SOCIAL TOPICS (Archive): INVESTMENT & ECONOMIC ANALYSIS

Published, Summer 2002

       By Bill Apfel

       As if the bursting of the Internet bubble, the tragic terrorist attacks, and the recession were not enough for the stock market to absorb. Misleading, sometimes fraudulent financial reporting has added to the market's woes in recent months, leaving the public in turmoil about the very integrity of the market system. After all, if investors cannot rely on companies to stay faithful to "generally accepted" principals of reporting, how can they make intelligent investment judgments? Indeed, can markets function without a reporting system in which investors have confidence?

       I believe there are at least four reasons why we have reached this predicament. 1) The bull market offered huge rewards to corporate executives who successfully misled investors. Here we should include Wall Street's so-called analysts many of whom have revealed themselves to be cheerleaders for companies with investment banking needs rather than methodical researchers. 2) The Generally Accepted Accounting Principles (GAAP) standards themselves failed to keep up with changing financial stratagems either because of the sclerotic system for changing them or the pressure of interested parties to maintain the status quo. 3) Market regulators, particularly the Security Exchange Commission (SEC) and the Federal Reserve, failed to reign in a multitude of questionable practices ranging from accounting for employee stock options to unreported special purpose entities. We can blame bureaucratic overload for some of these failures, but an ideological opposition to enhanced disclosure at the Fed was also a culprit. 4) Investors, both institutional and individual, perhaps out of greed or just wishful thinking and laziness, failed to exercise sufficiently their function as skeptical analysts of corporate reports.

       While we need reforms to improve accounting standards and analyst impartiality, and a regulatory approach that makes corporate transparency a priority, I emphasize here the last of these four points: the role investors can play in restoring the health of financial markets. First and foremost, many professional investors have not been the innocent victims of dishonest reporting. True, uncovering instances of outright fraud are beyond the skills of the average investor. But for those paying attention, the signs of misleading practices were plentiful. Indeed, many were clearly reported in the press.

       Consider just a few things that investors should have been howling about. Among my favorites is the recurring "non-recurring loss." When a company has a truly unusual event (a plant lost to an earthquake would qualify), GAAP standards allow it to specify the cost separately, by way of a footnote. This appropriately enables investors to evaluate the company's ongoing results. But when such so-called "non-recurring losses" are reported quarter after quarter, a practice that has become pervasive in recent years, investors should question whether these "special" charges are really just a cost of doing business. One of the largest most admired, and best performing companies of the bull market used this footnote device a stunning 18 times during 20 reporting quarters! Another quirky product of the bull market was something called "pension income." Plainly reported in financial statements, the earnings of many companies routinely included investment profits made by pension portfolios. While logic suggests that maintaining a plan is an expense, arcane rules actually required this practice even though such gains would never be available to corporate coffers. Some companies twisted the rules to their extreme, employing fanciful forecasts supplied by their auditors to generate accounting profits that were unlikely to ever materialize. Plenty of other practices should have raised red flags. Even in the case of Enron, page after page of the company's annual SEC filing documented (if opaquely) the existence of the mysterious entities that hid Enron's true liabilities.

       Perhaps even more important than the role investors must assume as skeptical readers of financial statements is the one they must play as owners of the companies in which they invest. Indeed, our market system surely will suffer further if shareholders continue to act more as speculators who trade their shares than as owners who employ managements to run their companies responsibly. Here the intersection between social investing and shareholder activism generally has been critical. We should all be encouraged that those interested in good corporate governance have joined social investors to demand that boards of directors have the independence necessary to supervise managements. The recent success at EMC Corporation is a case in point. (See EMC: A Season of Firsts in Summer 2002 issue of Values.

       It's true that even a reinvigorated investor class cannot by itself restore fully the confidence the financial markets need. Changes on Wall Street, in accounting standards, and in the focus of regulators are also required. Importantly, the SEC should embrace the role of investors as overseers of corporate managements. After all, big profits to smart investors are not all that is at stake. In the end better functioning markets will make for a greater public confidence in the fairness of our financial system, a prerequisite for stronger, more sustainable economic growth.

Bill Apfel is a senior portfolio manager and Director of Equity Research. He serves on USTC's Social Planning and Policy Committee.