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...compensation have profoundly shaken the confidence of investors. Yet the loss of public trust was not solely attributable to the greed and ethical deficiencies of the perpetrators. Those failings, however regrettable, are expectable. Perhaps even more affecting to investors was the growing realization that their faith in the legal and regulatory oversight mechanisms that were established to monitor and prevent the kinds of misdeeds that occurred had been grossly misplaced.
Some of our most venerable fiduciary institutions have been culpable. The boards of large publicly-held corporations, public auditors (CPAs), brokerage houses, mutual funds, the New York Stock Exchange and the federal government have all contributed to investor insecurity. Shareholders from individuals to the giant pension funds no longer know whom, if anyone, they can trust.
Collectively, the breaches of trust by some of the major institutions undergirding the legal environment of business may have far-reaching and long-lasting consequences, the parameters of which remain to be seen as the scandals--and the responses to them--continue to unfold. This article identifies and discusses inherent conflicts of interest as contributing factor to the scandals within each institution. Part I assesses the loss of trust among investors and the general public in these financial institutions, as measured by various surveys. Part II reviews the specific transgressions of trust that have aroused the investing public's sense of betrayal by the trusted institutions. Part III then discusses some of the major legal reforms, public and private, that have been implemented or proposed to prevent a recurrence and restore investor confidence.
MISPLACED TRUST
Evidence of eroding investor confidence among the 50 million Americans who own stock is unmistakable. (1) A recent Gallup survey said that 26% of U.S. investors are "less likely" to invest in mutual funds following disclosures of widespread improper trading at money-management companies. (2) The poll also said that 70% of investors "would consider" moving their investments out of funds named in the investigation; 20% said they would "definitely" move their money out of such funds. (3) In another poll, 43% of investors said dishonesty was the biggest issue facing the securities industry--up from 8% in 2001. (4)
A correlate recent survey found that 74% of the general public respondents indicated that their perceptions of a company's ethical behavior directly influenced their decision to invest in the company's stock. (5) Alarmingly, the study showed a yawning gap when comparing public perceptions with those of top executives from the nation's largest corporations. For example, 71% of the general public respondents said that, at best, "only some" of the top 1000 corporations in America operate in a fair and honest manner, 32% said "very few," and 6% said "none" operate ethically. (6) In contrast, 79% of executives surveyed believed that "most" or "almost all" of the top 1000 corporations in America are operating in a fair and honest manner. (7) According to the survey's author:
This survey only reiterates the immense impact of trust on our
corporate economy. Companies simply cannot underestimate the
destructive effects of ethical missteps on their short-term profits
and long-term reputations. The findings of this study reveal that,
despite the advent of regulatory measures and the compliance of a
well-informed few, most organizations are just not doing enough to
change longstanding and bitter perceptions among the lay
public. (8)
In Gallup's annual national poll of professions most admired for the honesty and ethics of their practitioners, only 18% of those surveyed indicated "Business executives," which was even better than "Stockbrokers" (15%). (9) Other polls reflect this distrust. Beginning in 2002, the Conference Board reported findings on public perceptions of the corporate scandals. Of the surveys addressing the prevalence of corporate wrongdoing, one survey found that 46% of the public believes: "Every company does this kind of thing, but only a few more will get caught." (10) In another survey, 79% felt that the practice of corporate executives taking improper actions to enrich themselves at the expense of their corporation was widespread. (11) When asked in the same poll who can be trusted, only 23% said "CEOs of large corporations," whereas 75% trusted "People who run small businesses." (12) And in a survey of employees, 37% said that in the previous year alone they had observed misconduct that they believed could result in a significant loss of public trust if it became known. (13)
Public consciousness of crises tends to congeal around particular symbolic events. When recalling the deeds that eventuated in former President Nixon's 1974 resignation, for example, most people would probable reference one botched break-in in the Watergate Hotel. Perhaps the events that most symbolize the nadir of the current wave of corporate scandals were the ousters of Harvey Pitt and Richard Grasso. Both were individuals in who were reposed large measures of public trust by virtue of their positions.
Harvey Pitt was chair of the Securities and Exchange Commission (SEC). The SEC is the primary federal government watchdog of corporate financial practices. But in November, 2002, Pitt was forced to resign because he had not revealed that his appointee to the Public Company Accounting Oversight Board (hereafter the PCAOB), the new regulatory body established by the Sarbanes-Oxley Act 14 to regulate public audits and financial reporting, had problems of his own in this area. (15)
Richard Grasso was chair of the NYSE. Amidst a continuing wave of scandalous reports of excessive CEO compensation--sometimes at failing companies--was revealed Grasso's outrageous $188 million compensation package. Grasso resigned under pressure in September, 2003.
THE TRUSTEES
The Public Accounting Profession
Although Arthur Andersen & Co. received the most notoriety, the entire public accounting profession was stigmatized by the corporate scandals. Enron, WorldCom and other corporate collapses were widely seen as a failure of the profession which is perceived as Public Watchdogs certifying the honesty and accuracy of corporate financial reporting. (16) The CPA firms whose incompetence failed to detect corporate reporting fraud were now rubber-stamps; the firms complicit in the fraud were foxes guarding the henhouse.
Critics maintained that the expansion of CPA firms into myriad new and highly lucrative non-auditing services (e.g., management and financial consulting) had compromised their objectivity. Simply put, a conflict of interests obtained. Some CPA firms succumbed to the conflict. In so doing, they breached their responsibility to those in the public arena who rely upon CPA certification of financial statements--existing and potential investors, lenders and the government--in favor of private gain.
Arthur Levitt, a former SEC chair, had railed for years against this inherent conflict of interest. But he needed (and sought) Congressional support to fix it. Formidable forces opposed him. The public accounting profession, especially the global accounting firms--whether it was the Big 8, Big 6 or Big 5--coveted its self-regulatory prerogatives in general and the substantial consulting revenues in particular.
In his book, How the Accounting Profession Forfeited a Public Trust, (17) Mike Brewster details how the profession's trade association, the American Institute of Certified Public Accountants (hereafter the AICPA), fought Levitt's proposal--even after enactment of the landmark Sarbanes-Oxley Act, the reform legislation passed in 2002 in reaction to the scandals. Sarbanes-Oxley threatened the public auditing industry in two major respects. First, it threatened the industry's autonomy. Second, it specifically endorsed the Levitt proposal by outlawing public auditors from performing a wide variety of non-auditing consulting services to their auditing clients. (18) The AICPA hired lobbyists to recruit Congressional legislators sympathetic to the profession, including Representative Michael Oxley (R-Ohio). Writes Brewster: "There may be no greater irony in the wars of accounting reform than Oxley's name being attached to the legislation, as it endorses essentially what Arthur Levitt wanted in 2000, which is just about everything Oxley had fought against on this issue." (19)
After WorldCom announced in June, 2002, that it had overstated earnings by $3.6 billion, any major resistance to the reform withered. (20) So the AICPA and its allies tactics and fought a rearguard action to weaken the implementation and enforcement of the law. To do this, it was critical they get the right person to head the PCAOB. The original choice was John Biggs, the retiring head of TIAA-CREF. Biggs was a staunch advocate of accounting reforms, including banning firms from selling non-auditing services to their audit clients. When word got out that Biggs might actually want the PCAOB to ignore AICPA recommendations and write its own rules, most importantly the ban on consulting services for audit clients, the AICPA lobby and its friends in Congress and the White House pressured Pitt to rescind the offer. (21)
An undercurrent of the resistance to Biggs was the fear that he would reintroduce the search for fraud as a primary duty of auditors. The industry's aversion to this was probably impelled by concern over jeopardizing the new, lucrative consulting service. If public auditors were more diligent in the search for client fraud, that would create a more adversarial relationship between auditors and management--not exactly conducive to chummy consulting contracts with the same firm. Nevertheless, the public trust in CPA certifications of corporate financial statements supports the need for auditors to look beyond mere compliance with Generally Accepted Accounting Principles and actively search for client fraud.
Corporate Boards
Enron, WorldCom, Tyco, Qwest, Adelphia: What these and other members of the corporate scandal Hall of Infamy shared were top managements whose corruption resulted in monumental losses to shareholders and employees. Their sins range from overstating corporate net income to looting their corporations' assets. In each case, the structural problem was the failure of the institutional oversight mechanism to detect and rectify the wrongdoing. That mechanism is the corporate board of directors, whose primary role, at least in theory, is to monitor top management so as to ensure that the law is followed and the corporation is run for the benefit of the shareholders and other stakeholders. In short, the board of...
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