Chapter 1. The Importance of Investor Confidence

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.