Asleep at the Wheel

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.

Investor Attitude

A crisis in investor confidence means that the very people who support the corporate system become disillusioned with the system. The corporate form of business relies on investors to fund a company with capital through the purchase of its stock. The dynamics of the corporate system are described in the next chapter. However, the role of investors is a critical component to the corporate system and to capitalism in general. So, is there really a crisis in investor confidence? One way to find out is to simply ask investors.

United States Trust Company frequently surveys Americans deemed to be in the wealthiest 1 percent. Their 21st survey occurred in 2002 and included several questions about confidence in the corporate system. [4] Before we examine the responses, we should get to know the people considered to be in the wealthiest 1 percent of Americans. People are considered to be in the top 1 percent if they either have a net worth of at least $3.75 million or earn at least $300,000 annually. In addition, most of these people created this wealth themselves ”only 5 percent inherited wealth. Indeed, nearly 70 percent of respondents said that they grew up in a middle class or lower household. So, how did they create this wealth? Generally, they became wealthy in the business world. For example, 41 percent thought their corporate employment was a very important source of their wealth. Family-owned business was a very important source of wealth for 37 percent of those surveyed. In other words, these people know about business. They have worked in the business world for several decades and were able to create wealth for themselves . They are business insiders.

How do these insiders feel about the corporate system? Figure 1-1 shows the percent of those surveyed who agree with various questions about investor confidence. First, 38 percent are wary of investing in public companies. These affluent Americans mostly obtained their wealth through the business world, yet more than one third of them are wary of public companies! Why are they concerned ? The graph shows that 76 percent of those surveyed do not trust public company financial statements, 73 percent do not trust equity analyst recommendations, 66 percent do not trust corporate management, and 58 percent do not trust auditors . If these business insiders lack confidence in the corporate system, then the rest of us should too!

Figure 1-1. This graph shows the percent of affluent Americans who agree with the statement about confidence in the corporate system. Source: U.S. Trust Survey of Affluent Americans, June 2002


These attitudes are bad news for the economy because the wealthy are likely to reduce their spending as a response to their drop in wealth and mistrust of the corporate system. For example, 41 percent of those surveyed stated that they were likely to postpone home improvements, 39 percent will cut back on big-ticket purchases, and 37 percent will postpone the purchase of a new car or boat. If this reduction in spending actually occurs, it will hurt the economy. Both consumer spending and business spending drive the economy. If consumers reduce spending, the economy will be adversely affected.

The average investor also seems to have lost confidence in corporate America. CBS News conducted a poll of 685 people on July 8 and 9, 2002. [5] When asked, 79 percent of the respondents thought questionable accounting practices were widespread, 68 percent thought insider trading was widespread, 67 percent thought American corporate executives were not honest, and 57 percent thought white- collar crimes happen very often. Investor reaction to the scandals can be seen in the media, which often reflects an audience's mood. Print, radio, and TV media frequently bring up the crisis in investor confidence. Newspapers are printing many letters to the editor from readers on the subject, and thousands of messages are being posted on stock-oriented discussion boards . Will the lack of investor confidence also translate into changes in consumer spending?