A Look at the SEC
Five years after the great stock market crash of 1929, Congress created the Securities and Exchange Commission to keep a close eye on corporate finances. No one wanted to face another crash fed by corporate corruption and a market gone wild.
For more than sixty-five years the system worked reasonably well. But in 2000, after nearly a decade of boom, the market began a slide that lasted more than two years. One reason—corrupt corporate accounting. Dazed investors learned the SEC had tried to head off the wave of accounting scandals but it had been hamstrung by Congress, which failed to give it the money needed to police the booming stock market.
The SEC’s problems were compounded by the failure of the private sector at nearly every level to do its job, says Bernell Stone, visiting scholar at the SEC and finance professor at the Marriott School. “There was a failure on the part of accountants, lawyers, investment bankers, commercial banks, securities analysts, and corporate boards to protect investors. In many cases they became allies of unethical corporate managers,” he says.
Investor greed for higher earnings, growing corporate debt, and “increasingly significant moral decay” in American society added to the volatile mix that led to the accounting scandals, says Steve Albrecht, an internationally known fraud expert and associate dean at the Marriott School. “Eventually, all these factors came together in what I call the ‘perfect storm,’” he says.
Fortunately, Congress has passed new laws to help the SEC crack down on corporate lawbreakers and approved new funds to beef up the agency’s overworked staff. In the long run, this should help tame the accounting manipulations that made Enron, WorldCom, and Tyco household names. But in the short term, accounting irregularities persist and new problems continue as the SEC tries to regain its hold on the markets.
AN EROSION OF INVESTOR PROTECTION
After booming through much of the 1990s, the market peaked on 14 January 2000, as the Dow hit 11,772. Then the long slide began. The attack on 11 September 2001 drove the average still lower. But the Dow began to recover, pulling above 10,000 in early December of 2001, before the Enron bankruptcy ushered in the corporate accounting scandals. By mid-2002, the Dow bottomed at 7,702, a loss of more than 4,000 points from the market high. The NASDAQ index underwent a meltdown, losing roughly 80 percent of its value.
What went wrong? Arthur Levitt, SEC chairman through most of the 1990s, supplied some of the answers in his recent book Take on the Street—What Wall Street and Corporate America Don’t Want You to Know.
“Investor protection is supposed to be the responsibility of three institutions: The SEC, the stock exchanges, and the courts,” Levitt wrote. “Yet over the past several years, the effectiveness of each has been eroded.”
Levitt portrayed the SEC as an agency unable to do its job because of inadequate funding and pressures from businesses and members of Congress who jointly sabotaged proposed regulations designed to prevent the sort of accounting fraud that helped bring down the market.
The underfunded SEC was woefully short-staffed for a workload that ballooned in tandem with a national stock-buying frenzy. By the year 2000, corporate America filed nearly 100,000 financial documents with the SEC—or about 1,000 documents for every accountant assigned to scrutinize them. That meant each accountant was supposed to examine roughly forty documents a week, or about one every hour. Some documents ran hundreds of pages, so the task was impossible.
Thus, the SEC faced the unenviable task of trying to figure out which companies were filing honest earnings numbers and which weren’t. This is a tough job in the best of circumstances, because a set of books created through carefully crafted fraud may look pretty much like an honest set of books.
“If somebody is cheating, it’s hard to find it in the documents,” says Everett Smith, a 1983 BYU MAcc graduate who worked as an attorney in the SEC’s Division of Corporation Finance from 1990 to 1996. “Just look at Enron.”
Albrecht says, “The SEC gets tons and tons of annual and quarterly reports from corporations. Unless the SEC gets a tip, they probably wouldn’t investigate these filings for fraud.”
So an investor looking at corporate financial statements on the SEC’s web site might be basing his or her investment decisions on page after page of falsified numbers. It happened to the thousands of individuals and funds that bought Enron stock. They were soaked for $60 billion. Stockholders at Tyco, WorldCom, and many other firms also suffered big losses.
SCANDALS FORCE CONGRESSIONAL ACTION
Fortunately, Congress pays attention to scandals that cost Americans their pensions. In the wake of the latest market disaster, lawmakers mandated a series of reform measures geared to help the SEC find corporate crooks.
Congress has given the agency more cash to beef up its accounting and legal staff. And, it passed the Sarbanes-Oxley Act, which requires top corporate officers to certify that their financial statements are accurate.
The same act also targets the auditing industry, which was riddled with conflicts of interest. A Dow-Jones Newswire study found these firms made $3.7 billion on consulting and other non-audit services in 2000. This was triple what they made auditing corporate books. So there was little incentive for accountants to kick the tires as they examined corporate ledgers. To do so invited the loss of lucrative consulting contracts.
Former SEC Chairman Levitt sums up the situation this way, “Corporations were playing with the earnings calculation until they arrived at the best possible number. Auditors, increasingly captives of their clients, would give them the clean audits they wanted, despite lots of chicanery.”
Levitt sought to enact rules that would have barred such conflicts, but the effort was short-lived. Pressure from auditing firms, from business, and from members of Congress who threatened to cut the SEC’s funding, forced Levitt to back down.
The accounting scandals, however, spurred Congress to reverse direction. Under the Sarbanes-Oxley Act, auditors are now barred from providing many non-audit services to their accounting clients. But the act doesn’t close the door entirely. Auditors can continue to provide tax accounting and certain advisory services.
A BIG JUMP IN WHISTLE-BLOWING
Fortunately, the scandals have spurred a big jump in corporate whistle-blowers, and this is a huge help to the overworked SEC lawyers and accountants. In essence, the tipsters are telling regulators where the bodies are buried. Typically, such tips come as anonymous phone calls or a letter signed “someone who cares,” says former agency attorney Smith.
“The whistle-blowers are usually people involved in the financial aspects of the company, and they can pretty much pinpoint what happened,” says Jacob Given, a Marriott School accountancy student who works as a research specialist in the SEC’s Los Angeles office. “These days we get a lot of people calling in.”
The SEC specifies which documents companies must file, when they must be filed, and what must go in them. Sample documents include annual reports,
proxy statements, quarterly reports, and stock and bond registration statements. As documents come in, they are posted on the SEC's web site, after which the text is sent to SEC lawyers to examine while the numbers go to agency accountants.
Omissions and outright fraud can be difficult to find by examining the documents. To look for instances of each, SEC staffers scan the Internet for revealing news stories. A search might reveal that a company is facing huge product liability judgments that it didn't disclose in its SEC filings. Or the SEC might find a web site reference to a shareholder's lawsuit that alleges fraud.
The SEC also compares a company's profitability with others in its industry. If the numbers look too good, there may be a problem. But some fraud is very difficult to find and that's why the SEC needs tipsters. Without tips, the SEC has to look for fraud by looking at the numbers, and that's a difficult, often impossible job. Someday, however, computers may help by analyzing a company's books for patterns that may indicate deceit.
One recurring problem has nothing to do with fraud. All too often, companies turn in documents that are unintelligible to investors because they are full of jargon or legalese that only a company insider could interpret.
When that happens, the SEC tells the company to rewrite the offending sections in plain English, says Greg Belliston, an attorney with the SEC's Division of Corporation Finance. The SEC even has a title for this process— "The Plain English Initiative," says Belliston, who received his MAcc from the Marriott School in 1998 and his JD from BYU in 2002.
The agency also drafts rules used to implement new securities laws passed by Congress. This is a complex process because business has the right to object to the way SEC staff wants to draft new regulations, and often does so. "There's plenty of interaction between business and the SEC in the rule-making process," says John Faust, a staff attorney who works in the rule-making office of the SEC's Division of Investment Management and a 1998 Marriott School MBA graduate.
"In the last year and a half, we've had a tremendous amount of rule-making that was spurred by the accounting scandals. A lot of things had gone wrong, and Congress was trying to create regulations to curb those abuses."
leaving almost no one untouched. When the market slide began in 2000, so did the value of college endowments and pension funds. The Enron debacle alone cost Florida’s state pension system $325 million and the University of California’s pension fund and endowment lost $145 million.
Insurance companies were battered as well. Insurers often make money by investing premiums in stocks. When the market plunges, insurers make up for investment losses by raising the premiums on all kinds of insurance.
Millions of individual investors were also battered. Some Enron employees not only lost their jobs, but they watched the value of their 401-K retirement plans, which were heavily invested in Enron stock, drop to nearly nothing.
Falling markets are often accompanied by slumping economies, and that has happened in the current downturn. When Americans see their net worth rising, economists say, they are more likely to spend. When their stock portfolio is sliced in half, or worse, they are more apt to shun big-ticket purchases that help to drive the economy.
Former Harvard University economist John Kenneth Galbraith describes a similar cause-and-effect relationship in his book The Great Crash 1929, which looked at America’s worst market collapse. “The stock market crash and the speculation which made it inevitable had an important effect on the performance, or rather the malperformance, of the economy in the ensuing months and years,” Galbraith wrote.
By those lights, a revival of the stock market could help to spark the sputtering economy, which has suffered a net loss of jobs since late 2000. But luring investors back to the market is no easy task. Many of them continue to avoid the market lest they get stung by a new wave of corporate accounting scandals.
ACCOUNTING PROBLEMS CONTINUE
Investors’ fears aren’t without foundation. One gauge of how well Wall Street has reformed is the number of incidences in which corporations have been forced to restate earnings data. Huron Consulting Group, a national consulting firm, recently looked at the issue and found matters had not improved.
For the year ending 30 June 2003, a total of 354 publicly traded companies had restated earnings because of accounting errors. “When comparing quarterly filing activity on a year-to-year basis, we have not observed a slowdown in the volume of restatement filings for accounting errors,” says Joseph J. Floyd, Huron’s chief operating officer.
SEC’S VISITING SCHOLAR BERNELL STONE
Marriott School Professor Bernell Stone is serving a one-year term as a visiting academic scholar at the SEC. Stone is part of a team tackling one of the agency’s toughest problems—how to spot companies that have “cooked their books” and given the SEC phony profit figures.
With a background in computer science and applied mathematics, Stone is trying to create software that will allow computers to screen tens of thousands of financial documents annually for problems. If the computer can throw up a red flag, it will tell SEC accountants and lawyers where to best spend their time. Initially, the effort will focus on 10-Ks or annual reports and 10-Qs or quarterly reports.
“Instead of looking at all reports equally, we want to see which ones potentially have a problem,” Stone says. “We want to get through the forest and see which trees to look at.
“We have traditionally looked at financially distressed companies. But we missed Enron, WorldCom, and Tyco. They were hyping the numbers so much that they looked like they were high-performing companies.”
The son of a chemist, Stone got his undergraduate degree in physics at Duke University and his master’s degree at the University of Wisconsin. But he shifted his focus for his PhD at MIT, with dual majors of applied mathematics and management and minors in economics and computer science. At MIT, he worked with two Nobel laureates in economics, Paul Samuelson and Franco Modigliani. “Both of them pointed me toward financial economics,” Stone said.
Stone is the Harold F. Silver Professor of Finance at the Marriott School and an internationally recognized expert in financial systems, especially those that involve cash management, bank operations, payments systems, and corporate planning. He was founding editor of the Journal of Cash Management and has served as associate editor of six other journals.
He has written more than one hundred financial journal articles and four books. A fifth book, Corporate Cash Management, is scheduled for publication by Oxford University Press in late 2005. Stone’s recent research has focused on such areas as stock return forecasting, investment management, financial reform, and mortgage redlining.
He was recruited to BYU in 1986 by Dean Paul Thompson, who was in the process of making the Marriott School one of the country’s top business schools. “I bought into his vision,” Stone says.
The SEC has not hired significantly more staff, even though Congress has given the agency the money to do so. Lynn E. Turner, who served as the SEC’s chief accountant under Levitt, says two factors are to blame. First, there is a shortage of professionals with the legal or accounting skills required at the SEC. Second, the SEC is hampered by antiquated hiring practices. “They’re just not getting ramped up that fast,” Turner complains.
He says the SEC has also failed to take the lead in efforts to crack down on recently uncovered wrongdoing by Wall Street firms. Instead, the leadership role has been snatched by New York’s aggressive Attorney General Elliot Spitzer, who has mounted, with minimal resources, a frontal assault on Wall Street corruption.
“I love the SEC and what it has accomplished,” says Turner. “But one thing is driving me batty: on the major issues, it has not been the SEC that has brought action first. Spitzer has gone first.”
Turner says tipsters were going to Spitzer with allegations of corporate fraud instead of turning to the SEC because “they aren’t sure the SEC will get the job done. They know Spitzer will. And, Spitzer has done it with a staff of a dozen attorneys. The SEC has hundreds. It’s a case of the tail wagging the dog.”
But BYU’s Bernell Stone sees a brighter picture. He believes the structural problems that allowed corporate corruption to thrive are being cleaned up, thanks to pressure from a wary investing public.
He cites efforts to double watchdog staff at the SEC, tough new provisions of the Sarbanes-Oxley Act, and moves by corporate managements to return to accurate bookkeeping.
The shift to better bookkeeping is a direct outgrowth of investor pressure, Stone says. “Investors are demanding better corporate governance. The stocks of corporations that play numbers games with their books are being avoided,” he comments.
“It’s all part of a cycle we’ve seen before—the boom, the bust, and the demand for reforms so it won’t happen again. If you look at the history of the 20th century, you had the booming markets of the 1920s, the crash, and the reforms of the 1930s,” Stone says. “We had the bull markets of the 1980s and 1990s, the extreme bubble, and then the bust. Now we’re seeing the pressure for reform.”
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Article written by Douglas McInnis
ABOUT THE AUTHOR
Douglas McInnis writes about business, science, and agriculture from his mile-high base in Casper, Wyoming. He has a BA from Oberlin College and has written for the New York Times, Popular Science, and leading farming and ranching magazines.
