The Power of Markets to Solve Their Own Problems

Its staff has stepped up its reviews of annual financial statements. Its Chairman, Harvey Pitt, has called on the New York Stock Exchange and Nasdaq to review corporate governance and listing standards. And the SEC has proposed several new disclosure rules, while serving notice that these proposals are the beginning of a new regulatory agenda covering several other components of the regulatory framework such as accounting standard-setting and the regulation of audits and the auditing profession.

Before moving too far down this path, securities regulators need to assess how far market participants have gone in solving its problems. Because of the speed advantage inherent in market forces, already the signs are already evident.

The most visible reaction is that investors are punishing companies with questionable accounting practices. Investors have rewarded companies in the past for being aggressive in their financial accounting. However, these same companies are now being served notice that such practices are no longer acceptable. Some companies have already begun responding to investor concerns by releasing more information on their off-balance sheet exposures and one company, Krispy Kreme, has announced it will finance a new manufacturing facility on its books rather than through an off-balance sheet synthetic lease to avoid investor misperceptions.

Evidence of changing company behaviour is also evident from the adoption of new corporate policies on giving their auditing firms consulting work. Several large companies, such as Uniliver and Walt Disney, have announced they will not give their auditors any more consulting work and more are expected to follow. Shareholders are increasingly encouraging companies to adopt these policies.

In recognition of the changing attitudes of their clients, the large accounting firms are responding to the conflict of interest issues. Although the previous SEC Chair failed in his efforts to force accounting firms to spin off their consultancy businesses, two firms had already voluntarily spun off their consultancy businesses before the Enron controversy.

Since then, two more firms have announced plans to do the same. When Deloitte Touche announced its decision, it indicated its belief that the issues of auditor independence is one of perception only, but it still believed that splitting the company was in the interests of its clients. The remaining large firm, Andersen, has announced that it will no longer take on consulting business from its audit clients.

As to be expected, Enron’s shareholders and creditors are taking civil legal action against Enron, its officers and directors, and its auditor. The victims of Enron will inevitably be unable to recoup all of their losses. However, officers, directors and auditors of public companies will surely be more vigilant in the exercise of their duties to avoid the risk of financial and reputational loss from litigation.

Moving forward, regulators need to remain wary of the costs of excessive regulation, which are self-evident and long recognized by the SEC and other securities regulators. Quite simply, excessive regulation impedes capital formation. Without question, a post-Enron review can be a healthy exercise in determining shortcomings in the US’ existing regulatory framework.

Clearly, some issues have to be addressed, such as the role securities regulators should have in setting accounting standards. However, regulators and public authorities need to be realistic in setting their objectives. Total eradication of any possibility of fraud, deceit and misconduct in capital markets through more regulation is possible only through market strangulation. Rather than proposing new regulations, a better starting point for the SEC would be to ask itself how regulation should be changed to better enable markets to solve their own problems.