by Tom Slee
Weak-kneed response leaves investors to fend for themselves.
They say talk is cheap. Well, political rhetoric is even cheaper. As you may remember, a few months ago small investors were promised a brave new world. Shocked by the scandals and worried about their jobs, politicians and enforcement agencies seemed determined to flush out the North American markets. President Bush and our Prime Minister, no less, vowed to restore confidence by legislating new safeguards. Well, it was all a sham. The powerful lobby groups in Ottawa and Washington can rest easy. Most of the new proposals have now been unveiled and I can assure you that it's going to be business as usual in the future. As small investors, we will have to fend for ourselves. But that's nothing new.
To recap briefly: the recent spate of scandals on both sides of the border showed very clearly that we have three major ongoing problems in North American stock markets.
a) Analysts are under constant pressure to promote companies that pay their employers underwriting and advisory fees. In other words, analysts are being bribed to produce misleading reports.
b) Auditors have massive conflicts of interest because they earn management fees from their clients and no longer act at arm's length. Many auditors are almost employees of the companies they audit.
c) CEOs are a law unto themselves. They effectively hire and fire the officers, directors, and auditors and promote their own stocks by applying pressure to analysts. To all intents and purposes, the CEOs own their companies.
In other words, the system is largely out of control. No wonder investors are disillusioned and disgusted.
So, what are the remedies being suggested? Well, let's start with the analysts. In the U.S., the new Sarbanes-Oxley Act and proposals by the National Association of Securities Dealers half-heartedly address the conflicts of interest. There are proposals to have research departments hived off from the investment banking units so as to reinforce the so-called "Chinese Walls" that have never worked. However, little thought has been given to banning underwriters such as Merrill Lynch from issuing seemingly independent research material. There is no suggestion of a law separating true brokers from dealers, like the Glass-Stengall Act prevented investment bankers from lending money. Of course not. It would ruin those Wall Street giants if they had to choose between their IPO business and servicing investors in the secondary market.
In Canada, there is even less effort to provide proper safeguards. The Ontario Securities Commission (OSC) has sent letters to the 10 largest brokerage houses asking them to explain how they compensate analysts. Doesn't the OSC know? The Investment Dealers Association and TSX, on the other hand, seem content to sit pat with the toothless Crawford recommendations that never addressed the dealers' conflicts. It's all pretty casual.
The trouble is that a lot of Canadian officials still see the scandals as an American problem. According to Mr. Chretien, we in Canada have been spared. That goes to show that his personal account was not with one of the Canadian brokerages that has come under investigation and that he never owned a slug of Bre-X. With all due respect, our Prime Minister has no idea of what he is up against. The fact is that Canadian analysts work for the bankers and dealers who actively solicit business from the companies being analyzed. That has to be a conflict of interest. It's a time bomb waiting to go off!
We have a similar situation with the auditors. The Sarbanes-Oxley Act imposes a complete ban on internal audit and systems design work by external auditors in the U.S. The same law requires that all non-audit work by auditors must be properly disclosed to shareholders. That's not much of an improvement, but it's better than nothing.
Here in Canada, a new Public Accountability Board has been established to ride herd on the accounting industry. Big deal! The Board has no power to impose penalties or make rule changes. It can only offer recommendations to the professional bodies that will continue to set the real standards. Does it not occur to somebody that it was the profession, in the shape of Andersen, that allowed investors in Enron to be swindled out of billions of dollars? Incidentally, Canadian auditors have indicated that they intend to keep on providing their clients with management services and, in effect, audit their own results.
Finally, there is the matter of CEOs, the modern day Czars, and the problem of corporate governance. Once more, the Americans have tinkered at the edges while the Canadians have ignored the problem altogether. American CEOs must now sign their financial statements, although the undertaking is hedged to death by weasel words like "to the best of my knowledge". In addition, Sarbanes-Oxley bans public companies from making direct loans to executives and directors and requires faster insider trading reports. All of this must seem like a joke to people like Dennis Kozlowski, the former chief executive of Tyco, who spent $2.1 million of shareholders' money on a personal birthday party and faces charges of blatant tax evasion.
To give you some idea of the feeble Canadian response to possible corporate excesses, the TSX has announced that it is going to amend its governance guidelines. The Exchange now feels that listed companies might adopt some of the Saucier Committee recommendations. One of these suggests that at least one director on the audit committee of a public company should have some accounting experience. Give me strength!
Even the proposed new powers for the Ontario Securities Commission, which made headlines recently, are more bark than bite. Sure, the penalties for insider trading will be stiffened but that's yesterday's problem. CEOs promoting their own stock by juggling the figures do not have to resort to insider trading. Requiring people to disgorge their ill-gotten gains is a hollow threat. The offshore havens are quite secure. Just ask the Canada Customs and Revenue Agency. And, as I mentioned before, requiring a crooked CEO to sign misleading statements is a joke.
So there you have it, the great house cleaning. It amounts to a warning and little else. A great opportunity has been lost. What could we have had? Well, in both Canada and the U.S., shareholders should have been given sweeping powers to sue directors and officers for negligence. There could have been rules to preclude auditors from doing any work whatsoever for companies they audit. A law requiring that shareholders be offered a choice of auditor each year without a recommendation from management would have been a step forward. Dealers and bankers could have been restricted from giving stock recommendations. Most important, enforcement should have been taken away from the stock exchanges, accounting bodies, and dealers associations. We need the full weight of the law to prevent another fiasco.
Still, it's no use crying over spilt milk. The market has always been a free-for-all. We just have to watch ourselves in the clinches. It's obvious the regulatory authorities are not going to help very much.
Tom Slee is a certified financial analyst who worked for many years as a professional money manager. He is also a CGA.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada's top money experts. For more information about becoming an Internet Wealth Builder member, Click Here