Reclaiming Your Company

To be sure, a number of high flying companies have been caught up in scandal over the past few years. It is an age old problem. There are any number of solutions that are being tried. Many new ideas to solve the problem are being bandied about. The problem is many are expensive to implement or ineffective or both. The turmoil is being used to advance various agendas, but only give false hope to investors.

Take a look at Section 404 of the Sarbanes-Oxley Act. This calls for documentation of the company's internal controls, testing, correction of weaknesses, outside audit of controls, management opinions on effectiveness and outside auditor's opinions on the management's opinion. This whole exercise is culminated with the CEO and CFO giving their sworn affirmation not once, but twice that they are in control and there are no errors. These affirmations are presrcibed by the SEC and no deviation or qualification of the wording is allowed. This whole process is consuming vast amounts of leadership time and mountains of cash. The immediate reward for the investor is lower earnings and a lower stock valuation. The long-term reward includes less resources for product development or acquisitions, and a management that is more focused on their personal liability and criminal risk generated by inadvertent error by themselves or their staff.

In the end errors still happen. Bad judgment is still an everyday occurrence. Everyday the articles still flow in the business press of financial restatements and SEC inquiries. They will continue to grab headlines, because the reality is they were always there.

Another example of a false flag for the investor's hopes is the new SFAS 123R which directs companies to expense the value of stock options at the time of grant. Instead of considering why stock options can lead a management astray and into poor decision making, we enact an accounting rule to try and discourage its use. Stock options are not the real problem. The concept of aligning employee, management and investor interests is really quite sound. It is in the implementation that the incentive goes wrong.

Since most stock options generate a tax liability at the time of exercise, the average employee is basically forced to sell shares and not hold the stock. This defeats the whole purpose of the stock option since ownership is not established. Other practices such as immediate vesting of options play right into encouraging fraud. The discovery of fraud is almost always a matter of time. Fraud can be covered up for one, two or three years, but eventually outside influences come to bear. Overstatements start to become evident as they build on the Balance Sheet or banks demand payment on hidden obligations.... Eventually every house of cards will fall. Why do we allow our management the opportunity to reap rewards in such a small window of time when longer term vesting would reduce much of the risk.

In the end, the cures to these ills will not come from rules and regulations. It will come from good governance. It will not come from wasting the company's resources or trying to shoe horn every company into a certain set of controls and having them perfectly documented and complied with. It is one thing to prescribe that outside auditors will deal more directly with a company's Audit Committee, but it pure foolishness to believe that a small group of outside board members can provide the day-to-day diligence over a diverse accounting staff performing a variety of complex tasks.

Meanwhile, the outside auditors are being disengaged from the executive management that we are so worried about. New independence rules are preventing the outside auditors from giving advice on new accounting rules and their application. They can no longer provide services such as completing tax returns for executives. Many of these types of functions were once consider useful since they gave the outside auditor a view into how aggressive management was and gave early warning into the executive's own personal financial position. Now the tools that would have raised early flags are being stripped away and the audit firm is flying with a shroud over its head.

The time is coming that investors will need to take back their companies. If we were following grandma's sage advice about an once of prevention, we would be heading in the right direction, but in our current climate we are applying the principle backwards. Today a pound of prevention is worth an once of cure. It is time to come back to core principles of holding people accountable. Investors need to hold their Boards accountable and Boards their managements. Outside auditors need to reevaluate what task they were hired to do and who they really serve. In the end, it will come down to governance. It will come down to investing in companies with quality managements. Boards and investors will need to discipline themselves to take a longer view and provide incentives accordingly. Regulation is simply flushing scarce resources down the drain, and as it always does in a free market, will destroy our ability to compete effectively.