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A Year of Corporate Scandal

Has enough been done to prevent a repeat?

In 2002, Texas prosecutors drove Arthur Andersen L.L.P. out of business. New York's attorney general fined Citigroup hundreds of millions of dollars. Adelphia, Enron and Rite Aid executives were charged with criminal fraud. President Bush demanded a new accounting standards board. And Congress passed the Sarbanes-Oxley Act, which urges more independence for corporate lawyers, auditors and boards.

Will all this really make corporations behave?

Investors, lawyers and even some regulators say it will take more than new laws and showcase prosecutions to keep powerful businesspeople honest.

"No set of rules issued [under the federal Sarbanes-Oxley securities law] or any regulation of the SEC is going to allow you to see every I dotted and every T crossed," warns veteran stock-picker Jim Meyer, principal at Tower Bridge Advisors in West Conshohocken.

Even with increased scrutiny and new laws, there will be more frauds, Meyer said. "If people are shocked, they shouldn't be," he said. "They're kind of repulsed by it today, but that's because we all lost a lot of money and we all want to blame it on someone else. But we all share some of it."

How is it investors' fault? Big pension and mutual funds, who own the most stock, should have known better, Meyer said. "We knew analysts were influenced by their investment-banking department to [recommend] stocks. That's not a new revelation. That's like the old snake-oil salesman out West - he succeeded because you wanted to believe what he was telling you. That's what happened in 1999 and 2000."

The air has cleared - for now, Meyer says. "A few years ago, corporations were running to the mantra that 'Growth for growth's sake drives stock prices and will be rewarded with a higher stock price,' " he said.

The message is different today, Meyer said. Investors want "transparency" in a company's financial reports, meaning the numbers and footnotes should be easy to understand.

This new "cynicism is a very healthy thing, as long as you remember the lesson," Meyer added. But, he said, it is more likely that "investors will forget and reward growth and not care when it happens again in the next speculative cycle."

The Sarbanes-Oxley Act, signed by President Bush in July, only affirms what companies have long known about leaving directors and auditors free to make tough decisions, said Arthur "Ari" Gabinet, the Philadelphia securities lawyer tapped earlier this month to head the Securities and Exchange Commission office in Philadelphia.

Still, Gabinet hopes the SEC will be able to do more once the Bush administration makes good on its pledge to boost funding. "That will make people understand that this administration is serious about enforcement. Hopefully, that will bring investors back," he said.

A fan of the "incredibly charismatic and energetic" Harvey Pitt, who quit last month as SEC chairman, Gabinet welcomes "the new focus on accounting," which will make it easier for the sophisticated investors who are capable of "making sense of information" to make smart investments.

But Gabinet doubts any amount of regulation will make it possible for "the small investor to be able to pick up a 10-K [annual financial report] and at least understand what is going on." Small investors will always be at a disadvantage.

As an example, Meyer pointed to the documents associated with the complex acquisition of AT&T Broadband by Comcast Corp. during 2002. "Putting together 500-page prospectuses like the AT&T-Comcast [merger] prospectus is fine for the analyst, I suppose. But the average investor in AT&T or Comcast is going to get this phone book, be completely overwhelmed, and get rid of it," he said.

Richard Levan, a former SEC official who is now a Philadelphia lawyer who represents investors, says regulators' direct impact on public companies is limited, but the potential for pressuring Wall Street brokerages is greater.

While the SEC can do little more than harass public companies to improve their filings, brokerages "have become far more vigilant" because the SEC can take their licenses away, he said.

"I think it's terrific" that brokerages are feeling pressure, said Thomas Egan, a retired investment banker in Malvern. "The only problem is that no one gets criminally prosecuted. They're afraid it will crumble Wall Street! This is fraud, and there should be punitive actions taken."

Still Egan argues that Wall Street has been operating the same way for years. When he worked at now-vanished firms such as Furman Selz and Montgomery Securities, it was common practice for brokerages to give lucrative initial public offering stock to big, favored customers, he said. The practice was one of several targeted by New York Attorney General Eliot Spitzer in the $1.4 billion settlement signed by the nation's biggest investment firms Dec. 20.

Typically, big mutual-fund families and retail brokerage chains would get first crack at the shares of newly listed companies. By contrast, small investors could not get in the door, Egan said.

"It's laughable that people are acting so shocked, so indignant," Egan said. "For regulatory people to act like this is something new is bogus."

Industry lawyers complain the Sarbanes-Oxley law has made it tougher to find directors - especially for audit committees, which must include people with experience as chief financial officers and independent auditors. However, many companies are reluctant to put competitors' CFOs on their boards and independent auditors may be barred by their employers from serving as directors.

Also, the stricter rules "have made the board meeting a two-day event," said Michael Pollack, a partner at Reed Smith L.L.P. "More committees are meeting on more agendas. The time commitment has increased."

LeVan disputes there is a shortage of qualified board members, even under the new rules: "There's a lot of retired CFOs and auditors who'd love to fly around the country and serve on a corporate board for $50,000 a year," he said.

Pollack said the Sarbanes-Oxley law pressured lawyers to be more active in informing authorities about possible wrongdoing by their corporate clients. That could have the unintended side effect of corporate management being less likely to consult legal counsel. Lawyers would then have less of an opportunity to warn against illegal conduct. The end result could be more corporate misconduct, not less, he said.

What would push companies to change?

Corporate executives often say they feel pressured by mutual-fund and pension managers' demands for higher earnings. But Josh Brooks, a chief investment officer at Delaware Investments in Philadelphia, says executives were the biggest beneficiaries of exaggerated profits - thanks to their "astonishing" stock-options packages.

"Take away the potential for that kind of growth, and you take away the potential for funny accounting," Brooks said.

Who has the power to stop executives from enriching themselves?

"The one group of investors who have been remarkably silent are the institutional investors. They've traditionally been a lapdog of management," said Tower Bridge's Meyer.

"Microsoft would provide even better [investment] returns without their excessive stock-options program," he added. "Why not vote against it? If large institutional investors like Fidelity and Vanguard voted against it, you watch how fast compensation would come down."

In fact, the Vanguard Group voted against 64 percent of all corporate option packages at companies it invested in last year, the mutual-fund company told the SEC in a recent letter. The Malvern company said its private pressure had forced at least a few companies (which it would not name) to curb their selfish behavior.

But Vanguard will not say which plans it approved - and, like other mutual-fund companies, it opposes an SEC plan that would force it to disclose those votes.

Disclosure would be too expensive, and it would invite "so-called 'corporate responsibility' " activists to interfere with fund managers, Vanguard general counsel R. Gregory Barton told the SEC in a Dec. 5 letter.

Vanguard founder John C. Bogle disagrees.

It is "self-evident that each mutual-fund shareholder has the right to know" how his or her shares are voted, Bogle said in an article he wrote a week after Vanguard sent in its testimony.

"Shareholders are partial owners of the stocks," Bogle added, calling on mutual funds to publicize their votes or stop making claims about their impact which "lack credibility."

Indeed, Bogle blamed "the recent stock-market bubble and the bear market that followed" on mutual funds and their failure to demand companies put their owners' interests first.

Joseph N. DiStefano's e-mail address is jdistefano@phillynews.com

Copyright 2006. Richard A. Levan. All rights reserved