A New Deal For American Investors
By Paul Weinstein, Jr.
By overwhelming margins, both the U.S. Senate and House of Representatives passed bills aimed at strengthening oversight of the accounting industry and stiffening penalties for business executives who knowingly misrepresent their companies' financial health. While the Senate bill is superior to both the corporate reform bills the GOP-controlled House has approved, none of these measures goes far enough. As Andrew Grove, chairman of Intel Corporation put it recently, "corporate misdeeds, like poor quality, are a result of a systemic problem, and a systemic problem requires a systemic solution."
Over the last month, the cooked books and earnings misstatements that brought down Enron and may yet destroy WorldCom, have begun to taint corporate stalwarts such as Xerox and others. American investors, already badly bruised from a bear market of over two years, have seen their retirement nest eggs and their children's college savings accounts dwindle as the market decline has reached new lows. By the end of the week of July 19 -- a week in which nervous investors withdrew $3 billion from the stock market -- both the Standard and Poor's 500 Index and the technology-oriented NASDAQ Composite were floundering near a five-year low. For the 42 million Americans with 401 (k) plans, the financial news seems to go from bad to worse.
The Bush administration has failed to arrest the public's crumbling confidence in the basic integrity of America's financial markets. When the crisis began nine months ago, the White House mostly sat back and watched, hoping the Enron debacle would be a one-day story rather than the tip of the iceberg. Only when public demand for action became too loud to ignore did the president finally offer a response. Unfortunately, the markets' reaction to President Bush's July 9 call for a renewed ethic of corporate responsibility was a two-day drop in the Dow Jones industrial average of more than 400 points and a decrease in the NASDAQ market index to its lowest mark since 1997. The president's lack of leadership on corporate accountability, together with the administration's reckless fiscal policy, has fed a downward market spiral that now threatens our economic recovery.
The Senate stepped into the leadership vacuum on July 15, passing a strong reform bill drafted by Senate Banking Committee Chairman Paul Sarbanes (D.-Md.) on a 97-0 vote. The Sarbanes bill rightly focuses on restoring confidence in the accounting industry and assuring that stock analysts provide unbiased information to investors. But more needs to be done on the crucial issue of corporate governance.
Today's crisis of confidence in corporate America stems from a structural imbalance in which corporate executives have gained power at the expense of directors and shareholders. Even as stock ownership has become democratized -- approximately 60 percent of all Americans now own equities -- firm decision-making has become more concentrated than ever in the hands of top corporate leaders who have chased short-term gains at the expense of their company's long-term health. Corporate boards, originally designed to protect the interests of a small number of wealthy shareholders, have failed to adapt to the new reality of the growing millions of small shareholders saving for retirement or for their children's education. Excessive executive compensation, abuses of stock options, deceptive bookkeeping, sweetheart loans to company directors -- all are symptoms of an outmoded and unbalanced system of corporate governance developed a century ago. PPI believes the key to restoring investor confidence in our financial markets is to modernize corporate governance for the New Economy. This entails creating a new system of checks and balances between shareholders, corporate executives, and boards of directors.
In this paper, PPI proposes a New Deal for American Investors that would take a decisive step toward a New Economy model for corporate governance, while also tackling the need to restore honest and independent accounting, end conflicts of interests between stock analysts and investment bankers, and toughen penalties for corporate leaders who don't play by the rules.
Summary of Existing Corporate Reform Proposals
The Sarbanes Reform Legislation
The Public Company Accounting Reform and Investor Protection Act developed by Democrats is by far the best corporate accountability proposal being offered. The bill is a good first step, but only a first step, toward restoring confidence in the system. For the most part, we agree with the majority of what the bill proposes. Specifically, we support the bill's requirements for chief executive officers (CEOs) and chief financial officers (CFOs) to relinquish bonuses in the event of fraud or negligence and to certify the accuracy of their financial statements and disclosures. We would quibble with some of the bill's provisions, such as the mandatory requirement that companies rotate lead auditors every five years, which might actually undermine incentives for good auditing practices. But focusing on the auditors is not enough. We must soon address the broader issues of corporate governance to fully restore public confidence, beefing up federal oversight of publicly traded companies, restoring the independence of corporate boards, and ensuring that executives do not profit by betraying investors and workers. The key provisions of S. 2673, the Public Company Accounting Reform and Investor Protection Act, would:
House Republican Bill
The House of Representatives passed two corporate accountability bills, but which differ little from one another. For the most part, both are on par with President Bush's except that the House legislation includes tougher penalties for corporate fraud. Like the president's proposal, the bill contains no provisions dealing with conflicts of interest among stock analysts, or ensuring the independence of corporate directors and their audit committees. The primary change espoused in the House legislation is the proposal to give the SEC the option of creating an oversight board. The bill also calls for a variety of studies including auditor independence, the role of corporate boards, and the impact of stock options. Specifically, the House bill:
The Bush Administration Plan
Early this month the president outlined his proposals for improving corporate responsibility. Not surprisingly, the administration's plan has emphasized enforcing laws already on the books rather than tightening the laws themselves. The president's bill is arguably even weaker than the House Republican legislation. The key points include:
Not surprisingly, the president's latest policy iteration contained little in terms of new ideas. First, federal law already criminalizes mail fraud and obstruction of justice. Second, the president could have called on Congress to directly increase the penalties for fraud, but simply chose to call on the U.S. Sentencing Commission to do so in the ordinary course. The Commission cannot even begin to act until after Congress has acted. Third, the president's plan does not address several key issues. For example, his plan does not address requirements for independent boards of directors nor debarment from Federal contracts for corporations convicted of "corporate greed" violations.
PPI Corporate Accountability Reform Proposal: A New Deal for American Investors
We believe the key to restoring confidence in our financial markets is modernizing our system of corporate governance and empowering shareholders. Below are eight steps that would address the structural deficiencies that exist in corporate governance and the relationship between investors, corporate directors, and CEOs.
1. All investors have the right to an independent board of directors who will act in the long-term interests of shareholders and the company, rather than at the whim of the CEO. Corporate directors are responsible for objectively negotiating executive compensation packages and aggressively questioning company management and the outside auditors to ensure that the financial statements truly reflect the value of the company. But when director independence is compromised, rubber-stamp endorsements of huge pay packages and misleading annual reports can be the results. To safeguard the interests of the investor, we should prohibit company directors from consulting for any company on whose board they sit. They also should not be allowed to accept perks from the CEO, such as use of corporate jets, club memberships, or loans. In addition, all publicly traded companies should have at least one board member selected by the exchange on which the company's stock is traded (NYSE, AMEX, NASDAQ, regional exchanges, etc.). Finally, when board members clearly fail to satisfy their fiduciary responsibility to shareholders, the SEC should have new powers to prohibit them from serving as directors for any other corporation.
In addition, we also believe the time is at hand for Congress, outside the heated debate over the current legislation, to weigh deeper changes in corporate governance. For instance, several European nations prohibit one individual from serving as both chairman of the board and CEO. When an individual is both chairman and CEO, he or she is all-powerful. This configuration often makes it extraordinarily difficult not only for scrupulous employees to raise issues of malfeasance, but also has led to boards that all too often give rubber stamp approval to proposals from the CEO. Such a separation, as Andrew Grove of Intel and others have suggested, is worth exploring, as it would change the dynamics within corporate boardrooms.
2. All investors have the right to laws that deter and punish corporate greed and malfeasance. The best deterrents to corporate fraud are real penalties and enforcement to back the laws up. Too many white-collar criminals believe they can get away with ripping off investors and employees. We believe it's time to get tough on corporate crooks. The approach taken by Senators Patrick Leahy (D.-Vt.) and John McCain (R.-Ariz.) would strengthen existing penalties for corporate crime and create additional penalties. Leahy-McCain would create a securities fraud felony, punishable by up to 10 years in prison, and a new crime for any "scheme or artifice" to defraud shareholders. The amendment would also enhance current fraud and obstruction of justice sentences by directing the U.S. Sentencing Commission to raise penalties in obstruction of justice cases where evidence is destroyed and in fraud cases where there are many victims or where victims are financially devastated. Finally, Leahy-McCain would encourage witnesses to report fraud to authorities, by protecting corporate employees who blow the whistle on fraud.
But Congress should also ensure that corporate crooks have to give up money not fairly earned. If a company restates its earnings because of fraudulent accounting, the CEO and CFO should be required by law to repay all profits and compensation -- other than base salary -- earned during the years for which earnings are restated. This recapture of profits should apply to all bonuses, stock options, and stock sales. This proposal, as Adam Solomon of Shaker Investments has suggested, would ensure CEOs make the right decisions.
The CEO and CFO create the culture in which small deceptions can flourish and eventually spiral into massive scandals. Corporate officers, who should be well aware of major policies and procedure at their companies, should not be financially rewarded when that culture breeds dishonesty and greed. If the CEO's and CFO's potential for creating personal wealth are tied to their ability to create a culture that rewards both growth and integrity, they will make the right decisions.
3. All investors have the right to a corporate governance system that will enable their real-time participation in important matters. The primary opportunity for investors to interact with company management is at their annual meetings. Unfortunately, most small investors lack the means to travel to these conferences at which vital business decisions are ratified. Some companies like The Coca-Cola Company offer their stockholders the chance to vote via the Internet. We should guarantee that Internet voting is available to all shareholders and require that every publicly traded company provide a Web cast of its annual stockholder meetings starting in 2007.
4. All investors have the right to know. While senior Enron executives sold millions of shares right before their company's collapse, many small investors and employee shareholders were left in financial ruin. To level the playing field, corporations should provide real-time disclosure of information to investors, including all sales of company stock by the firm's executives, within 24 hours. In addition, Congress should require companies to file their earnings statements with the Securities and Exchange Commission the same day they issue their earnings press releases. Providing both documents simultaneously would give investors a truer picture of a company's performance. Finally, public pension funds and mutual funds should have to disclose their proxy votes so that their participants/ shareholders know how their fiduciaries are voting their shares on important issues.
5. All investors have the right to hold corporate managers accountable for playing by the rules. Chief executive officers and other top executives should not be allowed to play by a different set of rules than the rest of us. In fact, those who are entrusted to lead their companies should be held to a higher standard. That's why Congress should require that CEOs and CFOs take responsibility for their companies and certify their annual reports to investors. Furthermore, corporate America should heed Sen. Joe Lieberman's (D.-Conn.) advice to create a council of business advisers to guide the government's policies on reform and to push companies to adopt voluntary codes of conduct.
6. All investors have the right to independent auditors who act on their behalf. As Arthur Andersen LLP has discovered, an accounting firm's reputation is priceless. Once it disappears, so do the clients. To restore confidence in the accounting industry, Congress should eliminate possible conflicts of interest by prohibiting accounting firms from providing certain types of consulting services to businesses they audit. To improve the quality of audits, the SEC should be granted the authority to hire a second accounting firm to conduct a second audit at random or when requested by a significant majority of shareholders.
7. All investors have the right to honest and unbiased information from stock analysts. Many shareholders rely on stock analysts at brokerage firms for unbiased information on companies. Sadly, as Enron and other cases have revealed, many analysts issue favorable reports to protect their employer's investment banking relationship at the expense of honest research. All financial analysts should have to disclose the nature of any financial relationship between the companies they cover and their employers. Furthermore, to guarantee independent reporting, analysts should not be permitted to cover companies for whom they have a consulting or other type of financial arrangement.
8. All investors have the right to expect that laws to protect shareholder interests and encourage efficient markets are enforced. It makes no sense to create new requirements for corporations without enabling the SEC to ensure that companies comply with them. Between 1991 and 2001, SEC filings rose by 59 percent, but the SEC's enforcement staff grew only 16 percent. Last year, in fact, just 16 percent of 10-K filings received financial reviews. The rest just sat there. To fix this problem, Congress should raise the SEC's budget to meet the increase in SEC filings and ensure that its employees are paid as well as their counterparts at other financial regulatory agencies.
Conclusion
Over the next several weeks House and Senate conferees will have the opportunity to modernize our corporate governance structures and bring real accountability to the boardroom. However, if Congress fails to truly reform corporate governance, the American investor and the U.S. economy will be the big losers.
Paul Weinstein Jr. is a senior fellow at the Progressive Policy Institute and teaches at Johns Hopkins University. He is also co-author of the textbook "The Art of Policymaking."