Philadelphia Reflections

With skillful honest management, a business can save a lot of admin. cost by just trusting the managers. With dishonest or incompetent management, a business will go broke unless it spends a lot, a lot, of money policing itself. The issue here is one of balance. Evidently, SOX was an apparently good idea but went somewhat too far in the direction of distrust.

By Jane Bryant Quinn
Newsweek

Washington Rolls Back Investor Protections

July 16, 2007 issue - Remember the "ownership society" that the administration swore to promote and protect? Remember the admiration lavished on the so-called shareholding class? You probably thought that meant you, because you invest in the stock market and own mutual funds. You would be wrong.

Even with the corporate frauds of the '90s barely out of the headlines and 21st-century frauds taking over (rampant insider trading; backdated stock options for executives), your government is rolling back some investor-protection rules. It's also urging the courts to side with corporate captains against their trusting shareholders. Key people in Congress, mindful of campaign contributions, stand on the captains' side.

I have three cases in point.

Block the SOX: The Sarbanes-Oxley law, SOX for short, passed in the wake of the WorldCom and Enron accounting frauds. Its critical Section 404 orders senior managers to test the effectiveness of their companies' financial controls, with oversight by independent auditors. You probably thought that was already part of a manager's job, but as it turns out, only the better companies cared. The rest have been whining about SOX ever since it passed.

The scrutiny forced by 404 has uncovered thousands of cases of bad financial reporting. A record 1,538 companies had to restate their earnings last year. Not surprisingly, their stocks lost a median of 6 percent in market value, reports the consulting firm Glass Lewis, compared with a gain of 15.7 percent in the Russell 3000 Index. But once they improve their financial tools, their businesses should improve as well.

This idea cuts no ice with a blinkered cadre of overpaid CEOs who get sore when restatements reduce earnings (and their option awards). They're sobbing that 404 costs too much. So, to wipe away their tears, the Securities and Exchange Commission plans to reduce the amount of testing required—creating "404 lite." (It's probably churlish to add that good accounting costs pennies compared with the size of CEO bonuses, but then CEOs never think they cost too much.)

Without question, SOX had a bad launch, says James Cox, a securities-law professor at Duke University. It cost more than expected and confused auditors and companies alike. But costs are falling and the benefits to investors are becoming clear. "The old, pre-404 system of preventing misleading statements failed," says Barbara Roper, head of investor protection for the Consumer Federation of America; 404 lite "turns back the clock."

A loftier argument claims that SOX is driving financial business away from the United States. Yet for new public offerings, foreign firms have increased their listings since SOX was passed. New York is indeed losing some ground to London, but for other reasons. Its new trading systems are faster than ours, its investment bankers charge half as much (are you listening, Goldman Sachs?) and it lets more crummy companies sell shares to the public. That's business we don't want.

Too many legislators oppose investors, too. Last month the House passed an amendment delaying 404 reporting for smaller companies—the very ones most likely to issue false financial statements. "That's a terrible precedent," says former SEC chairman Arthur Levitt. "It politicizes financial accounting and greatly increases the risk to investors."

Bash the class: When shareholders think they've been had, they bring a class-action suit. In the past, some suits overreached, leading Congress, in 1995, to pass a law making it harder to get into court. One big question remains: what do shareholders now have to prove before they can sue? In a Supreme Court case known as Tellabs, the SEC filed a fierce brief, essentially asking the court to kick out as many claims as possible. Last month the court rejected that view and adopted milder rules. Suing still isn't easy, despite those who say we're drowning in "frivolous" shareholder claims. The number of new lawsuits plunged to a record low of 110 last year, according to Cornerstone Research.

Free the team: Here's something you probably didn't know. Under a 1994 Supreme Court decision, shareholders cannot sue any corporate advisers—lawyers, accountants, investment banks—that "aid and abet" a fraud. A federal court recently stopped a lawsuit against Merrill Lynch, Deutsche Bank and Barclays, among others, for their alleged role in Enron's collapse.

Next term the court will hear a similar case known as StoneRidge. Details don't matter; here's the gist: Did third parties "merely" aid and abet in a communications company's fraudulent transactions, in which case they go free? Or were they primary players and hence liable? The SEC planned to enter the case on the investors' side, but both the White House and Treasury Secretary Henry Paulson (himself an investment banker) said no.

If the court lets third-party players walk, "it gives underwriters, auditors and attorneys a license to kill," says Lynn Turner, a former chief accountant for the SEC. "They'd create a safe harbor for fraud." In a decade, we could see Enron redux.

"Other icons are under review"?

Here's an idea: 1975 was a watershed year in the financial industry and for none of the reasons usually given.

1975, of course, was the year of May Day when fixed commissions were no longer mandated by law (can you imagine legally-mandated theft?). Not that you'd notice if you were a client of Merrill Lynch or Janney Montgomery Scott.

How the ending of fixed commissions mattered was that it allowed Charles Schwab and Joe Ricketts to begin the discount brokerage industry, which has morphed into the Internet brokerage industry.

This has liberated the self-reliant investor from the teeth and talons of the ever-avaricious and wholly unprincipled broker.

Schwab essentially failed in is mission, and gave in to profit pressures, giving us such astonishing things as the purchase of US Trust, an institution devoted solely to the extraction of fees from its "high net worth" clients.

Joe Ricketts, however, has remained true to his ideals. Whether you choose to trade with AmeriTrade or Vanguard or Fidelity or Scottrade is a personal choice; but it was Joe who has given you that choice.

Bogle, also arose in the fateful year of 1975, to give the world the product it so desperately needed: a low-fee professionally-managed index fund. A product type that may soon be eclipsed by the ETF (if they aren't completely polluted by the major financial institutions first), but here again, it was a titan of the year 1975 that gave us our choices.

And our lives are richer for it.

(By the way, the origianl Merrill, of Merrill Lynch, was a principled customer's man; it was your friend Don Regan who turned MLPFS into a dumping ground for the likes of Henry Blogett.

There's another story for you to write about ... I'm sure both Merrill and Regan visited Philadelphia at one time or another.)