Reforms Coming to Remedy ‘90s Abuses

The scope of reforms coming to the U.S. corporate regulatory system could be greater than any seen in the six decades since passage of the first securities laws and the creation of the Securities and Exchange Commission.

That became clear last week when the SEC said it had opened inquiries into the accounting practices of 49 companies, many of them on the Fortune 500 list of the largest firms in the United States.

Regulators suspect a widespread pattern of corporate managements inflating revenues and earnings by adroit and misleading accounting. Enron Corp. was the tip of the iceberg.

So laws and regulations on the governance of corporations are being considered by Congress, the SEC, corporate boardrooms and business schools. A few changes almost certain to come in the new era of reform era are:

* Boards of directors will have more responsibility in the corporation. The “hero” CEOs of recent decades will be subject to instant dismissal, or even prosecution, if anything goes wrong on their watch.

* Shareholders will gain a greater collective voice, possibly electing or dismissing company directors every year, because individual retirement accounts have become the largest single force in the U.S. equities market. IRA accounts control

$2.65 trillion in common stocks, 20% of the value of all stocks. That compares with traditional pension plans at $2 trillion, defined contribution pension plans at

$2.5 trillion and insurance company annuities at $1.1 trillion, according to Pension & Investment News, a trade publication.

* Accounting firms will be forced to stick to auditing and not offer consulting services to corporations they audit. A blue-ribbon supervisory board, appointed by the government but independent, will oversee the accounting industry. A similar board may be created to oversee corporate governance.

* Companies will be required to disclose off-balance-sheet partnerships and other connections and finances not now included in their published accounts. The SEC, which could grow in staff and authority because of new legis- lation, will require more complete disclosure in corporate accounts.

Strengthening the Authority of Boards

Corporate regulation is entering a new phase with proposed legislation pending in Congress. A bill sponsored by Republican Rep. Michael Oxley of Ohio calls for oversight of corporate accountability. Another measure sponsored by Democrat Sens. Christopher Dodd of Connecticut and Jon Corzine of New Jersey--a former co-chairman of Goldman Sachs--would establish a public accounting oversight board.

Formal regulation by the SEC and informal pressure from pension investment groups will strengthen the authority of boards of directors over corporate managements, says Ira Millstein, an expert on corporate governance, professor at the Yale School of Management and senior partner in New York law firm Weil Gotshal & Manges.

Audit committees of independent directors will decide what accounting systems a com- pany uses, Millstein says. “They will be able to dismiss a chief executive if misleading accounting is found on his or her watch.”

Most of all, say Millstein and other experts on corporate law and governance, the board of directors should be independent of management and able to represent the interests of shareholders. Directors should not have a consulting relationship with the company or with senior management, advises professor Edward Lawler of USC’s Marshall School of Business.

A shift in thinking about corporate responsibility is occurring in response to abuses at Enron and other firms in the last decade. Enron issued misleading accounts--that it later had to restate--to keep its stock price higher than it might have been otherwise. But Enron was not alone.

Xerox Corp., once a greatly admired company, has paid a $10-million fine for misleading reports of revenue from leases that made its business look better than it was. Officers of the company may face further SEC charges.

Qwest Communications International Inc., a pioneer of fiber-optic technology, is accused by regulators of recording revenue from sham transactions to boost the value of its business.

Such behavior caused two problems, says Lynn Turner, former SEC chief accountant. One is that “wrong information causes wrong decisions,” meaning that the companies made unwise investments based on their own false figures.

The other problem is that investors were misled. When true results became known, the stocks of both companies fell sharply. Both are down more than 80% from their historic highs and have caused material losses for individual investors--that is, voters. That’s why Congress is on the warpath.

But will reform really come? Veterans of business and investment markets, who say the debate will result in much talk but little action, can be excused for cynicism.

Yet this time could be different. An example of reform is Cendant Corp., which is pushing the envelope on corporate governance. Cendant, which owns Avis Rent a Car, Century 21 real estate brokers, Days Inn hotels and many other service businesses, was accused of fraud three years ago when false accounts were discovered in a company with which it had merged. Cendant settled a class-action suit and took steps to reinforce its board’s independence. (A former Cendant chairman and vice chairman have pleaded not guilty to federal charges of securities fraud and are awaiting trial in Connecticut.)

This year Cendant is proposing that its shareholders vote directly on whether the company should grant stock options to managers and employees. The New York-based company is instituting limitations on the ability of company officers to trade in company stock. And shareholders are asked to vote each year to elect or dismiss any and all directors.

“We expect these initiatives to contribute to building shareholder value,” Cendant Chairman Henry Silverman says. So far, the company’s stock price, which closed Friday at $18.60 on the New York Stock Exchange, has recovered from the plunge it took a few years ago to less than $8 a share. But Cendant’s stock is priced lower than the average for other firms on Standard & Poor’s 500 index, possibly because as a conglomerate its accounting is complex. The firm recently had to publicly explain investments in several outside ventures simply because analysts voiced suspicions.

In this new post-Enron atmosphere, companies must be above suspicion or see their stock shunned by investors. This era will create difficulties to be sure. “Many qualified people will hesitate at the risks of serving as directors,” says Charles King, who heads recruiting of corporate directors for Korn/Ferry International.

Restoring Credibility to Corporate Finance

But beyond short-term difficulties, another stage in the evolution of the corporation may be underway. In the 1920s, Wall Street investment managers organized pools to run up stock prices, attract small investors and then leave them holding the bag as insiders sold out. The securities laws of the 1930s stopped such practices and restored credibility to corporate finance.

In the 1990s, Wall Street investment bankers and corporate managers manipulated initial public offerings to generate huge gains for insiders but massive losses for an investing public that has now grown to include one of every two Americans.

And so now we are embarking on a new era of reform to restore credibility to corporate finance and to provide some relative protection for retirement savings. Reforms won’t eliminate greed or change human nature. But regulating corporate behavior, either by the force of law or through shareholder pressure, is imperative for a healthy economy.

“If reforms aren’t made, we’ll have more scandals in a few years,” Millstein says.

“And if reforms are made, we’ll still have future scandals but not so frequently.”

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James Flanigan can be reached at jim.flanigan@latimes.com.