USA Today
Scandals shred investors' faith
By John Waggoner and Thomas A. Fogarty, USA TODAY
By Kenneth Lambert, AP
Fired Andersen auditor David Duncan pleaded guilty in April to obstruction charges. The Enron and Andersen scandals are helping erode investors' trust in companies.
A drumbeat of corporate misdeeds has helped crush stock prices and eviscerate pension plans. But the biggest victim may be trust — investors' trust in financial advisers, stock analysts and Corporate America.
During the bull market, corporations and those who ran them seemingly could do no wrong. Now they're feeling the backlash, in the form of congressional hearings, bankruptcy trials and investor outrage.
"The guy in Georgia who stored dead bodies instead of cremating them went to jail," says Maggie Green, a marketing analyst in Oklahoma City. "But these guys steal billions, and have any of them gone to jail yet?"
Trust keeps the financial system together. Once lost, it can take years for Wall Street to regain it. Signs of how badly trust has eroded are everywhere. Investors are starting to give up on the stock market and are plowing money into their homes instead. And Congress is warming up to write new business regulations.
Unless Corporate America moves quickly to regain public confidence, Wall Street could languish for years.
Examples of corporate misdeeds bombard investors nearly every day. On Tuesday and again today, Congress is flaying oil executives on charges of keeping gasoline prices artificially high by manipulating supply. Industry representatives deny wrongdoing. But that's just the most recent development. In the past few months:
Enron, the Houston-based energy trading company, collapsed into bankruptcy protection amid allegations of fraudulent accounting.
The New York attorney general has accused Merrill Lynch, the nation's largest brokerage firm, of publicly hyping stocks to secure investment banking business. Merrill Lynch's CEO apologized to investors for internal e-mails in which analysts disparaged stocks they publicly touted.
Arthur Andersen, a Big Five accounting firm, faces a criminal trial Monday for obstruction of justice in the Enron scandal. The government charges Andersen with shredding key documents.
The list seems endless: Firestone sued for knowingly selling defective tires. Communications giants WorldCom and Qwest investigated for their accounting practices.
Investors may not have done their homework for the companies whose stocks they bought, but until Enron they always assumed the financial numbers companies provided were correct, says John Markese, president of the American Association of Individual Investors.
"My trust has become somewhat jaded," says Anthony Breault, an American investor working in Sydney. "It's difficult to put hard-earned money into companies we believe in based on the figures provided."
Stoking the outrage: The public doesn't believe CEOs and other top executives have shared the pain of this bear market. Some people point to Kmart, which gave former CEO Chuck Conaway a severance package of $9.5 million after filing for bankruptcy protection in January. The package included forgiveness of a $5 million loan.
Others can't get Enron executives off their mind. "I just can't believe they're out there walking free," Green says.
Investors haven't staged a mass exodus from the stock market, but the flow of money has slowed dramatically since 2000. Mutual fund investors have put $55 billion into stock funds through March, according to the Investment Company Institute. That's up from 2001 but a far cry from 2000, when they flooded stock funds with $168 billion in new money.
Clearly, fear of the bear market has kept some away. Worries about corporate integrity haven't helped. "People aren't jumping back in," Markese says. Given a choice between putting money into stocks or real estate, many choose the red-hot real estate market.
Polls show declining trust
Polls show trust in business, though never very high, is plummeting. Just 16% of Americans say they have a great deal of confidence in major companies, down from a pre-Enron high of 28%, a Harris poll says. Executives have taken a beating, too. Just 16% of Americans rate their ethics as high, down from 25% before Enron, says a USA TODAY/CNN/Gallup Poll.
Restoring trust
Financial scandals have spawned proposals to restore public trust. Under scrutiny:
Insider partnerships. The Financial Accounting Standards Board is considering tighter limits on Enron-style partnerships, which hid debt from the company's books and boosted the appearance of profitability. The goal: assuring the so-called special purpose entities are used as intended — mainly to reduce borrowing costs.
Overly ambitious earnings projections. The Securities and Exchange Commission may require fuller disclosure in corporate financial reports. Companies would have to tell investors how they arrived at some profit estimates.
Accounting firms doubling as auditors and strategists. SEC Chairman Harvey Pitt has called for a governing board for the accounting profession that would be controlled by non-accountants. President Bush has a separate proposal for a new board. Some in Congress favor forced separation of auditing and consulting.
Retirement. In Congress, several bills would protect workers from the risks of holding too much company stock in 401(k) plans. In general, workers could diversify out of company stock received as a matching contribution after three years. The bills also would require 30-day notice to workers who might be barred from moving money in their retirement accounts during an administrative change in the plan.
Executive compensation. Bush favors requiring CEOs to return stock option awards and bonuses if their firms' earnings statements must be revised downward because of fraud or mismanagement.
Self-serving stock touts. The National Association of Securities Dealers may limit Wall Street analysts' ability to trade stocks of companies they cover. Investment banks would be prohibited from issuing research on a company for 40 days after an initial public offering of stock.
The recent scandals have refocused the public's skepticism about American business, says John Richardson, a Pepperdine University business professor. "Before Enron, most of the heat was on marketing as the most corrupt element of American business, but this has put accounting and finance on the front burner," Richardson says.
As a result, Richardson says, classroom discussions on ethics this year have shifted to Enron, Andersen and Merrill from, say, Nike, which once misled golfers by promoting a type of mass-produced balls as those used by Tiger Woods. He uses a different, custom-made ball. The new lessons seem more profound. Students "see these as something that's not going to go away," Richardson says.
Ritu Gupta, one of Richardson's part-time MBA students, says the business scandals validate her decision a year ago to go to work at her family's small manufacturing business in Santa Fe Springs, Calif. Classmates have become deeply skeptical of big corporations, she says. That may not be all bad if it makes them self-reliant rather than "trusting 110% the big bosses," she says.
Bear market reveals excesses
The lessons Enron and Andersen have left for business students have yet to sort themselves out, says finance professor Keith Brown at the University of Texas. But if problems fester to the point that the average little guy starts to believe that stock investing is a sucker's game, he says, "We'll have a serious problem."
Peter Kendall, co-editor of newsletter The Elliott Wave Financial Forecast, says a bear market often reveals the worst excesses of a bull market. "Everything that was revered on the upside is a target in a bear market." Those excesses have to be corrected before the public regains its confidence.
Typical features of the so-called recrimination phase:
Reviled CEOs. "Those who had Teflon in the bull market have Velcro in the bear market," Kendall says. In 1929, the chief target was Richard Whitney, president of the New York Stock Exchange. Kenneth Lay, former CEO of Enron, may be the current target.
Tarnished icons. You don't have to be a CEO to incur a sudden loss of status in a bear market. James Cramer, co-founder of TheStreet.com, became famous enough to be part of ad campaigns for Rockport shoes. Now he's the subject of an unflattering book by a former associate.
Increased interest in regulation. The Securities Act of 1934, the groundwork for most of today's securities law, was a result of abuses during the roaring '20s — as was the Investment Company Act of 1940, the foundation of mutual fund regulation.
The Securities and Exchange Commission is considering rules for corporate disclosure. The National Association of Securities Dealers (NASD) has proposed rules to limit conflicts of interest with stock analysts. Several pension reform bills are in front of Congress, which is holding hearings nearly every day on business abuses. This week was the oil industry's turn in the hot seat.
"Gasoline companies have not been forthcoming as government has sought to understand how competitive the industry truly is," said Sen. Joseph Lieberman, D-Conn., at a hearing Tuesday on gas pricing. "That further erodes the confidence of the American people — who have a right, through their government, to ensure that companies are behaving fairly."
Reform and regulation are one step to regaining the public's confidence. But that often happens well after much of the damage is done to investors' trust.
"The government takes steps after the horses have left the barn," Kendall says.
The SEC took wide-ranging steps to reform the financial system after the bear market of 1973-74. But investors continued to yank money from mutual funds for nearly a decade. It took a generation to get over the excesses of the 1920s, despite the government's overhaul of the financial system.
Louis Thompson, head of the National Investor Relations Institute, says the problems uncovered at Enron and among financial analysts are every bit as serious as those of the past.
"The collapse of (railroad company) Penn Central in the 1970s, the fall of (junk-bond dealer) Drexel Burnham Lambert in the 1980s — none of these touched the magnitude of Enron," Thompson says. "Now we see it's beyond Enron. It's an ethical problem, and it has touched nearly every nerve — shareholders, employees and employers."
He says he'd like to see analysts banned from owning stocks they cover. And he says he'd like to see companies that underwrite stocks be banned from issuing research reports on those companies for six months.
Is the system broken beyond repair? Bill Nygren, manager of the Oakmark mutual fund, doesn't think so. "The U.S. has the best financial disclosure in the world," Nygren says.
But, he adds, the bull market made investors sloppy. A diligent investor should look at several years' worth of annual reports, not just earnings per share. "The rules were never written so that one line gave a clear picture of a business."
It would be wrong to think that only corporations made mistakes that need to be corrected. Investors should bear part of the blame, too, says Jeffrey Seglin, a professor who teaches ethics at Emerson College in Boston and author of The Good, the Bad, and Your Business. "When things get tough, we look for people to blame," Seglin says. "Fraud and Ponzi schemes are wrong, but if Vanguard isn't returning 20% a year, that's not wrong."
Painful as it is to watch, the public floggings of corporate wrongdoers by congressional committees and the press are beneficial.
"The market is largely self-correcting," says former SEC commissioner Arthur Levitt. "Humiliation and embarrassment have already begun to change behavior."
One example: Corporate earnings reports are getting longer as companies disclose more. IBM's recent financial discussion of its earnings grew by 10 pages from the previous year.
And, ultimately, the corporate scandals will lead to a better system. "This is a healthy cleansing of weak and unscrupulous companies," says Phil Reeder, an investor in Rancho Bernardo, Calif. "All of this is positive for the long-term investor."
Of course, in the long term, as late economist John Maynard Keynes noted, we're all dead.
Thompson says action has to start now: "If we all show an interest in reform, we can help restore investor confidence. But we have a lot of work to do."
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