains to be done in the United States.

At the same time, we are debating the role of the legal profession in the financial scandals. The general counsel for Tyco is on trial, while counsel at Parmalat is under investigation. Corporate counsel and their roles at companies such as Enron, WorldCom, and Spiegal have also come under scrutiny. While members of the legal profession may have a role to act as staunch advocates for their clients, they are nonetheless the one profession in the business of justice. Accordingly, wise minds must find a way to ensure the profession serves justice and not just those who sign the checks.

Sixth, the independence of those who make the rules, be it accounting standard setters or regulators, needs to be paramount and unquestioned. Those responsible for the independence of the standard setters must protect it with the passion of a zealot. This is an unending task as observed today with certain European financial institutions and the European Commission compromising the principles of the IASB when it comes to reporting financial instruments. Likewise, the high-technology industry and some members of the U.S. Congress are attempting to compromise the Financial Accounting Standards Board in its quest to require expensing of stock options. Yet we have seen all too clearly in the United States what the costs are to the capital markets when independence is lost and congressional votes are sold to the highest bidder.

Seventh, investors should have a voice in the corporate boardroom of underperforming companies when the executives and boards become entrenched and unresponsive. In those situations, the investors in the company should be permitted to nominate their own slate of directors, using the same resources and processes available to management and the board. By giving the investors a chance to institute change in those limited situations, it creates an incentive for companies to fulfill their obligations to their investors.

Eighth, adequate internal controls are necessary to ensure the accuracy and adequacy of disclosures, as well as compliance with all laws and regulations. In the United States, such controls were mandated by legislation adopted in 1977 after disclosure of hundreds of corporations engaging in improper payments. When hundreds of financial institutions failed in this country in the 1980s, costing the taxpayers roughly one-half trillion dollars, they were required not only to have the controls in place and operating, but also to have their independent auditors test and report on them.

More recently, with over one out of every 10 companies having to redo their financial statements, the U.S. Congress has once again required companies to have their internal controls in place, operating effectively with both management and the independent auditor reporting on those controls to the investing public and regulators. Surprisingly, the Financial Executives International has long urged companies to report on their internal controls to their investors. However, that sound recommendation fell for the most part on deaf ears. Indeed, based on the whining we have heard from some in the business community here, one wonders just how many companies have had effective systems of internal controls in place. While businessmen have complained about the costs they are incurring to make their internal controls adequate to provide information necessary for investors, and quite frankly for successful management of the company, those same businessmen fail to note the hundreds of billions of dollars lost by investors, and the resulting impact on our economy. While they say legislation should “do no harm” to business, they have failed miserably to ensure business does no harm to investors.

Ninth, we need to see stronger enforcement in all areas affecting the financial markets. From enforcement of accounting, auditing, and disclosure rules, to independence standards, ethical conduct, and fiduciary responsibilities of boards and gatekeepers, law enforcement agencies need to take more timely and rigorous action against those who fail in their legal or fiduciary responsibilities to investors. When laws are broken, action needs to be taken promptly so as to keep a level playing field for those who chose to play by the rules.

As many global businesses have a significant portion of their operations outside of the country they are domiciled in, the regulators need to find ways to more effectively and efficiently cooperate and prosecute illegal behavior when it occurs. It is no longer acceptable in a global society for one regulator alone to investigate and prosecute cases such as Enron, Parmalat, Shell, or Nortel. Those who chose to ignore the law need to understand that the policeman is just around the corner.

This also means that those who fail in their obligations and responsibilities should not be given immunity from penalties associated with their behavior. For example, in some countries the accounting profession has asked for limits to their exposure to lawsuits by those who have suffered damages, including when the auditors failed in their professional responsibilities. Indeed, the European Commissioner, Fritz Bolkenstein, has noted that exposure to that liability does have an impact on auditors when they contemplate the work they need to perform. If an auditor is able to escape meaningful responsibility for the product, one can only wonder what the quality of the product will be in the future.

Tenth, finally and foremost, the mission of those responsible for the capital markets must be based on and driven, just as it is with every successful business, by the quality of the product needed and desired by the end customer. When a business fails to deliver a product its customers demand, it becomes a dinosaur. Likewise, in a glob ally connected world of international trade, finances, and markets, those who deliver the highest quality product to investors will become the successes of the future. Those who do not will become extinct.