SEC 'Rules' Assist Corp Criminals

Did you know that the current accounting scandals have their origin in government rules? The public needs to know the real cause of the scandals before Washington inflicts yet more damage on our institutions.

First, understand that the bankruptcies of Enron and WorldCom were not caused by how they kept their books. The real scandal is that SEC rules permit the creative accounting which enabled the companies to delay public recognition of their failures for several quarters. Perhaps executives had hopes of turning things around, but the scene stinks because executives used the borrowed time to sell stock and award themselves bonuses.

Second, understand that adding another layer of rules will not prevent future scandals. Indeed, new rules will contribute to future scandals, just as the existing rules caused this one.

Previous reforms aimed at providing investors with more timely information about the profitability and financial condition of public companies. Thus began the focus on quarterly earnings.

Other reforms tied executive compensation to performance as indicated by the company’s stock price. Thus began the use of stock options for executive compensation. (A stock option allows the holder to purchase a specified number of shares at a future date at the price that held when the option was granted. If the share price rises, it pays to exercise the option.)

Two more reforms completed the refocusing of executive attention to short-run performance as measured by share value. These two reforms were put in place in the early 1990s. One capped the amount of executive salary that could be deducted from taxable income at one million dollars. Cash compensation larger than $1 million had to be justified by performance or paid out of after-tax profits.

The other and final foundation stone for the current scandals was put in place by the SEC when that agency changed Rule 16b. Previously, executives who exercised their stock options were required to purchase the stock at the option price and hold it for six months before selling. The SEC changed the rule and permitted executives to sell the stock the minute they exercised their options, thus eliminating the executives’ exposure to the market.

These “reforms” could not have been better designed to produce the current crop of accounting scandals. Reforms tied executive compensation to short-run stock price, not to the health of the company, and SEC rules replaced accounting principles. Misleading accounting is permissible as long as companies and their accountants stay within the SEC rules.

The old accounting principles were designed to give an accurate picture of financial health. The new rule-based system only requires compliance with rules. As we have again learned, it is possible to comply with the government’s rules and still give a misleading picture. Only government does a better job at this kind of financial dissembling.

Regardless of the contribution made by government rules to the scandal, some executives behaved in ways that are widely regarded as dishonest, if not illegal. Something has happened to the character of people. A shortfall in character cannot be corrected with more rules and punishments.

The character shortage is not limited to the business arena. After the Clinton years not even the naive can view government as a house of rectitude. Recent books have made it clear that big media is no more worthy of public trust than Janet Reno or Bill Clinton. Not even the government’s police agencies can be said to have behaved honorably at Waco and Ruby Ridge, where no one has been held responsible for the government’s massacre of innocents.