As chairman of the Securities and Exchange Commission from 1993 to 2001, Arthur Levitt warned that inadequate disclosure and the conflicts of interest entangling Corporate America with its auditors and analysts could ultimately damage confidence in the capital markets. It's fair to say that during this period, the SEC and finance executives viewed each other as adversaries more than allies. Yet with the passage of time, Levitt has come to believe that, going forward, finance executives will play a crucial role in promoting and maintaining accuracy and transparency in financial reporting—the cornerstone of the U.S. stock market. He explained why in a speech that he gave to an audience of finance executives at the CFO Rising conference in Tampa this past March.
Three years and one week after the peak of the bull market, it's hard to conceive of how much distance we've traveled.
On March 10, 2000, Nasdaq was at 5,048. Today it's a little over 1,200. Three years ago the dot-com bubble had not entirely burst. Accounting firms bragged in advertisements about their aggressive consulting services, as their lobbyists fought ferociously to preserve their ability to offer those services. Now they are running full-page ads, like the recent one from PricewaterhouseCoopers, declaring that Corporate America has entered a new era of transparency. Hot-shot analysts were doling out millions in initial public offerings. Corporate governance was a topic best left to academics. Foreign policy ranked almost dead last on a list of America's top concerns. Enron was trading in the neighborhood of $80 per share. And for the previous five years, Fortune magazine had touted the company as the most innovative in America. Little did we know that its most noteworthy innovations were not being done in their business, but in their books.
Enron's fall brings to mind another massive bankruptcy. The company I refer to was one of the largest enterprises in the nation, and it collapsed under the weight of its multilayered, interconnected corporate structure — a structure supported, of course, by very creative accounting. This company's fall touched hundreds of thousands of investors. Newspapers called it the biggest business failure in the history of the world, and this historic moment happened in 1931. The company was Insull Utility Investments (IUI), founded by Samuel Insull, a onetime private secretary to Thomas Edison.
Make no mistake, the fall of Enron, WorldCom, and the others, while massive in size and shocking in scope, is nothing particularly new. And neither is the market's or the public's reaction.
The historian Ron Chernow said that after the collapse of IUI more than seven decades ago, people felt so swindled that they never went near the market again. There was a lost generation of investors. Today we must ask ourselves: Will there be a second lost generation? Will the total collapse of investor confidence in our markets and trust in the private sector ever be rebuilt? These questions are ones facing all of us, from Wall Street to Capitol Hill, from those running million-dollar mutual funds to families sitting around their kitchen tables wondering how they are going to pay for college or prepare for retirement. And while our elected officials have passed new laws, regulators have issued new regulations, and many companies and boards have embraced new policies, the success or failure of those reforms rests in large part on the success or failure of our financial executives.
You are in the front tier in the battle for more transparency, more accountability, and more ethical behavior on the part of Corporate America. In many ways, you hold the most important positions in your companies. You are the investors' guarantor of good information, and through that a crucial gatekeeper ensuring that our markets allocate capital efficiently and fairly.
Perhaps most of all, you are the person who says no. You can and should bring a dose of reality to the hard-charging CEO. You can and should set the standard for the numbers that guide company decisions. You can and should be the conscience of your companies, providing the moral, ethical, and professional grounding that our executives need. It's a big responsibility, but it's absolutely the type of leadership that the times demand.
Having been in and around the markets for more than 40 years, I've seen my share of downturns and bad markets, but there is something unique that bothers me about our current crisis. Beyond Enron, beyond Andersen, beyond stock options and stock-market bubbles, and even beyond bad accounting, is the absence of true leaders from the business community.
I'm talking about the kind of leadership that instinctively steps forward when it is needed. The kind that puts the public interest above corporate interest and above career advantage. I'm talking about private-sector leadership that is both influential enough to be listened to by politicians as they cook up reforms and trusted enough by the public so that when a drive for reform overreaches or otherwise hurts the very markets they are trying to save, private-sector voices will be heard and will be listened to.
There are plenty of good and honorable people at the head of America's corporations. But there are few business leaders recognized throughout the country for probity and integrity in the way such leaders as Edward Filene, who headed the department-store empire; Irving Shapiro, the head of DuPont; Walter Riston of Citibank; and John Whitehead of Goldman Sachs were recognized as being spokespersons for a set of realistic, intelligent, public-spirited values. I can't think of a time since I began my Wall Street career when the business community and market institutions have been viewed with such general disdain by the public. Ask anyone to draw up a list of business leaders to head an important public board or commission, and I'm afraid the list of candidates would begin and end with Paul Volcker (former Federal Reserve chairman).
Unfortunately, this lack of leadership has also infected the ranks of financial professionals. Of course, CFOs like Enron's Andrew Fastow, WorldCom's Scott Sullivan, or Tyco's Mark Swartz are the most notorious. But during the past decade, how many financial executives found themselves caught up in the rush to manage earnings and boost stock prices? How many CFOs found themselves using their knowledge of accounting not to paint an accurate picture of a company's health, but to hide debt and a corporation's vulnerabilities in order to court favor with an overbearing CEO? How many CFOs worked hand in hand with the CEO to manage the numbers while failing to manage the business?
I'm afraid all too many CFOs fell into those traps. Those who guarded the numbers acceded to management's demands. And as John Bogle, the founder of The Vanguard Group, has pointed out, this led to a company's numbers becoming more important than a company's business.
That's not to say that CFOs are to blame. Not at all. But it is to say that a key gatekeeper joined the audit committee, the accountants, the lawyers, the analysts, the standard setters, the board members, the journalists, and the investors in being seduced by this culture of gamesmanship, a culture in which it was acceptable for corporations to bend the rules, to tweak the numbers, to let obvious problems slide in order to meet Wall Street's desires and expectations.
Moving forward, we need financial executives to reclaim their role as watchdogs and guardians of the shareholders' investments. I don't need to tell you how important your job has become. You are the ones who are putting your signatures on the company's financial reports, the ones in long meetings with auditors and with audit committees. And, if you should make a false statement in an SEC filing, you are the ones who face up to $5 million in fines or 20 years in jail.
Of course, exhorting you here to behave better is relatively simple, and an easy way out. But instead of finger-pointing, I'd like to offer some suggestions about how we can navigate this new world of tougher regulations — in some cases unreasonable regulations — and heightened security. I've drawn up a rough list of guiding principles to get through these challenging times:
(1) Select accounting principles from those that best reflect — from the view of the investor — the actual economics of the underlying business transaction. If it means more volatility and more complexity, so be it. Make your focus managing the business, not managing the numbers. If the business is well managed, good numbers will follow.
(2) Recognize that GAAP is not a standard to be met, but a foundation on which to build. In this new environment, the market is clearly going to reward companies that establish a reputation for both transparency and honesty. Since it is impossible to write rules to govern every potential set of facts or business transaction, it's up to you to ensure that the most relevant principles are being used.
(3) Consider what other key performance indicators (KPIs) investors need to know. In each company and each industry, there is a set of statistics that provides great predictive capability with respect to the future earning power and cash-flow-generating capability of a business. In some businesses, it may be the number of patents being used; in others, how many units of a product have been sold, where they have been purchased, when they will be paid for. While the SEC should consider whether and which KPIs should be disclosed, financial executives in the interim should take the initiative and begin to disclose this relevant information.
(4) Remember whom you work for — the shareholders. To that end, when you sign off on financial statements and disclosures, put yourself in the shoes of your shareholders. The experts say to invest only in companies whose business you understand. Therefore, make your statements obviously understandable. Ask yourself if there is any information that you would want to know about the company before investing in it that hasn't been made known, and if so, make it known.
(5) Guard and respect independence. It's crucial to engage with your audit-committee members in a meaningful way. And it is important to be responsive to their queries. Always respect their independence. At the same time, be sure to ensure your own independence from your company's outside auditors. While improvements in the auditor rotation rules and in stopping the revolving door between corporate suites and accounting firms have helped somewhat, we all know that the community of financial professionals is a small one. Only you can guarantee your independence.
(6) Remember that whoever governs, rules. Use your positions of power and influence within your companies to make sure that an effective corporate-governance structure is in place and that directors are of the highest quality. If we have learned anything from the past year it's that corporate governance is critical to making our private sector work. That's why earlier this year, to improve corporate effectiveness, the Blue Ribbon Conference Board Commission on Public Trust and Private Enterprise recommended a series of best practices regarding the future structure of corporate boards.
Among our recommendations was to separate the office of chairman of the board and CEO. Of course, one size does not fit all. And for some companies, that separation would be either redundant, costly, or unnecessary. But the concept of a lean independent director, I think, lacks that redundancy. And I think one or the other of these solutions would be useful for almost any board.
I think throughout our board structure, directors would be independent more than in name only. They must be truly empowered and motivated to carry out their duties. I've sat on enough boards and audit committees to understand the kind of culture of seduction that characterizes many boards. It's a game that many CEOs played and played well by seducing their boards with perks and private attention and contributions to favorite philanthropies, and meetings that were short on substance and long on fluff. The boards became willing accomplices. And it's part of the American personality to go along and become more fraternal rather than more vigilant.
Some may look at these recommendations and ask, with all that is being asked of boards today, how are we going to recruit good, competent people? Won't it be much tougher? I guess my answer to that is, yes, it will be and it should be. Director slots should be filled by people who are qualified and able to devote the amount of time needed to be effective members of that board.
Now more than ever, placeholders have no place. There is now no role for directors whose only qualification is that they send their children to the same private school as the CEO. There is no role for directors whose only qualification is that they were great baseball players or running backs. Not long ago, a major media company had O.J. Simpson not just on its board, but on its audit committee. And that's no joke. Such types of appointments are totally inappropriate to the demands of today's market.
Even when good directors are found, financial executives should take the lead in quality control. Take the time to fill in the gaps in your directors' knowledge base. Make education a key part of your role.
That leads me to my final suggestion:
(7) Make sure you are part of the solution, not part of the problem.Be leaders not just within your own companies, but in the public debate about reform as well. And the one issue where we need your input and the one that I suspect will evoke the greatest amount of dissonance is the debate over the expensing of stock options. While there are many factors that led to the bubble of the 1990s, I agree with Jack Bogle that if we have to name a single father of the bubble, we would have to say that it was executive compensation tied to fixed-price stock options. When executives are paid more the higher they push the stock price, that is exactly what they will do. And for some that means pushing accounting principles to the very edge, and very often even over the line.
Thankfully, during the past 18 months the move to treat stock options as an expense has gained steam. Some 175 companies, including GE, GM, and Coca-Cola, have chosen to expense options. Business leaders and investor advocates from Warren Buffett to the California Public Employees' Retirement System have called for their expensing. Yet there are those who are still playing the politics of private interest at the expense of the public interest. They are using their influence with lawmakers to stop the movement toward more-accurate financial statements.
Financial executives can be a powerful voice in this debate by pushing your own companies to expense stock options and offering expert advice to those undecided. In addition, as we are clearly moving toward expensing, we will need your expertise to help hone the tools we use to measure the value of these options, to improve the economics, consistency, and comparability of the measurement of the cost.
Recently, I was struck by one small piece of data hidden in a large report put out by Deloitte & Touche and BusinessWeek about CFOs and their role in American companies. Based on their research, they found that nearly a third of CFOs don't think that the Sarbanes-Oxley Act will make another Enron less likely. At first glance, I found this troubling. After all, this is the legislation that is supposed to change business as usual, and the men and women polled were in the vanguard of enforcing these changes. But I guess I've had enough experience with legislation to know that it is the last possible solution to any problem, and always carries unintended consequences.
The truth is that the CFOs who responded that way were absolutely right. Rules alone will not prevent another Enron. But honest, ethical, vigilant business leaders will bring us back the kind of public confidence that is essential to the renewed growth of American business. Financial executives who understand the obligation a company has to its shareholders can change Corporate American culture and restore public confidence. And financial executives and accountants dedicated to removing the tarnish from the public franchise they have been given will lead people to trust the numbers, the men and women who issue them, and their corporate leaders once again. That same element of trust belongs to the CFOs and CEOs who are the custodians of the public trust.
Taken together, this will do more to restore public confidence in the markets and in our private sector, lift our stock markets, and strengthen our economy than any law we pass or any regulation that is implemented.
Since leaving the Securities and Exchange Commission in 2001, Arthur Levitt has been busy. In between lecturing and serving on the corporate boards of Carlyle Group and RAND Corp., he has written a book for investors, Take on the Street (Pantheon Books, 2002), about his experiences as SEC commissioner. At the CFO Rising conference, he sat down with CFO editor-in-chief Julia Homer and deputy editor Lori Calabro to discuss his hopes for the SEC going forward and the roles of FASB, the FEI, GAAP, and the auditing profession in improving corporate reporting.
It's obvious from your book that you hold the SEC in high esteem. Have the accounting scandals discredited the agency at all?
No. I think the agency has a reputational core which has been a function of its traditions, of its independence, of the kinds of cases it has brought. Every agency, every chairman, has dealt with scandals that were generated by a previous agency or even under that chairman's administration if he stayed long enough. But that's what we're there for: to deal with scandals, not necessarily to uncover them before they occur.
Do you think William Donaldson is a good choice to head the SEC?
Yes. I think the agency had only one direction to go after he came in. He's experienced enough to avoid some of the obvious pitfalls. And some of his first steps have been very encouraging: he's changed his position on expensing stock options, on fair disclosure, and on some core issues that, in the public's mind, determine whether the chairman is its chairman or is a political chairman.
What advice would you give to Donaldson?
The advice I would give is to restore the morale of the agency as his top priority and manifest in every possible way the primacy of investors among the many constituents that he's responsible for. Investors' interests should be placed above corporate, political, and all other interests. By doing that he can't go wrong.
Do you think that the relationship between the SEC and the Financial Accounting Standards Board could change in any way?
It probably should change. I had different relationships with FASB. When I came in, I had the notion that FASB was to be protected as you'd protect your own child against the barbarians. I fought very hard to protect it and, at the same time, I was very much involved in its proposals and in the kinds of things that it put on its agenda.
When [former Republican senator from Texas] Phil Gramm became head of the banking committee, he urged me to disassociate myself from FASB except as its protector. His argument was, how could I say "hands off FASB" to the Congress and to the White House if I was using FASB to accomplish my own goals in terms of accounting standards? He was probably right: if FASB is to be independent, it should be truly independent.
From the outside, I took the position — as I have today — that FASB needs to totally revise the way it sets standards and the way it is governed. They have a governance body in the FAF that I think is way out of date. It's a constituent body. It represents vested interests rather than the public interest. And now that FASB has independent funding, it should think of better ways to make decisions to make them faster and more responsive to the needs of a much more complicated financial landscape. I think FASB has a very good chairman now in [Robert H.] Herz, and I think its defining moment will come in its willingness to expense stock options.
You wrote in your book that when you look back, your biggest mistake was probably letting the stock-option issue not be resolved. What would you have done differently?
I could have allowed FASB to go ahead with it. I didn't, because I felt that Newt Gingrich [former Speaker of the House of Representatives ] and Joe Lieberman [Democratic senator from Connecticut] would override FASB and in effect close it down. I was wrong: the country had begun to swing back toward the center. I think it would have gone through had I allowed it to. But I consciously persuaded [Dennis Beresford, then chairman of FASB] to back down.
Obviously, FASB is also debating the merits of generally accepted accounting principles versus principles-based accounting these days. How has your thinking changed on that issue?
I would not dismiss certain principles. GAAP is still the best and most useful standard, but it is not the beginning and the end. And just as every audit involves objective judgment, I believe that some principles are important to consider. Relying on a formula has gotten us into trouble.
What do you think of the role of Financial Executives International? Has it been successful in championing the CFO's case, in your opinion?
It's been a mixed bag. During the latter part of the 1990s it stood shoulder to shoulder with the SEC on some issues; on others, it was the Greek chorus representing the business community. But I wouldn't call it as irresponsible as the AICPA. I felt that group did a vast disservice to the interests of the accounting profession, and allowed the public image of the profession to deteriorate in a way that I think was shameless. The people in the Big Four accounting firms are very responsible people, and they looked like a bunch of bandits. I place a large part of the blame on their cheerleading trade group, the AICPA, and its chairman, Barry Melancon.
Speaking of accounting firms, do you think what happened to Andersen was justified?
No. I think that action was very unfortunate. A lot of good people were hurt, and accounting reform was set back because competition was reduced. The new heads of the accounting firms appear to be aware of their responsibilities. Are they still lobbying and trying to defend themselves? They are, and I would do the same if I ran an accounting firm. But I think they understand the reputational damage they've sustained, and some of them are trying in constructive ways to change that.
How should CFOs manage their relationships with external auditors?
I think it should be an arm's-length relationship. But I think this is a lesson that the accountants have learned as well: their franchise is on the line, and they're not going to be the poodles that they were in the past; they'll become more Doberman pinschers. The lesson for CFOs is to understand that, and not try to persuade them to do what the CEOs necessarily want them to do.
Do you still think it's a good idea for individuals to buy stock?
I think the stock market is still the best possible investment for individuals, and it would be a dreadful mistake for them to pull out.
But most individuals who are investing less than $100,000 a year, in my judgment, shouldn't make their own investment decisions unless they are prepared to devote the time to researching securities. Most investors belong in index funds or using their 401(k)s as their principal investment source.
Overall, are you optimistic or pessimistic about the prospects for reform?
I'm optimistic, not because I think [the] Sarbanes-Oxley [Act] will necessarily be hugely effective, but because boards have changed so dramatically and the attitudes of CEOs so enormously. Humiliation and embarrassment have brought about changes that legislation could never bring about. And with a chastened universe of executives, investors, and boards, we're in a much better position today [for reform] than we have been at any time in the past two decades.