Over the past year, a lot of media attention has been given to corporate scandals … companies such as Enron and WorldCom have become the poster companies for all those looking to define corporate greed, fraud and indulgence. Those in the know have skillfully shifted the focus from what is a criminal issue, executed by a very small number of individuals, to creating the perception in the investing public that there is a significant deficiency in corporate regulations, and specifically corporate reporting and governance. Today, most corporate executives are viewed with a sense of mistrust, an image of high-flying individuals whose primary business focus is to defraud a naïve investing public by issuing fraudulent financial reports.
The challenge we face is that there are many constituencies at play, each intent on maintaining and sustaining their individual interests. When the Enron story first came to light, the majors in the accounting and audit industry were first to react by publicly distancing themselves from Enron and calling for sweeping changes to corporate reporting. In fact, many wrote books, articles and worked the media to get their message through. The theme of their messages was clear … they were working to build public trust, the current reporting structures were wildly inadequate and as one of them put it … they had to “stand up and be counted”.
When one investigates this response, an interesting question comes to mind. Why stand up and be counted NOW? These same individuals earned a handsome living creating financial reports for all of the major corporations in the world. If this reporting was so inadequate, why were these inadequacies not identified earlier and fixed.
The reality is that we already have some of the finest corporate governance practices in place. While there is always room to improve, corporate governance will never stop individuals who aim to defraud. The fact that individuals periodically speed does not justify having traffic police on every roadway to monitor speed and issue tickets to offenders. One would consider such a response excessive and self-serving, as is the current response to corporate governance.
What is clear to all involved is that changes in corporate reporting and governance will do little to protect the investing public. It will create a false sense of comfort, create significant additional revenue for those in the financial reporting business, put additional strain on corporate profits and at the end of the day diminish shareholder value. The reality is that those who analyze corporate reports, provide projections, valuations, and those responsible for presenting this information to the public have a far more substantial impact on the capital markets than anything else … including corporate reporting or corporate performance. And the real question is who holds these individuals accountable?
Consider two of the major declines on the Canadian markets … the slide of Nortel and 360 Networks. In both cases, the impact to shareholders and employees was comparable to Enron’s. In both cases, there was NO reporting impropriety, there was no fraud and yet the impact was devastating. This carnage has been repeated many times at numerous companies and has impacted a significant number of people and wiped trillions of dollars out of the capital markets. By focusing on Enron, and on corporate reporting and governance, attention has been diverted away from the real issue.
The challenge that faces the capital markets is not corporate governance, but corporate valuation. For a company that makes money, corporate valuation is a fairly simple process … a multiple of earnings provides a consistent mechanism for valuation. But for many of the key players in the capital markets … from analysts, to investment bankers, to brokers, to mutual fund managers, to corporate finance to those in the financial media, such companies are boring and provide no activity or income.
This is because the entire capital market thrives on uncertainty. When there is uncertainty, there is activity. When there is activity, they all make money. If there is no uncertainty, the capital markets will perish or they will create the uncertainty … you get the picture. This activity can be as simple as trading or raising capital to as complex as various forms of mergers and acquisitions.
The markets reached their peaks in 2000, fuelled primarily by greed. I recall a discussion on the valuation of Amazon.com at a time when the company was focused on selling only books over the Internet. A mathematician questioned an analyst’s projection on revenue, suggesting that even if every book that was ever bought by anyone on the face of the earth were purchased from Amazon.com, the revenue projections would still not be met. Similarly, in an era of well-known and recognized analysts, there was not a single analyst who had a 12-month price for Nortel at $1.00 one year ago.
Everyday, based on analyst recommendations, a company’s stock climbs or declines, creating uncertainty for the investors but significant revenues for those involved in the capital markets. While the analysts have a difficult task with little or no control on how companies perform, they prepare recommendations and define capital markets trends with no regulation or governance other than their own reputations. Since they clearly have a significant impact on capital market performance, one wonders why no one has focused on their actions and activity.