A successful economy depends on many things.
The rule of law, protection from theft and fraud, enforcement of contracts, freedom from excessive taxes and regulation, control of unfair trade practices, regulation of financial reporting and securities markets, etc. are all required.
In spite of all the efforts of the government and legal system, business depends on trust. If one cannot trust the people one is dealing with, it becomes very difficult and expensive to complete transactions. Auditing and litigation costs do not add economic value, and are a drag on the system.
In the high-profile debacles in recent years, the perpetrators displayed a complete disregard for the trust that had been given them. They may have rationalized their misdeeds by saying that they were maximizing the value for their shareholders. Unfortunately, the frauds committed by the managements of Enron and WorldCom destroyed more shareholder value than any in history. These managements are responsible for terrible damage to the repudiation of American business. These people should spend the rest of their lives in prison and lose all of their assets.
Let’s look at WorldCom
Amount of fraud (overstated earnings): $11 Billion
WorldCom equity (market cap.) destroyed: $180 Billion
If we make the (generous) assumption that the average person’s lifetime earnings is about $2 Million, this means that the equivalent of 90,000 people’s lifetime earnings were destroyed. Yes, I know that the creditors still have some of the remaining value of the company now called MCI, but the stockholders lost $180 billion.
This is only the beginning. The lost trust in corporate governance hurts everyone. Congress felt the need to do something, so they passed the Sarbanes-Oxley act. The cost of the new requirements, especially section 404 internal controls, makes the U.S. capital markets less competitive. More IPO’s are being listed on the London and Hong Kong exchanges that would have listed on the NYSE in the past. We are seeing many public companies taken private to avoid the cost of compliance.
What We Should Do
The damage done has been huge. In order to help repair some of this damage, I think the following should happen.
- Corporate boards need to take more responsibility. They need to be more than a rubber stamp for management.
- Shareholders need to hold boards accountable. With so many shares held by pension funds and mutual funds, the owner’s are disconnected from the underlying shares.
- Revise Sarbanes-Oxley. Many of the new regulations were needed, but the cost of some of the requirements greatly outweighs their benefits.
- Inflict even harsher penalties on wrongdoers. The SEC needs to do its job and stop the practice of allowing fines with no admission of wrongdoing. Criminal penalties for multi-million dollar frauds should be greater than for robbing a gas station.
- Consolidate the regulatory functions of the NYSE, NASD, and perhaps the SEC. The many regulatory bodies put the United States capital markets at a disadvantage versus foreign markets.
I have gone on at length on this, but feel I’ve only scratched the surface. I welcome your comments.
An interesting paper on how overvalued equity can destroy value:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=480421
Or the same on Archive.org:
http://web.archive.org/web/20060911101002/http://www.law.uiuc.edu/content/conferences/capitalmarkets/pdf/jensen_agency_costs.pdf
Wikipedia has some good information on Sarbanes-Oxley:
http://en.wikipedia.org/wiki/Sarbanes-Oxley_Act
Tim Callison
www.tcallison.com
