THE LOSS OF TRUST IN CORPORATIONS

by Robert N. Charette, Fellow and Director, Risk Management Intelligence Network, Cutter Consortium

In light of recent corporate excesses, Teddy Roosevelt's remark of 100 years ago in response to the corporate scandals of the time seems most apt: "Corporate cunning has developed faster than the laws of nation and state, so when the weather is good for crops, it is also good for weeds. Sooner or later, unless there is some readjustment, there will come a riotous, wicked, murderous day of atonement" [2]. Well, the time for atonement has come. Over the past two years, we have seen a parade of corporate executives led away in handcuffs for insider trading, lying to government investigators, misuse of their position for personal gain, misleading the public about the financial state of their corporation, and dozens of other acts of corporate malfeasance. The bankruptcy of just five companies in 2002 -- Enron, Global Crossing, WorldCom, Tyco, and Qwest -- destroyed more than US $.5 trillion in shareholder value.

While the explosion in corporate scandal has happened seemingly overnight, the lack of confidence in the management of public corporations has been building for more than a decade. Throughout the 1990s, corporate critics chastised management's excessive focus on meeting short-term earnings targets at the expense of long-term investments; this took place alongside Wall Street analysts' severe punishment of companies that did not meet the analysts' projected quarterly numbers. Additionally, the critics argued that corporate boards of directors awarding huge salaries, bonuses, and stock options to senior executives who successfully hit the numbers created a dangerous mix.

Former US Security and Exchange Commission (SEC) Chairman Arthur Levitt warned that this combination of reward and punishment might tempt some executives to manipulate their corporation's financial numbers to hit their market forecasts. He foreshadowed things to come in a 1999 speech: "Information is the lifeblood of markets. But unless investors trust this information, investor confidence dies. Liquidity disappears. Capital dries up. Fair and orderly markets cease to exist. As the volume of information increases exponentially, the quality of information for investors and the markets they comprise must be our signal concern. The promise of a global marketplace, like never before, depends on it" [1].

In 2002, as the stories of Enron, WorldCom, and others unfolded, it became obvious that many corporations were producing fictitious financial information, inflating revenue numbers and deflating costs. During 2000 and 2001, for example, WorldCom reported US $5 billion in profit when it actually lost $74 billion. It soon became clear that many corporate executives, boards of directors, stock analysts, public accountants, and government regulators had violated their legal, regulatory, and fiduciary responsibilities.

On the heels of the dot-com bust and a souring economy, the scandals forced the US government to act -- which it had strongly resisted doing up to that point -- to restore investor confidence in the market and trust in public companies generally. In 2002, the US Congress, following the lead of European and other foreign governments that had earlier approved corporate reform laws, passed the Public Company Accounting Reform and Investor Protection Act of 2002 (also known as the Sarbanes-Oxley Act or "Sarbox" for short). Most observers regard Sarbanes-Oxley as the single most important piece of legislation affecting corporate governance and public accounting since the passage of the National Labor Relations Act in 1935.

Sarbox tightens the rules of public corporate financial reporting and, among other things, requires the CEO and CFO to personally certify the accuracy of financial statements. Sarbanes-Oxley imposes a maximum penalty of 20 years in jail and a $5-million fine for making false statements in corporate financial certifications. This means that financial information must be both valid and verifiable. This increased accountability has in turn pushed the CIO squarely into the middle of the corporate governance requirements. In the future, for example, the CIO must ensure that risks -- say, the altering of a financial transaction -- to any IT system used to produce, gather, store, or transmit financial-related data are not only being managed but that the processes to manage the risks are effective.

-- Robert N. Charette, Fellow and Director, Risk Management Intelligence Network, Cutter Consortium

References

[1] Levitt, Arthur. "Corporate Governance in a Global Arena." Remarks to the American Council on Germany, New York, New York, USA, 7 October 1999.

[2] Morris, Edmund. Theodore Rex. Random House, 2001, p. 360.