The Cause of the Corporate Collapse—and Its Cure
Ohe secret to restoring investor confidence and the health of American business lies in the proper identification of the causes of the corporate scandals of 2002 and the accompanying market collapse. Despite the Commission's craven and predictable prostitution of itself to the accounting and legal interests, the news is not necessarily all bad.
The Sarbanes-Oxley Act, of which I approve for a number of reasons, treats the problem as one of the failure of transparency in financial disclosure permitting corporate managers to manipulate earnings and put out misleading, if not illegal, disclosures of corporate financial positions.
To some extent this is accurate. But much of the Act's concerns can be addressed by vigorous enforcement by the Commission and the Justice Department of existing law. Nonetheless, the Act is a needed corrective in reversing Congress's and the Supreme Court's thirty-year deregulation of the securities laws and as an important public statement of Congressional intent that the laws actually be enforced.
This has had a significant positive effect on investor confidence in the market, although more needs to be done. That more comes from understanding the real causes of the collapse.
The real cause of collapse, and one at which the Act doesn't directly aim, is the culture of short-term investing and the resulting short-term managerial perspective that has built up over the last twenty years and led to a managerial ethic that focuses on increasing short-term stock price at the expense of the long-term health of American business, our markets, and our economy. If you live by the short-term, you die by the short-term, and that is what we have seen.
As the Commission has fleshed out the Act under its proposed regulations, the Act may nonetheless have the effect of reversing this ethic and encouraging managers to manage business instead of finance, giving investors the opportunity to profit by becoming long-term investors in America rather than in-and-out traders looking for a quick buck. I'll summarize the causes of the collapse rather briefly, and then I'll show how the Commission's rules can have this effect, as well as suggest an additional solution to the problem.
Short-termism is the product of twenty years of sometimes related and sometimes unrelated events in American history and business. It begins with the election of Ronald Reagan. After the years of "malaise" under the Carter administration, Reagan preached the gospel of greed as beneficial to society. It was a gospel we were ready to hear, and it took root.
Just a few years later, the takeover boom of the ’80s began. This showed stockholders that they could indeed profit in the short-term rather than waiting to realize their corporation's ultimate value by holding for the long-term. Investment strategy became a game of handicapping the next big takeover target and investing in it. Of course this didn't affect every corporation, but it did have a pronounced effect on investor expectations and mentality.
By 1990, the third piece of the puzzle was in place. Institutional investors owned approximately 50% of the United States' equity markets, a position they continue to hold. At the time, many of my colleagues hailed this development as solving the age-old problem of the separation of ownership and control. Finally we would have a concentrated and powerful group of owners monitoring corporate management. As I wrote at the time—and was roundly ignored—this was a bad idea. You see, institutional money managers are compensated on the basis of short-term performance. So the kinds of pressures they have put on management are not for the long-term health of the company to realize their gains over time but to pump up the stock prices in the short run so their compensation rises. All you have to do to see this is look at the websites of the allegedly most active institutional investors—TIAA-CREF, CalPERS, and the AFL-CIO funds. It's all about removing takeover protections, which is all about the short-term.
The next development is the 1993 amendment to the tax code encouraging compensation in executive stock options rather than cash, Again this was celebrated as aligning managerial and investor interests. Problem was, there were no time constraints on executives holding the optioned stock. So again, short-term incentives. And the impact on the market is big—as recently as 1999-2000, 15% of market capitalization consisted of stock optioned to executives.
Finally, we have the bubble market of the 1990s, bringing in a whole new class of investors who had never been in the market before. They were conditioned to expect huge capital gains fast, and their in-and-out trading to realize this dramatically increased stock price volatility and gave managers an incentive—as if they didn't have enough already—to manage stock prices rather than business, to keep their stock price increasing, to keep from being taken over.
Of course it's hard for the average business to keep posting gains quarter after quarter after quarter. So how do you do it? You monkey around with the financials, first within the loose confines of GAAP and then, in some cases, by outright fraud.
So the real story is one of incentives, and the best solution addresses incentives rather than attempting direct regulation. Of course we need to throw the criminals in jail—that creates one kind of incentive, and a necessary and just one. But there are others. I'd first like to describe one approach that I've suggested elsewhere that creates negative incentives for short-term trading and positive incentives for long-term holding, although I don't have time here to flesh out all of the details. I then want to describe the ways in which the proposed regulations under Sarbanes-Oxley help to destroy the incentives—or at least the utility of managing earnings for the purpose of focusing on short-term stock prices.
If the problem is incentives, let's address incentives. As much as one would hope that the SEC is adequately funded to serve as an effective policeman and, through its civil enforcement powers (although the President is doing his best to avoid this) and the Justice Department's prosecutorial powers, crimes will be punished and violations deterred, this doesn't seem likely and surely not enough. For enforcement, while it does provide incentives against violation of the law, usually has its greatest effect after the violations have occurred. Far more effective would be preventing the violations from happening in the first place.
The way to create the proper incentives for this is through revision of the capital gains tax laws. Right now we have a two-way on-off switch for capital gains taxation, with one period serving all as defining the long-term. But serious investors—Warren Buffett most prominent among them—have correctly made clear that one year is not the long-term when it comes to investing in stock. Instead what we should do is select for each industry an appropriate long-term, and then tailor a sliding scale capital gains tax to that particular industry. Take the auto industry as an example. Let's assume, for purposes of discussion, that we determine that ten years is the long-term in the auto industry. We could tax very short-term trading—say one month or three months in- and-out—at punitive levels of, say, 75%, with a sliding scale down to the point where we don't tax capital gains at all on stock held for the full ten-year period. Of course we'd need to make exceptions for professionals like specialists and market makers who actually help to stabilize the market by short-term trading. And we could have an appeals process for those who sell by necessity, say a medical emergency, at least for the punitive period until the capital gains rate approaches the top marginal rate on ordinary income.
But these important details aside, the power of this approach to alter the incentives for short-term investing and, with it, short-term managing, is clear. It is an approach that Congress should seriously consider, for by adopting it we can change the investing and managing culture of this country in a way that will benefit us, our children, and our children's children, and maintain the economic preeminence of the United States. If we fail to do this or something like this we will, in the long run, be doomed to the same economic second class status as befell the once dominant Portuguese, Spanish, Dutch, and British.
The Act does not address the root problem of short-termism. But in certain provisions of the Act, and even more in the regulations proposed by the Commission, one can see the tools necessary—if not sufficient to reverse the short-term managerial ethic. For in these statutes and rules are the seeds of the destruction of the utility of managing earnings. If managing earnings can no longer serve its purpose of misleading investors, then the incentive to manage earnings will disappear. As a result, we could well see managers return to the economically and socially important task of managing businesses rather than stock prices.
There are a number of places where these tools are introduced. They include the Commission's rules requiring the clear explanation of non-GAAP financial information (which means pro forma financial statements which means earnings projections), rules governing the clear explanation, disclosure, tabular presentation, and discussion in the corporation's Commision filings of off-balance-sheet financing, CEO and CFO certification of financial statements, with the Commission's added emphasis on cash flows as well as their additional requirement that these officers certify as to the general fairness of the corporation's financial presentation, and not simply the GAAP presentation, should also help.
Taken together, these provisions and regulations effectively demand that any attempt to manage earnings be clearly disclosed and explained as such and that the absence of an attempt to do so be certified by the CEO and CFO. The incentive to manage earnings is destroyed—it can't be hidden any longer. Any attempt to circumvent this incentive change exposes the corporation's CEO and CFO to liability. Without the opportunity to manage earnings, increases in stock prices can only come from real earnings, real cash. The Act and its regulations have the potential to return managers to managing businesses, rather than managing financial statements, and leading corporations and their investors to reap their profits the old fashioned way—by earning it.
Professor Mitchell is director of the Sloan Program for the Study of Business in Society and the International Institute for Corporate Governance and Accountability. He joined the George Washington University Law School faculty in 1991 after having taught at Albany Law School since 1987. For six years before entering academia, Professor Mitchell practiced corporate law in New York City. His teaching and scholarly interests include corporate law and finance, and jurisprudence. Professor Mitchell has had articles on corporate law published in the Cornell, Pennsylvania, NYU, Duke, Vanderbilt, Texas, and Toronto law reviews, among others; he is the editor of Progressive Corporate Law (1995), and he has also co-authored a casebook, Corporate Finance and Governance, with Professor Lewis Solomon. His book Stacked Deck: A Story of Selfishness in America was published by Temple University Press in 1998 and was submitted for the Pulitzer Prize in general non-fiction. In 2002, Yale University Press published his most recent book, Corporate Irresponsibility: America's Newest Export.
Copyright © 2003 The Baltimore Chronicle and The Sentinel. All rights reserved. We invite your comments, criticisms and suggestions.
Republication or redistribution of Baltimore Chronicle and Sentinel content is expressly prohibited without their prior written consent.
This story was published on February 10, 2003.