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The Importance of Investor Confidence

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Take an in-depth look at the crisis in investor confidence that is affecting corporate America. You will see how this lack of confidence could seriously damage the economy and how the crisis can be reversed before too much damage is done.
This chapter is from the book

One scandal rocks investors after another. The problems with Enron, Arthur Andersen, Rite Aid, WorldCom, Adelphia, Global Crossing, Martha Stewart, Merck, etc., have been blamed on greedy accountants, analysts, executives, and directors. The intense media frenzy and investor attention has allowed many people to grab the limelight, and much grandstanding has occurred. Regulators have gone after high-profile companies for fraud. Politicians have suggested and enacted new regulations and laws. Prosecutors have indicted individuals at these scandal-ridden firms. Yet the actions and proposals do not seem to be enough to satisfy investors.

In order to reverse the crisis in investor confidence, investors need to believe that two things will happen. First, those individuals in the corporate system that have misbehaved will be punished. The tough rhetoric from regulators, prosecutors, and politicians makes punishment seem very likely. Second, investors need to see changes in the system that will preclude bad behavior in the future. In general, there are two ways to change behavior—the carrot and the stick. The U.S. government is good with the stick—that is, deterring misbehavior through a fear of legal punishment. The government can make the stick thicker, harder, and more accurate. Indeed, nearly all the proposals have dealt with more laws, better laws, and more regulation. Such measures can change some behavior, but if you really want to change behavior, offer the carrot. In fact, a well-designed incentive system can be a far more powerful motivator than regulation. In a nutshell, this idea has been the triumph of capitalism over socialism. The U.S. government, however, is terrible at offering solutions with the carrot.

When corporate scandals are viewed from an understanding of the corporate system, then solutions can be designed that enhance the system, not drag it down. For example, many view the recent corporate failures as a problem with accountants and auditors. However, the accountants in a firm are operating in an environment created by the company's management in which the accounting department is directed to act like a profit center. Instead of a tracking and evaluation function, accounting departments have also been assigned the task of smoothing earnings and even generating profits. Managers do this to boost the stock price and cash in millions of dollars of stock options. These incentive packages are offered to top managers by the firm's board of directors—the stockholders elect this board of directors. Sure, the accounting profession must share some of the blame for the recent financial meltdowns. But blame can also be shared by managers, the stock option incentive, boards of directors, analysts, and even shareholders. Trying to fix the system by looking at only one piece of it in isolation is a doomed approach. A failure to examine the entire corporate system will only lead to temporary patches and not long-term solutions.

The purpose of this book is to examine the entire corporate system, identify the problems, and propose remedies that both fix the problems and enhance the system without creating more layers of costly government bureaucracy.

Asleep at the Wheel

To gain some perspective, it should be noted that these scandals originated from the excesses of the late 1990s. Indeed, there were strong signals in the late 1990s of forthcoming scandals. However, investors did not seem to care. As long as the stock market was going up, investors did not want to ask too many questions about the behavior of the corporate system that was earning them profits.

Consider SEC Chairman Arthur Levitt's speech to CPAs, lawyers, and academics in New York. The chairman attacked accounting chicanery and earnings management practices, and promised that the agency would go on the offensive. Although the speech was given in 1998, it is reminiscent of the post-Enron environment of 2001 and 2002. In the couple of years after the speech was given, the SEC took actions against many firms for accounting manipulation and fraud. Some firms were mega firms like Bankers Trust, Cendant, Sunbeam, Waste Management, and McKesson HBOC. Other well-known firms with accounting problems included Boston Chicken, Mercury Finance, Telxon, and Oxford Health.1 But were investors upset about these corporate misdeeds? Were Congressional inquiries made? For the most part, no.

Even the largest two firms (in market value) have been under suspicion—General Electric (GE) and Cisco. The media expressed concerns about the earnings management practices of GE, and, while the company is notorious for producing increased profits every year, Money magazine claimed that earnings would have been down in 1997 and flat in 1999 had it not been for some accounting maneuvering.2 Barron's questioned the long-term viability of Cisco's practice of financial engineering.3 The article specifically questioned the accounting used in Cisco's endless string of acquisitions. Indeed, the article went so far as to call Cisco a “modern house of cards.” Again, investors did not seem too concerned about the accounting problems. After all, investors had made a lot of money investing in Cisco and GE.

However, the stock market declined (along with the economy) in 2000 and 2001. Then came the failures and collapse at Enron in the fall of 2001. Enron's managers, accountants, analysts, and board of directors all failed the investors and employees of Enron. Investors became angry at the enormous fraud at Enron and at the other firms that have subsequently announced problems. However, the problems have been brewing for a while. It has only been since the Enron debacle that investors, the media, regulators, and politicians have taken notice and demanded accountability.

The outcry against corporate greed and fraud is a manifestation of the failing confidence of investors in the corporate system, which, in turn, is partially caused by the decline in the stock market. The following sections illustrate this crisis in investor confidence and how it affects the stock market. Eventually, the lack of confidence can become a drag on the economy. The crisis needs to be reversed before too much damage is done.

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