Corporations No Longer Trustworthy
June 17, 2002
by Irwin Stelzer
Most Wall Street analysts are guessing that share prices will recover as it becomes clearer that the economic recovery now underway is translating itself into rising profits. They may be wrong. Until what Goldman Sachs CEO Henry Paulson Jr. calls the “crisis of confidence” in financial markets is overcome, investors may hesitate to commit their savings to the tender mercies of those who they feel have betrayed their trust. Just as the discovery that the roulette wheel is crooked will drive away punters and force even the poshest casino into bankruptcy, so the discovery that corporate America, or some significant part of it, has been playing fast and loose with their dollars and their trust is keeping investors on the sidelines.
This has enormous consequences for the economy. Investors who once thought it reasonable to entrust their capital to corporate America now know that many of the advisors whose integrity they took for granted were being paid by their investment banker-partners to tout companies whose shares they knew to be s**t, in the immortal words of a Merril Lynch email. They know, too, that shares in initial public offerings (IPOs) went first to customers the investment bankers chose to favor, with ordinary investors allowed to buy only after the price of those shares had run up.
Finally, investors now know that the profits reported by far too many corporate high-flyers and certified by their auditors were fictions, failing to reflect off-balance sheet debts and the cost of share options promised to top executives, but counting as already trousered revenues that had not been received, and might never enter the coffers of the reporting companies.
So some investors are now putting their investment funds into houses instead of shares, while others have decided that consumption of tangible goods is a better use of their money than investment in shares that might prove as vaporous as those of Enron, Tyco, Adelphia Communications, Global Crossing, and a host of others.
Fortunately, markets have a way of correcting excesses. Investors are punishing companies whose executives and boards have deceived them, and the New York Stock Exchange is now threatening to delist companies that do not have a majority of truly independent, qualified directors that meets regularly (25 percent of NYSE-listed companies don’t meet that standard), that do not give shareholders an opportunity to vote on all stock option plans, and that do not have a CEO willing to take public responsibility for company’s compliance with the new standards.
Paulson would go further. He stunned his high-tech clients, among them Cisco Systems, by suggesting that the time has come for stock options to be recorded on company books as the expense they certainly are. Others, among them key legislators, have proposed that auditors be prevented from accepting lucrative consulting assignments from their audit clients; that investment banking firms get out of the stock touting business; and that firms rotate their audit firms so that accountants cannot retain their clients even if they accommodate the managers with less-than-stringent interpretations of accounting rules. All of these have proved too radical even for the shaken audit firms and most executives to accept.
But even if these more sweeping reforms were to be adopted, they alone could not restore the key ingredient that makes capital markets work: trust. Social scientist Francis Fukuyama points out in his aptly titled Trust: The Social Virtues and the Creation of Prosperity, “The United States was a relatively high-trust society throughout the period of its industrialization.” That enabled companies to reach beyond the family unit for capital with which to expand, and to raise billions to finance their enterprises—before there was a Securities and Exchange Commission or many of the regulations now existing and proposed.
That trust no longer exists. The result is that investors prefer to put their money into a larger home, or still another new car rather than entrust it to advisors who have betrayed them, and to corporate executives who have adopted the “Greed is good” philosophy that Gordon Gekko famously espoused in the hit movie Wall Street shortly before his insider dealings brought him to the attention of the authorities.
If America’s corprocrats wish to restore faith in the nation’s great capital markets they might look to three sources to guide their behavior. One is a little newspaper in Aspen, Colorado, which advises on its masthead, “If you don’t want to read about it in the papers, don’t do it.” Another is one of the country’s leading corporate lawyers: he has emblazoned on the notepads placed in front of each director at his clients’ board meetings, “Ladies and gentlemen of the jury.” If you don’t think you can explain your vote and notes of your actions to the juries that may some day review them, think again about what you are doing. The third is long-time Democratic congressman John Dingell. Dingell suggests the smile test: if you find it necessary to repress a smile when defending some proposed action, don’t do it. CEOs would do well to follow those rather simple guidelines—and to consider too the words of the aide to a famous Italian manager of a rather large enterprise, after a serious misstep: “Reputation, reputation, reputation! Oh! I have lost the immortal part of myself, and what remains is bestial.” All the CEO’s lawyers and all the CEO’s spin doctors cannot put a shattered reputation together again.
This is something to keep in mind when the next temptation to opacity arises, or when devising compensation schemes that enrich executives regardless of their performance, or when booking income that may never be realized, or when hatching any dodgey merely to satisfy Wall Street’s clamor for ever-higher earnings—not in the long run, but now, in this quarter. No sense in having to repeat Cassio’s lament when all one need do is follow the advise of a tiny Aspen newspaper, a shrewd corporate lawyer, and a wise old congressman.
This article originally appeared in London’s Sunday Times on June 16, 2002, and is reprinted with permission.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.