Home > Update > June 2007

Corporate Clean-up?

In the wake of Enron, WorldCom and other Wall Street scandals, major regulatory reforms, especially Sarbanes-Oxley, were imposed on public companies. Were the changes needed? Have they helped corporate accountability or just created paralyzing paperwork? UPDATE asked Finance Professor James Seward; Terry Maxwell, an industry professional now teaching at the School of Business; and Charles Gasparino, an investigative reporter who covers Wall Street for CNBC, to explore the issues (learn more about our panel). Moderating their discussion was Patrick Hammes, a second-year MBA student in Applied Corporate Finance.

Charlie, in your well-known book, “Blood on the Street,” you explored a time when investment banks were fudging sell-side investment research to generate banking transaction fees. Have things changed?

CHARLES GASPARINO: There clearly have been changes. In 2002, what was known as the Global Settlement was signed. Major investment banks agreed in principle to create a mechanism to prevent the sort of gross conflicts of interest that had led to over-optimistic ratings on stocks, and in some cases, outright fraud.

I would broadly describe the reforms as creating bigger, greater Chinese walls between investment banking and research. Yes, there are more rules now, but I don’t really think they address the issue. I’m a less regulation guy. I believe that if this was really bad behavior, the best thing to do, is not to put up walls that people can figure out how to get around. If there’s an indictable offense, you indict the person. When you look at the optimistic ratings for stocks out there, I don’t think it’s much different than it was in the past.

Terry, you’ve been an investment banker for over 20 years: do you agree with
Charlie’s observations?

TERRY MAXWELL: A number of Charlie’s points are good ones. There are a few that I have a slightly different perspective on. One is my perception of the Chinese wall. Historically, it was to prevent confidential information about a transaction from getting into the hands of the trading desk or an analyst that might affect the analyst’s recommendation of the stock. If someone was privy to information about a pending merger, they couldn’t step back and not let that influence the rating of that stock, or the sales desk from taking advantage of that. It was a confidentiality issue.

The Global Settlement was necessary for a different reason. It wasn’t the confidential information; it was the fact that the research people had become the principle motivator for why people got business. Some of that is just human nature. As an analyst, you want to be the most influential analyst on the street, and who gets the banking business can be a measure of that. Things clearly got way out of hand. The Global Settlement was necessary to draw firm lines between banking and research. I know from participating in the industry, mostly before the Global Settlement, and then for several years post-Global Settlement, the actual day-to-day business of how these firms are run is significantly different today. The separation between research and banking is real today. It was not what it should have been pre-Global Settlement. I think it was necessary, because the analysts got very swept up in the whole economic proposition of the banking business. There needed to be rules put in place to say, “Wait, that’s not the analyst’s role.” There is a human nature element that’s hard to regulate. As Charlie said, it’s hard to put rules in place to protect against everything.

Jim, what’s your take? Will investment bankers and analysts always find a way around rules and reforms?

JAMES SEWARD: The beauty of being an academic is that we can wait for tons and tons and tons of information, as opposed to somebody who actually has to make money. Clearly some things have changed, and it’s still all playing out.

You think about all the things that were done, and it’s clear the reformers were trying to address the conflicts of interest, but when you make change, two things need to happen. One is that you make some things better—you hopefully directly address the things that were wrong with the conflicts of interest. But sometimes these things have unintended side effects. We’re trying to sort out the unintended side effects of the settlement. Research used to be part of the profit equation for some investment bankers. Whether that was a good idea or not, is a different story. Now it’s regarded purely as a cost center. That has a couple implications. Number one, analysts
I talk to say it’s no longer considered a particularly good place to go. The reason is whenever you’re viewed as a cost center, you’re kind of a junior person at best. Ultimately, I’ll be curious to see what is the impact on the overall quality of people who become analysts and the role they play inside companies.

Private equity firms are playing an increasingly important role in banking activity.
Is this related to disparities in accountability between public and private equity firms, specifically with respect to Sarbanes requirements?

MAXWELL: Sarbanes has clearly had an impact on the cost of being public, the accountability, the level of scrutiny that public company management teams are under. But, the whole going private or “M&A boom” is fueled mostly by economics. The search for higher returns from investors, not individual investors, but institutional money, pension funds and large institutional pools of capital that are searching for larger returns on alternative investments. And so we’ve seen the rise in hedge funds, and the rise in private equity firms. You can see it every day in the paper with new, record-setting LBO deals. Sallie Mae isn’t going private because of Sarbanes. They’re going private because there is an economic opportunity, presumably in restructuring. That company and others are likely to be back in the public market again someday. So I don’t think that Sarbanes is the driver, I think it’s the search for higher returns and the enormous pools of capital that have been attracted into alternative investment vehicles driving the “M&A boom.”

The separation between research and banking is real today.

GASPARINO: I think the immense public glare, which includes Sarbanes-Oxley, and press coverage—especially in executive compensation—does force people to think, “Why do we need this?” And then they go private.

SEWARD: I’ll occupy the middle ground and make everyone happy. I do think there are a number of factors. In some of the work I do for companies I hear how much money and time they spend on Sarbanes-Oxley. It’s a considerable amount of human resources in addition to financial resources. A lot of them don’t like it.

You would think, however, that with the fixed costs, if that were the sole driver there would be a disproportionate number of small companies (going private), because the cost should be a much more significant part of what they do. Yet you pick up the paper everyday and it’s First Data, it’s Sallie Mae, it’s Sam Zell’s old company, and Chrysler may be out there. It seems clear to me that there is more to it than just the cost.

On the flip side, I’ve had discussions with people who think there are good things that came with Sarbanes-Oxley. There are privately held companies that have voluntarily adopted a fair number of the principles of Sarbanes-Oxley. As a public company you can’t pick and choose. You do it and pay whatever cost comes with it. As the U.S. economy and corporations have matured, fewer need the benefits of public status. I do think compensation is a huge issue. Everybody on the planet thinks pay for performance is a good idea. The question is to what extent and how much do you pay for performance.

Jim, what do you consider performance?

SEWARD: Clearly, there are too many escape clauses for people who don’t perform. Saul Steinberg gets a huge option package for going away. Ten years later when it matures the guy makes $200 million dollars and gets absolutely positively skewered in the newspaper. The market value of the company [Reliance Group] had been $2 billion and now it’s $24 billion. He made $22 billion dollars for shareholders at a time they were paying him $200 million. Was that too much? Too little?

This is one issue where I feel private equity firms understand that cash pays bills. If you do well and make a lot of dough for the company, you get paid a lot. And guess what? It doesn’t show up on page A1 of the Wall Street Journal because it’s a privately held company. So I think there is some attraction to private firms by CEOs these days due to that.

So, Sarbanes has increased accountability in public companies?

GASPARINO: I think it’s helped. It’s hard for a journalist to actually figure this out, because usually the stories come out after the people screw up. I think it’s helped on the accounting end. Would Sarbanes-Oxley have prevented WorldCom? I don’t think so. Would it have prevented Enron? Maybe.
I think that’s where you really have to come down.
A lot of legislation was created because of this. So, you have to ask yourself, would this law have prevented this stuff? I don’t think so. That’s the problem I have. There are costs to this, and it’s not so much the big companies that are bearing the burden because of Sarbanes-Oxley, it’s smaller companies.

MAXWELL: I agree with what Charlie’s said. Sarbanes was a regulatory reaction to the triple-whammy problem in the U.S. One was the dot-com bust, the second was the big fraud situations, and the third was Wall Street research bias. So, we had
a total undermining of the credibility of the financial markets. We had to have a regulatory response to restore confidence in the markets. The pendulum swung and more rules were put in place. It probably went too far, and you will see a lot of companies going public in London and China that wouldn’t have gone public there before.

It’s a global economy today, and you see companies going public where they’re most comfortable, and that isn’t the U.S. markets now. Part of that is regulatory and part of that is just public market psychology and the pressure of investors and short-term earnings. Sarbanes has served a purpose but it’s raised the bar too far for small companies in that it makes it difficult to consider going public.
I think we’ll see reform at some point to lower the bar. It wouldn’t have prevented WorldCom or Enron, because if people want to commit a crime, they’re going to find a way.

Do you think any easing of requirements mandated by Sarbanes regulation will start with smaller companies?

SEWARD: Unless there is a groundswell from somewhere to get rid of it, the changes will be incremental. They would perhaps lower the bar periodically, that companies below a certain size, whether it be sales or market cap, are exempt. There would have to be definitive proof that the costs outweigh the benefits. Ideally, you need to see for every single company what are the costs and benefits. One of the great things about the American economy is the rewarding of risk taking and entrepreneurship. That is what distinguishes us. You hate to see that cut-off by legislation that was precipitated by other companies on the other end of the spectrum.

The crime from the Enron and WorldCom cases came when they were trying to cover it up. They made poor business decisions. Unless you write legislation that says that stupid people can’t be managers at corporations anymore, we’re not going to stop this from happening. Boards of directors are acting more responsibly now, which has been encouraged by these regulations. It reminds me of airport security following 9/11. How effective has it been in preventing a repeat? We’ll never really know, because it’s designed to prevent the very thing. The same thing with Sarbanes-Oxley, it’s preventing these things from happening, but we’ll never be able to see or measure it exactly.

You see companies going public where they’re most comfortable, and that isn’t the U.S. markets now.

If Sarbanes wouldn’t have prevented an Enron or WorldCom, what can be done to make sure management acts in an ethical manner and looks out for the interests of shareholders?

GASPARINO: Regulators and prosecutors didn’t enforce the laws already on the books and that allowed a lot of these things to go on. The prosecutions of the people at Enron and WorldCom in itself has had a deterring effect. If there is a problem, you prosecute and regulate. You don’t need extra laws.

Terry, can laws ensure ethical behavior?

MAXWELL: I don’t think you can regulate everything. The prosecutions have been a positive. They put people on the front page of the paper, and people don’t want to be in that position. There is nothing stronger than enforcing laws that are on the books. That extends to corporate boards. You haven’t seen as much with that, but you’ve seen a bit, and you need to have teeth in the rules and enforcement. They are responsible for overseeing the activities of the management teams and looking out for shareholders and other constituents. But we do need to be careful not to go on a witch hunt of directors, because it’s hard to find directors today. If you hang them when they overlook something, that’s not a good thing either. There’s an institutionalized practice in the U.S. of boards being very management-friendly, being friends of the CEO. I don’t think boards should be held responsible if management commits fraud, because there is no way they could see that. But if they’re not showing up to meetings, and they’re not independent, then you have to question their purpose.

Sarbanes has served a purpose but it’s raised the bar too far
for small companies.

Jim, are we likely to see an Enron or a WorldCom at a private equity firm?

SEWARD: I don’t think you’d go through the Enron situation, where they just kept covering up mistake after mistake. There is something about the active monitoring and skin in the game. Money talks. I don’t think you’ll see the same things happen as with the public firms. Only when things get systemic, and when Sarbanes-Oxley came along, did people understand there was a systemic problem.

Will we see more legislation? It depends on what the next systemic thing is. Maybe we’ll get legislation that says you cannot backdate options. Well, fine, but you shouldn’t be doing it anyway. We don’t need to legislate that. If something comes up that’s systemic, we write legislation to deal with it, and then the system adapts and we figure ways to get around it.

I started a while back thinking about putting together a course called “Scandals and Scoundrels.” If we’re trying to train MBAs to be the business leaders of tomorrow, it seems there is an awful lot of fodder out there for what not to do. The course would need to be a couple of semesters. It would be very intriguing reading. It would have some blood on it—literally and figuratively. If our students read Charlie’s book, they might feel differently about certain things. Maybe I’ll propose that we scrap the ethics course and substitute “Scandals and Scoundrels” with “Professor Gasparino.”