Regaining the Confidence

Can investor confidence in the United States be restored? Can it be restored before the current trusting investors lose all faith and never return to the stock market? We believe the answer to both questions is yes. However, rebuilding trust will require time and effort. Trust is not gained overnight. It is gained through a history of good behavior. Unfortunately, the recent history is one of poor behavior.

Politicians and regulators will not be able to regain the lost confidence through talk. For example, President Bush proposed solutions for the governance problems in a speech delivered on July 9, 2002. He recommended that punishment be increased and laws be enacted to make it easier to punish corporate criminals in the future. His focus seemed to be on personal ethics and accountability. On the day he presented his proposals, the Dow Jones Industrial Average fell 178 points. The next day, the Dow fell 282 points. This was not exactly the reaction the administration was looking for. However, there wasn't much in the speech to increase confidence. After all, ethical behavior is not motivated through prosecution and punishment.

Senator Paul Sarbanes introduced Bill S.2673, a proposal to create a Public Company Accounting Oversight Board. Recall that this bill seeks to (1) oversee the audit of public companies, (2) establish audit report standards and rules, and (3) investigate, inspect, and enforce compliance relating to registered public accounting firms. The proposal was for more regulation, and it was eventually passed as the Public Company Accounting Reform and Investor Protection Act of 2002. The bill's history shows that it was first introduced in Congress on June 18, 2002, and it then began making its way through the political process. During the ensuing weeks, senators appeared in the news and on political shows talking up the bill. The Senate passed it on July 15, 2002. Over the four weeks between the bill's introduction and its passage in the Senate, the Dow fell 1,048 points. The day after the bill passed, the House passed a similar bill and Alan Greenspan spoke to Congress. He seemed to have two important things to say: First, he was upbeat about the economy; and, second, he agreed with proposals that executives should be held accountable to accurately state the financial condition of their firm. On this day, the Dow fell 166 points.

So neither talk alone nor enacting laws restores confidence. How is confidence regained after the trust has been broken? To answer this question, we should remember that trying to restore trust is a frequent occurrence in our society and in our lives. Restaurants work to regain a community's trust after an outbreak of food poisoning . A professional sport has to recapture fans' faith after a players' strike or an owner's lockout. And, of course, broken trust in a personal relationship (like in a marriage or between a child and parent) can happen to anyone . Unfortunately, restoring confidence in the corporate system is more difficult than it is in a personal relationship. This is because there are so many different participants in the system. While some are working hard to restore confidence, others are stonewalling the system and denying any wrongdoing.

There are several steps that need to occur in order to restore investor confidence. The first step is admitting that the trust was broken. Investors know that they lack confidence in the system. Politicians and the media have also expressed their anger at the breaking of trust. Regulating agencies like the SEC and the NYSE admit problems. While all this is useful, it is those groups that are directly involved with the scandalous behavior that need to step forward the most. Executives, auditors , boards , banks, and analysts must admit to the public that mistakes were made. Many of these groups and people are working within their own associations and professional groups to refocus themselves on their monitoring roles. In addition to these efforts, they need to address investors (the public) more directly. Quietly working to improve things is not enough. They need to be as creative and persistent in marketing their own participation in the solutions as they are in promoting their firms' products and services.

The individuals who are being investigated will not admit their crimes. Their lawyers will not let them unless it is in conjunction with a plea deal with the Justice Department. Anonymous people associated with the scandalized firms will not speak for fear that the spotlight will turn on them. Therefore, it is up to the executives at the good firms to speak. It is up to the ethical auditors and moral investment bankers to speak out against their colleagues. When these people keep quiet, the investor thinks that they are either protecting their colleagues in a "good-old-boys" network or have worries of their own. Neither belief leads to trust.

The second step is to fully explain how and why the trust was broken. In the rush to fix investor confidence, many public leaders forgot to actually find out what was wrong with the system. They were quick to blame one group or another ”such as auditors. In general, this approach leads to enacting laws that treat the symptoms and not the disease. The new laws for auditors are a good example. The Public Company Accounting Reform and Investor Protection Act tries to anticipate every problem with conducting an audit and assigns a law or regulator to overcome it. However, taking the time to learn how the entire system operates ”or fails ”would allow public leaders to address the system of problems instead of the multitude of symptoms.

We hope that this book helps investors identify all the participants in the corporate system and explain their participation in the breaking of the trust. We urge public leaders, regulators, and the media to do more than just look down their noses at the unethical evildoers and educate investors on the incentives for this behavior. When investors truly understand why the scandals occurred, they will be more willing to accept the fact that the problems can be fixed. The system really can become trustworthy again.

The third step is to punish the criminals and restore a measure of restitution. Before investors can truly get over their anger and mistrust , they need to feel that the people involved in the scandals are being severely punished. By severely punished we mean fines and prison terms that are greater than those received by the white- collar criminals of the 1980s. The infamous junk bond king Michael Milken served only 22 months in jail. Arbitrageur Ivan Boesky served only two years in prison. Charles Keating of the savings-and-loan disaster served four and a half years in prison. Oh, and by " prison " we actually mean a cushy, no-walls jail often referred to as Club Feds. Contrast this with another financial crime. Coleman Nee robbed two banks for $500 each in Boston and received a sentence of nearly five years. ^[6] Yet, his ill-gotten gains wouldn't have even paid for the $6,000 shower curtain Tyco's former CEO Dennis Kozlowski charged to his shareholders.

These corporate scoundrels could never repay the losses experienced by investors. Therefore, true restitution is not possible. However, for investors who lost a great deal of their wealth, like Enron employees , it is not comforting to see the wealth that white-collar criminals of the previous era were able to keep. For example, while Milken paid $1 billion in fines, penalties, and civil settlements, he was allowed to keep $125 million. His family members were allowed to keep more than $300 million. ^[7] Boesky was allowed to keep his foreign bank accounts.

The government appears to want to severely punish the corporate scoundrels. As we discussed in Chapter 12, the new laws passed in the summer of 2002 provide for stiffer maximum penalties and increased average sentences. However, having so many scandals to investigate and prosecute at the same time takes its toll on the system. Both the Justice Department and the SEC are working on more cases than ever ”and they are doing so with overworked employees. These cases are complicated, and it is hard to know exactly what charge to make and if it will stick. With all that Arthur Andersen contributed to the Enron collapse, it was convicted of only one count of obstructing justice. Of course, that was enough to bring down the firm, but is that action enough to enact severe punishments on the scoundrels?

The fourth step is to fix the system so that these problems won't happen again. Finding solutions to fix the corporate governance system is difficult. As we have argued, some proposed solutions would not have much effect, and other solutions could inhibit capitalism too much. Choosing the right balance is challenging. We advocate creating good incentives to motivate the corporate participants so that they will want to work hard to do the right thing. Laws that simply make bad behavior illegal sometimes get watered down during the next big economic expansion. Regulators find that over time, their budgets do not grow with inflation and sometimes even get cut. We thoroughly discuss government action and other proposals in Chapter 12 and our recommendations in Chapter 13. The solutions are not easy. Yet, just fixing the system is not enough. Investors have to be convinced that the solutions will really work. That is, the people have to first have confidence in the solutions before they will have confidence in the market. To have confidence in the solutions, the people will need to understand both the causes of the problems and how the new laws and regulations solve the problems. Therefore, investors should not just be educated in the failures of the corporate governance system, but they should also be made aware of how the solutions actually prevent failures in the long term .

Confidence can only be regained over time. Therefore, the last step is to prove that the system is trustworthy over time through good behavior. Remember, trusting investors began to invest in the stock market only after a history of good performance. They stopped investing only after a history of poor performance and a string of scandals. To expect investor confidence to be restored quickly is na ve and does not recognize the process of building trust.

Before we can witness the better behavior by the participants in the governance system, the system has to really be fixed. Many of the laws enacted in the summer of 2002 will take time before they can be implemented. It will be even longer before they affect behavior. Consider, for example, the Public Company Accounting Oversight Board that Congress created to oversee the auditing profession. By mid-fall of 2002, the SEC had not yet found the people to sit on the board. Indeed, the board has yet to hire staff, create bylaws and policy, or certify auditors. This process is going to take a while to get right. Also, consider the new listing standards that the NYSE has enacted. The NYSE allows up to one year for its listed companies to make the changes it wants to their boards. The solutions take time to implement. Afterward, investors can witness the behavior of the corporate system. If the system earns the trust of investors again, investors will regain confidence in the market.