Another week, another scandal. At least the regulators are learning from past mistakes. Having been upstaged by New York State Attorney Eliot Spitzer over conflicts in sell-side research, SEC chairman Harvey Pitt took less than 24 hours to respond after WorldCom admitted to a $3.8 billion accounting fraud.
And for once he was tough. Pitt has slapped a civil lawsuit on WorldCom, ordered the company not to destroy any documents, and forbidden it from paying any severance or bonus payments to officers, directors or employees.
Beyond that, he’s planning to force the chief executives and chief financial officers of the country’s largest 1,000 companies publicly to certify the accuracy of the financial statements in their last annual reports.
It’s the boldest attempt yet to try to restore investor confidence in America’s financial markets. He didn’t have much choice, really. The fraud looks likely to send WorldCom careering into bankruptcy, making it the largest ever in US history.
Whether his intervention can work is another matter, as the real trick lies in convincing people that there is someone, or something, competent minding the store.
It was not the SEC that discovered the fraud, for example, but WorldCom itself, although it decided to conduct an audit review after a more general SEC investigation.
The accountants didn’t pick up on the fraud – yes, it was Andersen, again. Nor did the investment bankers who are supposed to conduct vigorous due diligence on companies before underwriting and promoting their securities: the fraud was already at least five months old when JPMorgan and Salomon Smith Barney lead managed $11.8 billion in bonds for WorldCom in May last year, one of the largest corporate bond deals ever.
The same banks, joined by Bank of America, were lead arrangers on a 364-day revolving credit line that rolled over last June, and even these supposedly more cautious, covenant-loving bankers didn’t pick it up either.
Should we blame the bankers? Legally, they’re probably not liable, as they work off the same audited accounts as everyone else. Their defence is that they were misled like the rest of us. But that won’t stop Spitzer, who has already announced that he’s pondering looking for potential misdeeds by bankers.
And analysts themselves are, in private, admitting that they were, once again, caught asleep at the switch. The warning signs were there. WorldCom had higher capital expenditure figures as a percentage of revenue than other leading firms, but no-one thought to question this. Perhaps the sheer magnitude of the deceit made it harder to grasp.
The risk for the market is that other high-tech companies have performed similar manoeuvres. The areas where there is the greatest risk of more accountancy fraud is among companies that have had the highest growth and the greatest capital expenditure. The area where a sell-off would seem most justified is the TMT sector.
Analysts are now speculating that a number of other distressed telecom companies may have capitalized costs they shouldn’t have. Once again equity and credit analysts are privately conceding that they should have done a better job.
Let’s not forget the last group of financial professionals, whose collective silence on the issue of corporate governance is deafening: institutional investors.
They have been cast as the victims in the recent corporate scandals but they too, like corporate executives, analysts and investment bankers, played their part by rewarding companies that produced eye-popping earnings growth – by whatever means – with rising stock prices.
Tiaa-Cref and Calpers are the only firms that make much effort to bring corporate governance issues to public attention. But when was the last time that the really big asset managers, such as Fidelity, Putnam, Wellington and others, made a stand?
Hitting benchmarks and beating indices and peers in performance is a fine goal, but the top 40 asset managers control trillions of retirement dollars and have a crucial role to play in creating and maintaining stability in the firms that they own and the financial system as a whole. And right now they need to make that role loud and vocal.
Ownership brings responsibility.
