Companies, CEOs, directors, auditing firms, analysts, and investment bankers have all suffered from a loss of reputation and legitimacy. Confidence in these individuals and institutions is very low. Witness the number of antibusiness articles and media commentary, the negative findings of public opinion polls such as the report of The Conference Board mentioned previously, and the dramatic increases in restatements of financial statements within the past few years. The assessments of the situation and responses of the individuals and institutions that are now held in low regard varies tremendously and generally fall into three categories.
In the first category, many executives and directors simply continue to ignore the issue or simply hope that it will go away. Either they are in a state of denial or are so self-absorbed that they believe meaningful criticism of them is unthinkable. To the extent that they recognize that confidence in them has been lost, they assume it will be restored as soon as the markets recover. Some have simply not accepted that they are largely responsible for both the market bubble and decline and even view themselves as among the victims.
In a free economy, the abuses of a few very large enterprises can have many secondary impacts. In economics, this is called the multiplier effect.
A second group recognizes the loss of confidence but believes that by saying “it just ain’t so” it will be restored. Members of this group routinely declare that governance problems have been solved. As evidence, they point to their compliance with good governance checklists. They blame poor stock market performance on something other than governance and keep talking up stock prices by spinning growth stories, manufacturing earnings, and downplaying risks.
Yet a third group believes that the market may not recover substantially for an extended period or until real reform and fundamental change occur. In this scenario, the restoration of confidence has to precede a real recovery. The authors of this book fall into this category.
The current crisis in confidence differs from the many that preceded it. In previous crises, investors lost faith in executives’ and directors’ judgment and their ability to adapt strategies that would make their companies successful, like those who saw the dominant companies in the 1970s and 1980s disappear. While investors questioned the understanding and judgment of their fiduciaries, there is no ethical, moral, or legal requirement that fiduciaries must be right; they are only obligated to try to be so. In contrast, in the current crisis, investors believe that they were lied to and purposely misled.
In short, the legitimacy of corporations, executives, boards of directors, Wall Street bankers and analysts, accountants, institutional money managers, and many participants in the economic system is being questioned. Federal legislation has mandated a new oversight board for the accounting profession. Proposals have been made to establish an oversight body for mutual funds. Major stock exchanges and other regulatory bodies are dictating board committee structures, profiles of directors, new reporting requirements, the number of required board meetings, and who may attend, while some are facing increasing public criticism of their own governance practices. Investment bankers and analysts have been attacked, and independent research has been mandated— although ineffectively at the date of this writing. Trade unions have attacked corporate governance and ethics and have demanded transparency, even while remaining virtually opaque themselves and diverting large portions of membership dues to their leaders. Finger pointing is rampant.
- Chris Cole, director of Peregrine, begins selling 500,000 shares over next 9 days.
- Company fires auditor Arthur Andersen and hires KPMG.
- Peregrine announces it will delay earnings report to allow KPMG more time to review books.
- Shares fall 50% to $3.45 on announcement of delay in filing quarterly earnings report.
- Company announces it has launched internal investigation and may need to restate up to $100MM.
- CEO and CFO resign.
- SEC opens investigation.
- Company announces that it has fired KPMG as auditor.
- Gary Greenfield hired as CEO. Rod Dammeyer resigns from board. Eric Deller, general council, resigns.
- KPMG announces it was fired for uncovering accounting fraud beyond original scope.
- Peregrine hires PricewaterhouseCoopers as new auditors.
- Nasdaq announces it will delist Peregrine the following month due to listing violations.
- Bondholders express concerns over financial affairs.
- Company announces plans to restate reported revenue by $250MM or 19% of sales and $103MM in additional debt.
- It files for Chapter 11 bankruptcy protection.
- U.S. Justice Department launches criminal investigation into accounting issues.
The implications of this cannot be understated. Simple loss of confidence in the judgments of leaders can be fixed by recognizing new winners and leaders. Lost legitimacy requires real changes to the system. The longer it takes to adopt and follow governance principles that benefit everyone, the more drastic those changes must be. The principles outlined in Principles of Good Governance can help reinforce, reinvigorate, and legitimize the system that everyone once thought was working so well.
In the absence of changes like those proposed in Principles of Good Governance, a new system may have to be created. Unless boards of directors and executives take meaningful actions to address past lapses and go beyond lip service, something else will replace their offices and positions. Those mechanisms will likely be legally mandated, with power shifted to more centralized authority and arguably more subject to political pressures that are often more emotional than reasoned.
This legalistic path is not one that many want to take, but vacuums of responsibility are always filled. Even worse, unless accountability changes in the capital markets, there could be a real loss of legitimacy for democracy and the United States. Free markets and democracy can exist independently, but they are closely linked in the world’s perception of the United States. Because of a committed work force and sophisticated markets, America has succeeded in delivering relatively sustained growth. Through a dynamic political system, the country has extended economic success to a great majority of all productive workers. There is little doubt that the United States has done a better job of creating financial well being for its citizens than most countries. That success, however, has fostered dislike or even contempt in other parts of the world, even among U.S. allies in Europe.
The principles of good governance discussed in Principles of Good Governance, if adopted and followed, will work to help restore legitimacy and confidence.
Over the past decade or two, America has encouraged both democracy and free market initiatives, including privatization and entrepreneurship, in Asia, the Middle East, and parts of Africa. Growth in those economies accelerated as a result. We may have been less successful at introducing the checks and balances required to ensure that the benefits of a free market economy reach a substantial proportion of the population. In some instances wealth has become concentrated in very few hands and many around the world may indirectly blame America for an increase in their relative poverty.
Against this backdrop, the United States simply cannot ignore even a hint of a loss of legitimacy. The risks are too high. The misconceptions and misalignment of interests discussed in the The Alignment of Interests are not harmless. The abuses of options explained in How Options Work contributed significantly to the loss of confidence. Playing the Share Price Game (The Share Price Game and How to Spot When the Game Is in Play) had sobering consequences. The paucity of corporate checks and balances covered in The Balance of Power permitted abuses involving income distribution, market inefficiency, poor capital and labor allocation, and bankruptcy. The Measure of a Board lays out the need for more independent, effective, and informed boards, the fundamental requirement of good governance. In the absence of better boards, the U.S. economic system is threatened. The principles of good governance discussed in Principles of Good Governance, if adopted and followed, will work to help restore legitimacy and confidence.
Investors should insist on real reform. They cannot fully trust again until their trust has been earned and mechanisms put in place to verify that such trust is deserved.