Rule Maker Portfolio Restore Our Trust
Leaders address the crisis of confidence in the markets

After several months of outrage, from the accounting scandals dominating the headlines to the lack of punishment for CEOs, our nation's leaders are taking a crack at restoring integrity in the U.S. markets. Bill Mann wonders if these solutions, which are generally legalistic in nature, will address the perverse rewards for cheating and the fact that our school systems continue to release financial ignoramuses into society.

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By Bill Mann (TMF Otter)
July 10, 2002

Finally, our leaders have had enough. After months of nothing really happening to the Enron conspirators (Arthur Andersen aside), and a long line of hearings (during which our corporate leaders blew mostly hot air), we've gotten a few choice proposals from the SEC, Congress, and most recently, the White House.

President Bush went to Wall Street yesterday to exhort the keepers of public companies to act with integrity and to help restore the public's trust in the U.S. stock market. He released a 10-point plan that includes a SWAT team under the auspices of the Justice Department, stiffer penalties for those convicted of corporate fraud, confiscation of ill-gotten management gains, and an independent regulatory board to oversee accountants. Most importantly, and most difficult for anyone in a position of authority to mandate, was Bush's call for a return to integrity among our corporate leaders.

That's one of those "pro-children" kind of clarion calls. Who in his or her right mind would be opposed to greater integrity among people in whom we entrust our money?

I was both heartened and a little dismayed by this speech. Bush made the correct stand: Companies gaming the system of public disclosure are destroying the stock market. He was also correct that this has been developing for a while. Who knew that a good part of the vaunted "eight years of prosperity" from the previous administration were due to accounting gimmicks? And now we all pay the piper for the sin of not paying attention to details when the times were great. 

But this is a time-tested pattern: In tandem with a long-term bull market, there is generally a shadowy rise in fraud and malfeasance. And unfortunately, it will continue to happen as long as there is a marketplace. When hysteria reigns, the crooked will be there to take the money from the credulous. And some of the heretofore people on the straight and narrow will see the benefit of cutting corners.

Seriously, do you think that WorldCom (Nasdaq: WCOME) set out to hide several billion dollars in expenses? Or that the aggressive accounting practiced by legion companies was meant to flout the law? No. These acts were committed with the intent of keeping the good times rolling, keeping analysts happy, keeping shareholders coming in, keeping those share prices high, keeping those stock options and bonuses valuable.

The managers, who are paid to "deliver shareholder value," have incentives to keep share prices high and needed some help. Some cover, if you will. An accounting industry clambering for lucrative consulting contracts proved to be the perfect enabler. No, not all accountants or firms are bad or corrupt. But the system, with those built-in conflicts of interest and all that money flowing around, is inherently corruptible.

Managers who needed to meet earnings expectations, keep in compliance with debt covenants, or had big performance bonuses hanging in the balance found a group with the incentive to help them twist generally accepted accounting principles (GAAP) to within an inch of its life, or in some cases, a wee bit beyond that. Delivering shareholder value and delivering a pumped-up stock price are, as we should now know, very different things.

This is where a bill sponsored by Paul Sarbanes (D-Md.) could help restore some faith, by removing the right of self-regulation away from accounting firms, who have proven unfit to manage themselves. The bill takes away management's power to award consulting contracts to auditors and entrusts it with the audit committee of the board of directors. It also puts some teeth into the penalties for those who break the law. (You can read the bill at the Library of Congress website. Enter S.2673 for the bill number.)

Managers bent the rules because they thought it helped them deliver what shareholders demanded. But what are we, six years old? What shareholders want in the short term and what they require in the long term are often two very different things. And if this walk of shame by the dozens of accused companies -- as well as the shattered reputations of those whose shattered stock prices and bloated balance sheets belie their inability to continue to play the Wall Street game -- says anything, it is this: The long-term must take precedent. Short-term gains at the expense of the long term have always ended in tears and ignominy.

I think that the president showed some courage here. He is tarred by the fact that several of the disgraced companies, most notably Enron and Halliburton (NYSE: HAL), have painfully close ties with his administration. He has his own SEC investigation into past insider sales to contend with -- completely overblown though it may be. And he is a pro-business president left with the charge of placing heavier regulatory burdens on corporations.

But he has much further to go than what he presented yesterday. There was very little in Bush's speech that actually spoke to restoring trust by individuals in the stock market. Sure, we'll take away money after the badduns break the law, but is that preventative or just punitive? Frankly, I have no interest at all in placing my money in a mechanism where the biggest article of faith that I have is not trust, but rather prosecutory vigor.

What I want to know is what that $100 million in new funding for the SEC is going to get individual investors. A few months ago, I spoke with an investigator with the Justice Department who voiced some frustration that prosecutors generally disliked taking cases regarding corporate fraud. Why? The cases were boring, time-consuming, and hard to win. Sure, any eventual Enron trial is going to get the Court TV treatment, but what ensures that lower profile cases will be any different than those of the past?

We have laws on the books -- they've been there, in some cases, since the Great Depression (the last time investor greed brought forth some real sorrow), but they do no good if they do not yield convictions.

We don't give a damn about more laws and heavier regulatory burdens. What we care about is effective enforcement of existing laws, and the creation -- by carrot and by stick -- of an environment in which companies are rewarded for providing clear, concise communication of their finances. We've heard too much garbage about companies being "technically compliant with GAAP." It's not about compliance -- it's about communication. A document that is technically accurate but holistically deceptive ought to be reason enough to call in the cavalry.

I would encourage the president to get Sen. Sarbanes' bill. Unlike management, whose role in providing information may be murky, auditors' roles are clear -- they are the eyes and ears of the outside investor. We must be able to trust them. The Sarbanes bill spells out the formation of an independent, five-person oversight board manned by people external to the accounting industry, and provides stiff penalties for auditors who violate the trust of their constituency, the investors.

Sen. Sarbanes has crafted an entirely Foolish bill, one I would be proud to back. In fact, I'd suggest that other Fools get to know the key components of this bill themselves. If you agree, sign the petition in support of the bill. (If you do sign, be sure to write somewhere on there that you are a Fool!)

A Foolish plea
In the end, Mr. President and Sen. Sarbanes, restoring trust is something you both mention, but I think you miss a core concept in your initiatives. At some point, the sins of excess of the late '90s must be pinned upon the investing public. It is altogether too easy to lure people toward the sniff of easy money and, time and time again, this has turned out badly. The best-protected public is one that can protect itself.

And yet I have seen not the first mention of increasing financial education in our public schools. We must face facts: This country's schools are graduating financial imbeciles by the millions. We can fight this fight from an enforcement perspective, but it would be far more beneficial to help the public help itself. I continue to receive one come-on after another from some two-bit boiler room pushing low-grade, dirt-quality, bulletin board stocks. We hear of billions being lost by people who fall for those Nigerian confidence scams -- things that ought to fool no one, and yet do.

We cannot expect people to be able to sniff out every risk and, for this reason, better enforcement for risks purposely hidden from shareholders is late in coming, but welcome nonetheless. But a populace with some skills in understanding the language of finance can do nothing but protect itself from those who lie, cheat, and steal. That is something that we do not have, and our lack of education in things financial has assisted in parting people with billions of their hard-earned dollars.

As a dedicated participant in the stock market, the most powerful creator of wealth ever devised, I am of course in support of thoughtful actions that strengthen the institution. The U.S. markets have long been a haven of choice for trillions of dollars of international money. The American economy is dynamic, and our markets are considered safe and fairly run.

The scandals of the past several years, which have been brought about by a lack of caution years in the making, have seriously harmed our standing among global investors. Should this reduced veneer of safety propel a massive repatriation of investment dollars away from the United States, the resultant effects will be devastating.

You've made your proposals. You've stomped your feet. Now get to work.

[If you like Bill's work, you can work with him and Matt Richey (TMF Matt) in the Fool's When to Sell online seminar, starting July 18. They'll help you develop guidelines for when, why, and how to sell stocks Foolishly.]

Bill Mann will be in the studio for a special edition of CNBC's Capital Report featuring a discussion with Secretary of Treasury Paul O'Neil and Secretary of Commerce Donald Evans on the president's reform proposal. Airing on CNBC from 7-8 p.m. ET. Bill owns none of the companies mentioned in this article. The Motley Fool has a full disclosure policy.


 

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  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  MSFT MICROSOFT CORPORATION (0.97) (1.82%) 52.24 
  NOK NOKIA (0.7) (4.84%) 13.75 
  AXP AMERICAN EXPRESS COMPANY (1.33) (3.68%) 34.83 
  SGP SCHERING-PLOUGH CORPORATION (1.55) (6.95%) 20.75 
  INTC INTEL CORPORATION (1.15) (6.4%) 16.81 
  PFE PFIZER INC (2.07) (6.25%) 31.03 
  CSCO CISCO SYSTEMS, INC. 0.37 2.82% 13.51 
  TROW PRICE T ROWE GROUP INC (0.42) (1.4%) 29.57 
  KO THE COCA-COLA COMPANY (1.74) (3.08%) 54.70 
  JNJ JOHNSON & JOHNSON (2.32) (4.41%) 50.30 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 02/03/98 59 MSFT 49.35 52.24  6.72%
 02/15/00 250 NOK 27.21 13.75  -49.47%
 05/26/98 95 AXP 35.38 34.83  -1.31%
 08/21/98 44 SGP 47.99 20.75  -56.60%
 02/13/98 147 INTC 27.44 16.81  -38.37%
 02/03/98 66 PFE 27.43 31.03  13.61%
 06/23/98 182 CSCO 24.72 13.51  -45.15%
 02/03/98 75 TROW 34.12 29.57  -13.06%
 02/27/98 27 KO 69.11 54.70  -20.51%
 04/03/01 10 JNJ 43.65 50.30  15.23%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 02/03/98 59 MSFT 2,911.79 3,082.16  170.37 
 02/15/00 250 NOK 6,802.85 3,437.50  -3,365.35 
 05/26/98 95 AXP 3,360.87 3,308.85  -52.02 
 08/21/98 44 SGP 2,111.70 913.00  -1,198.70 
 02/13/98 147 INTC 4,033.23 2,471.07  -1,562.16 
 02/03/98 66 PFE 1,810.57 2,047.98  237.41 
 06/23/98 182 CSCO 4,498.76 2,458.82  -2,039.94 
 02/03/98 75 TROW 2,559.06 2,217.75  -341.31 
 02/27/98 27 KO 1,865.89 1,476.90  -388.99 
 04/03/01 10 JNJ 436.50 503.00  66.50 
Cash:1,745.92 
Total:23,662.95 


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The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.