Regulation: a help or hindrance to business growth?It's more coincidence than cause and effect, but Financial Executives International and substantial financial regulation were born at just about the same time. Thus, they share a history of about 75 years.
But the first inklings The Inklings was an informal literary discussion group associated with the University of Oxford, England, between the 1930s and the 1960s. Its most regular members (many of them academics at the University) included J.R.R. Tolkien, C.S. of regulation appeared a little earlier--during the economic woes of the end of the 19th century. An "irrational exuberance Irrational Exuberance
An infamous phrase uttered by Alan Greenspan in 1996 to describe the overvalued market at the time.
Although every word spoken by Mr. " in the stock markets, fed by a boom in railroad profits, faltered when the market learned of fraudulent financial statements. For the first time, the New York Stock Exchange New York Stock Exchange (NYSE)
World's largest marketplace for securities. The exchange began as an informal meeting of 24 men in 1792 on what is now Wall Street in New York City. demanded independent audits of public company books. The books were about all that got audited in those days. The simple math. The classic image of the accountant in green eyeshades poring over a ledger exemplifies the proto-audit of the 1890s. The auditor never thought to, say, verify inventory. It wasn't required.
The economy recovered some, but in the early 1900s it stumbled again. The federal government responded with antitrust laws antitrust laws n. acts adopted by Congress to outlaw or restrict business practices considered to be monopolistic or which restrain interstate commerce. The Sherman Antitrust Act of 1890 declared illegal "every contract, combination.... and the establishment of the Federal Reserve, the central bank that Alexander Hamilton had advocated shortly after the American Revolution American Revolution, 1775–83, struggle by which the Thirteen Colonies on the Atlantic seaboard of North America won independence from Great Britain and became the United States. It is also called the American War of Independence. . The Fed issued a bulletin on financial reporting by banks, including, for the first time, accounting rules developed by the accounting profession. In a national atmosphere of renewed confidence in financial reports, the economy recovered.
Then, the 1920s saw an unprecedented boom, a so-called "New Economy," based on then-new technologies--radios, automobiles and airplanes. As car manufacturers blossomed--with over 2,000 of them--the base of an economic bubble An economic bubble (sometimes referred to as a "speculative bubble", a "market bubble", a "price bubble", a "financial bubble", or a "speculative mania") is “trade in high volumes at prices that are considerably at variance from intrinsic values”. inflated, with not much more than irrational exuberance (quite similar, in fact, to the 1990's "dot-com" explosion, with its brand of new technologies). Then came Black Tuesday Black Tuesday
day of stock market crash (1929). [Am. Hist.: Allen, 238]
See : Bankruptcy , down went Herbert Hoover and along came Franklin Roosevelt and the country's first substantive financial regulation, a desperate attempt to instill in·still
To pour in drop by drop.
instil·lation n. public confidence in public companies and stock markets.
So, the era of substantive financial regulation began in reaction to the stock market crash of 1929 and the Great Depression that followed. Herbert Hoover's government was reluctant to use regulation to solve the country's economic woes, but by 1932 it was obvious that something had to be done.
In that year, financial executives, believing they might improve the situation through better accounting and accountability, established The Controllers Institute of America, predecessor of Financial Executives International (FEI FEI
Fédération Équestre Internationale. ). In the gloom and pessimism of a collapsed economy, the organization grew as it grappled with accounting, economics and something new to American business: regulation of the way they reported corporate financial conditions.
The first of these new regulations came in an avalanche following the election of FDR. The Emergency Banking Act provided for inspections of federal banks. The Glass-Steagall Banking Act established even more regulation. The Securities Act of 1933 and the Securities and Exchange Act of 1934 created the U.S. Securities and Exchange Commission (SEC) and mandated independent audits. Initially, the SEC intended to establish the same regulation system that the Federal Reserve had set up for banks, with government examiners conducting audits. But after testimony before Congress by members of the audit profession, it was decided that the private sector was better suited for the job.
Financial officers of public companies recognized the need for new rules, but questioned the SEC's required solutions. The Editorial Comment in the June 1934 issue of The Institute's magazine, The Controller, would echo through the century: "The excessive cost of preparing reports, statements and questionnaires for various government and state agencies is claiming the attention of controllers, on whom this increasing burden is falling." In the same issue, Judge William L. Ranson, of Whitman, Ransom, Coulson & Goetz, corporation lawyers of New York City New York City: see New York, city.
New York City
City (pop., 2000: 8,008,278), southeastern New York, at the mouth of the Hudson River. The largest city in the U.S. , argued, "Today it often seems that the primary task of the managers of an enterprise must be to conduct and record its transactions so as to comply with a multitude of complex requirements and regulations, imposed by all manner of public authority; then, if any time or energies are left, for production and selling, the enterprise is fortunate."
The comments fed into a consequent question: Who should set accounting standards--the accounting profession or the SEC? The SEC deferred, leaving the task to the private sector. At the same time, however, the commission established the position of chief accountant--giving that person ability to set accounting policy and, if necessary, override standards set outside the SEC.
New regulations hardly ended The Depression era, but the stock market began to rise, apparently buoyed by increased confidence. By 1937, however, the market stumbled again.
In 1939, an SEC investigation of massive fraud at McKesson & Robbins revealed inexcusable auditor negligence. Within the year, the profession formed the Committee on Accounting Procedure. Its goal: to issue "bulletins" that set the first auditing and accounting standards. For the first time, auditors would look beyond the math of corporate books and confirm such things as receivables and inventory.
Back When Standards, Regulation Were Simpler
Norman Strauss, Ernst & Young Executive Professor in Residence at Baruch College Baruch College: see New York, City University of. and former chairman of the American Institute of Certified Public Accountants' (AICPA AICPA
See American Institute of Certified Public Accountants (AICPA). ) Accounting Standards Executive Committee (AcSEC), looks back fondly on those early standards.
"Many of these standards were about three pages long and came out once every three years or so. So to keep up with accounting, you didn't have to read much--a couple of pages a year--in contrast to today, when some [standards] are 250 pages long and every sentence is fairly complex," says Strauss.
Former SEC Chief Accountant Lynn E. Turner, now managing director of research at Glass, Lewis & Co., explains that by the 1940s, accounting and financial regulation was part of a cycle that would continue into the next century. As he explains, problems with standards lead to corporate scandals, which result in economic recession, which inspire reforms and new regulation, which result in new standards. These bring about economic recovery, which allows compromises, which lead to problems with standards. The cycle happens within recurring environments of new technology, markets buoyed by irrational exuberance, a burst bubble and, in some faraway land, a war.
Before standardized accounting practices, companies had simply set their own standards, a practice that "resulted in some very bad accounting practices as companies began to dream up some very innovative ways to do accounting," comments Turner. "All the financial engineering that we have on Wall Street today, we had the same thing back then."
It was in the late 1950s that then-AICPA Chairman Alvin Jennings suggested that a separate accounting standard-setter be established and that companies be required to follow its standards. So, in 1959, the AICPA established the Accounting Principles Board The Accounting Principles Board (APB) is the former authoritative body of the American Institute of Certified Public Accountants (AICPA). It was created by the American Institute of Certified Public Accountants in 1959 and issued pronouncements on accounting principles until 1973, (APB APB
See Accounting Principles Board (APB). ), and the SEC required public companies to apply its standards. "As the APB started taking on issues, the process became extremely contentious," Turner says. By the late '60s, the APB agenda got into things like leases, pooling accounting, how to calculate earnings per share, mark-to-market accounting--all issues we are still dealing with, says Turner, adding, "the APB became a source of such controversy that the SEC often had to go to Congress to testify."
In the early '70s, the APB almost agreed on a standard doing away with many of the abuses associated with business combinations. Under pressure from corporate clients, however, certain certified public accountants Certified Public Accountant (CPA)
An accountant who has met certain standards, including experience, age, and licensing, and passed exams in a particular state. (CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. ) representatives on the board declined to allow the standard.
Around that time, a series of companies began to suffer scandals and bankruptcies, notably, the Penn Central Railroad bankruptcy in 1970. In reaction--and here's that deja vu See DjVu. again--the SEC called for a reassessment of how standards were set. By 1973, the APB was replaced by the Financial Accounting Standards Board Financial Accounting Standards Board (FASB)
Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). (FASB FASB
See: Financial Accounting Standards Board
See Financial Accounting Standards Board (FASB). ), the members of which had to cut all ties to corporations and audit firms.
FASB soon took on several hot projects that would be discussed, proposed, passed, amended, rejected, challenged and argued about for decades into the future. (See Financial Executive's FEI@75 feature article, "The Explosion of Accounting Standards," in the June issue for more on FASB.)
"It's amazing a·maze
v. a·mazed, a·maz·ing, a·maz·es
1. To affect with great wonder; astonish. See Synonyms at surprise.
2. Obsolete To bewilder; perplex.
v.intr. ," Turner says, "business combinations, research and development, fair value measurement, pensions and retiree benefits, leases--all of these have been on the agendas of standard-setters in one fashion or another for 40 years." The problem with the process, he argues, is that "people keep making compromises." He identifies three reasons for these perpetual problems: technical complication, corporate meddling med·dle
intr.v. med·dled, med·dling, med·dles
1. To intrude into other people's affairs or business; interfere. See Synonyms at interfere.
2. To handle something idly or ignorantly; tamper. and an inability to write a standard in plain English Plain English (sometimes known, more broadly, as plain language) is a communication style that focuses on considering the audience's needs when writing. It recommends avoiding unnecessary words and avoiding jargon, technical terms, and long and ambiguous sentences. that reflects economic reality.
"They write standards with a lot of loopholes [and], complexities that are difficult to implement and don't reflect economic reality, and which reflect a lot of compromises and watering-down," Turner says. "As a result, they [standards] don't stand the test of time. We have to keep going back to fix them."
Information not based on hard facts--known as "soft information"--has also been the subject of regulation. Through the '60s, the SEC allowed only information based on numerical facts. In the '70s, the commission began to allow forward-looking information and gave companies a certain safe-harbor leeway in their predictions. In 1980, as part of a company's 10-K filing, the SEC started requiring a Management Discussion & Analysis (MD & A) that used soft information to say what solid numbers couldn't say.
But soft information gave rise to litigation An action brought in court to enforce a particular right. The act or process of bringing a lawsuit in and of itself; a judicial contest; any dispute.
When a person begins a civil lawsuit, the person enters into a process called litigation. by disappointed stockholders, so in 1995, the Private Securities Litigation Reform Act The Private Securities Litigation Reform Act of 1995 (PSLRA) implemented several significant substantive changes affecting certain cases brought under the federal securities laws, including changes related to pleading, discovery, liability, class representation and awards fees and was passed, giving companies great protection. Though it by no means did away with related lawsuits, it gave companies more confidence to disclose more information, and securities markets responded positively.
In the mid-'70s, SEC investigations turned up 400 U.S. companies that had made questionable or illegal payments to foreign officials to grease the wheels of international trade. To prevent such activity, Congress enacted the Foreign Corrupt Practices Act Foreign Corrupt Practices Act
An amendment to the Securities Exchange Act created to sanction bribery of foreign officials by publicly held US companies.
Foreign Corrupt Practices Act (FCPA FCPA Foreign Corrupt Practices Act
FCPA Fairfax County Park Authority (Virginia)
FCPA Fujitsu Computer Products of America
FCPA Fair Campaign Practices Act
FCPA Fellow of CPA Australia
FCPA Florida Concrete & Products Association ) of 1977. Within 10 years, however, it became evident that honesty was putting U.S. companies at a disadvantage. A subsequent international treaty with the Organization of Economic Cooperation and Development (OECD OECD: see Organization for Economic Cooperation and Development. ) made it illegal for foreign companies to do what U.S. companies couldn't do, and in 1998, Congress implemented legislation prohibiting bribery in the U.S.
With scandals in both the corporate and public accountancy sectors in 1978, Congress passed legislation requiring more independence between auditors and clients. A Public Oversight Board was established to ensure that audit firms did what auditors should, and the SEC required more disclosure of fees paid to audit firms not just for audits but for consulting services. The SEC also suggested reporting on internal controls, and FEI suggested companies do so voluntarily.
After Ronald Reagan was elected president in 1980, industry enjoyed a loosening of regulation. The Federal Trade Commission (FTC FTC
See Federal Trade Commission (FTC). ) eased industry restrictions on advertising by auditors and how they could woo clients from other firms. Soon, companies were tempting their auditors to interpret generally accepted accounting principles The standard accounting rules, regulations, and procedures used by companies in maintaining their financial records.
Generally accepted accounting principles (GAAP) provide companies and accountants with a consistent set of guidelines that cover both broad accounting (GAAP GAAP
See: Generally Accepted Accounting Principles
See generally accepted accounting principles (GAAP). ) to their own benefit, Turner says--thus, to some extent, returning to the days when companies wrote their own standards. Voluntary internal control reporting went nowhere.
In 1985, the private sector took a big step toward better self-regulation through the formation of the National Commission on Fraudulent Financial Reporting, the "Treadway Commission." The commission's organizer, the Committee of Sponsoring Organizations (COSO COSO Committee of Sponsoring Organizations of the Treadway Commission
COSO Church of Spiral Oak
COSO Corporate South
COSO Class of Service Override
COSO Combat Oriented Supply Operations (USAF) ), made up of five major professional organizations--Financial Executives International, The Institute of Internal Auditors “IIA” redirects here. For IIA in decision theory, see Independence of irrelevant alternatives.
Established in 1941, The Institute of Internal Auditors (IIA) is an international professional association of more than 128,000 members with global headquarters in , AICPA, National Association of Accountants (now the Institute of Management Accountants The Institute of Management Accountants (IMA) is a professional organization headquartered in Montvale, New Jersey consisting of over 70,000 members worldwide. The IMA is dedicated to advancing the role of the management accountant and financial manager within the business ) and American Accounting Association--set benchmarks for internal controls, de facto standards Hardware or software that is widely used, but not endorsed by a standards organization. Contrast with de jure standard.
de facto standard - A widespread consensus on a particular product or protocol which has not been ratified by any official standards body, such as ISO, used to comply with SEC regulations and, later, the Sarbanes-Oxley Act See SOX. of 2002.
Banking scandals erupted in the late '80s, touched off by a recession in the Oil Patch oil patch
1. The petroleum and natural gas industry.
2. An oil-producing region. and a wave of savings-and-loan failures. Reforms followed, among them the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA FIRREA
See: Financial Institutions Reform, Recovery and Enforcement Act of 1989
See Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). ), and the Crime Control Act of 1990. An enormous taxpayer-sponsored federal bailout of the S & Ls put the federal government in the liquidation business.
During the '90s, individual investors complained that securities analysts and institutional investors were receiving information denied to individuals. In response, in 2000, the SEC enacted Regulation Fair Disclosure The U.S. Securities and Exchange Commission's (SEC's) Regulation Fair Disclosure, also commonly referred to as Regulation FD or Reg FD was an SEC ruling implemented in October 2000 (). (known as Regulation FD), requiring companies to make public any information that they shared with analysts and investors. In retrospect, Reg FD may have increased market volatility, since information is now available to everyone at the same time, and in more formal statements, market reactions can be more exaggerated.
In a continuation of the cycle, a subsequent "New Economy" brought an economic boom, a bubble of "irrational exuberance" (as referred to by then-Federal Reserve Chairman Alan Greenspan Alan Greenspan
Dr. Greenspan is Chairman of the Board of Governors of the Federal Reserve System. Dr. Greenspan also serves as Chairman of the Federal Open Market Committee (FOMC), the Fed's principal monetary policymaking body. ) that inevitably burst in 2000, bringing another round of regulation, most significantly the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley also led to the establishment and public funding Public funding is money given from tax revenue or other governmental sources to an individual, organization, or entity. See also
Much Remains the Same
And now, in 2006, as the stock market remains what many believe to be artificially high, compromises to Sarbanes-Oxley are under consideration. Meanwhile, work continues on accounting for mergers, fair value, pensions, leases and other issues of the last 40 years, and a war drags on in a faraway land. (Deja vu all over again?)
Just as it was with regulation in the '30s, the intent of the regulation embodied by Sarbanes-Oxley was to restore trust in the stock markets. So, too, was regulation that cracked down on the too-cozy relationship between stock analysts and their investment banking colleagues eager to trade on glowing reports--often trumped up--to solicit new investment banking business.
Joel Seligman Joel Seligman (born January 11, 1950) is the current President of the University of Rochester, in Rochester, New York, and is one of the leading authorities on securities law in the U.S.. , president of the University of Rochester The University of Rochester (UR) is a private, coeducational and nonsectarian research university located in Rochester, New York. The university is one of 62 elected members of the Association of American Universities. and author of The Transformation of Wall Street: A History of the SEC in Modern Corporate Finance, observes that overall, financial regulation has been beneficial, though not in every case.
"There's a reasonable inference that regulation has helped generate confidence in investment, and there's reasonable basis for that confidence," Seligman says. "There's much more disclosure, especially disclosure of bad news. The MD & A has given investors insights the likes of which they'd never have received before. The fraud remedies have given incentives to have honest disclosure in a way that wasn't fully developed in the period before the securities laws."
Seligman notes that an earlier draft of what would become the Sarbanes-Oxley Act had very few supporters before the parade of scandals involving Enron Corp., Global Crossing Limited, WorldCom Inc., etc. Shortly after Enron imploded im·plode
v. im·plod·ed, im·plod·ing, im·plodes
To collapse inward violently.
1. To cause to collapse inward violently.
2. , the bill was passed almost unanimously by the U.S. House of Representatives.
"It's most important to appreciate that the issue isn't regulation versus no regulation. It's wise regulation versus foolish regulation," argues Seligman. "When you think of it in those terms, a lot of securities regulations have improved corporate practices, generally improved investor confidence, led to more effective markets." But sometimes, he adds, "securities laws have been heavy-handed."
However, Seligman says these occasionally excessive laws have been tempered by "the genius of the SEC." So, as Turner sees the ongoing adjustments to the Sarbanes-Oxley Act as compromises, Seligman sees them as wise and necessary improvements made in the light of time and experience.
The SEC is still searching for the appropriate application of Sarbanes-Oxley for smaller public companies. A recent Government Accountability Office The Government Accountability Office (GAO) is the audit, evaluation, and investigative arm of the United States Congress, and thus an agency in the Legislative Branch of the United States Government. report found small public companies paying disproportionately more to comply with Section 404 on internal controls and detected a small but worrisome tendency for small public companies to go private. While these companies represent just 2 percent of all public companies, the number could grow as the July 2007 date--when smaller companies are required to begin complying with Section 404--approaches.
Mark Heesen, president of the National Venture Capital Association, says that many private companies are preferring to be bought by a public company rather than go public themselves. He says more and more entrepreneurs are asking if it is really worth going public, "with all the headaches involved in dealing with Sarbanes-Oxley, the liability and the overall hassle." He's also seen an increase in U.S. venture-backed companies choosing to go public outside their home country, in, say, the United Kingdom, Canada or Asia--where they will not have to comply with Sarbanes-Oxley.
At the same time, foreign companies are showing a reluctance to enter U.S. securities markets, in some cases due to the burden of regulation. As early as 2004, a Wall Street Journal article noted that many foreign companies on U.S. stock exchanges were considering deregistering.
Looking back over 75 years of financial regulation, it's hard to imagine a return to the pre-regulation days that preceded the formation of FEI. Regulation has unquestionably un·ques·tion·a·ble
Beyond question or doubt. See Synonyms at authentic.
un·question·a·bil helped bring economic stability and growth to the U.S. economy. But it has also failed, in recent years, to prevent massive frauds and bankruptcies. So, the cycle of scandal and regulation continues, and FEI presses on, intent on remaining involved and providing input to the process as the voice of financial executives. But questions remain: If financial regulation is good, is more of it always better? Does the amount of regulation stifle U.S. competitiveness? How much is too much?
Glenn Alan Cheney (firstname.lastname@example.org) is a freelance writer in Hanover, Conn., who writes on finance, accounting and business issues and is a frequent contributor to Financial Executive.
RELATED ARTICLE: A View on How Corporations Should Behave: 30 Years Later
Financial Executive's Executive Editor Ellen Heffes asked me to read an article I wrote for the magazine in 1976-30 years ago--and comment now, in 2006, on how I feel about what I wrote then. The article for FEI's magazine was titled: "Views on How Corporations Should Behave."
Having written the article in the twilight of my term as SEC Chair, I read the piece with interest and with pleasure as to the views I expressed then. I should add that I wrote it also in the wake of the commission's experience with about 200 U.S. companies that had made "questionable payments" to foreign officials. At the time, there were loud calls for major legislation to impose serious regulatory authority Noun 1. regulatory authority - a governmental agency that regulates businesses in the public interest
administrative body, administrative unit - a unit with administrative responsibilities over the conduct of corporate boards to prevent further misbehavior by corporations.
The loudest clamor was for a "federal chartering" of major publicly traded corporations, a proposal of the then-powerful Ralph Nader This page is currently protected from editing until (UTC) or until disputes have been resolved. . The thesis of my article was that:
"[T]he recent revelations [of questionable payments] do not call for new Federal standards..... The notion that our present system should be scrapped just when it proved its worth would surely be an improper government response."
We had, after all, caught those responsible for the payments, and we had taken three serious steps to enhance corporate governance Corporate Governance
The relationship between all the stakeholders in a company. This includes the shareholders, directors, and management of a company, as defined by the corporate charter, bylaws, formal policy, and rule of law. :
* We established the need for internal financial controls to enhance the effectiveness of corporate auditors;
* We required auditors to look for suspicious actions by companies and to report their suspicions to someone independent of their suspicion; and
* We persuaded the New York Stock Exchange to require independent audit committees for their listed companies.
In the article, I pointed out that:
"Our efforts ... [were] to create an internal reporting system that will place these difficult payment questions squarely before the independent directors, outside auditors and outside counsel."
Rather than create a new bureaucracy with federal chartering, I suggested we need to look at "what is presently wrong with corporate behavior."
"What is missing on too many boards," I said, "is a truly independent character that has the practical capacity to monitor and change management."
So, what do I think now of what I said then?
Well, I am as convinced now, as I was then, that the SEC was on the right track. In a real sense, the Sarbanes-Oxley Act confirmed the wisdom of our approach:
* Section 404 of the Act is an aggressive enforcement of the requirement of internal controls;
* The creation of the Public Company Accounting Oversight Board tells the auditing profession in no uncertain terms that it has the responsibility of making sure that the internal controls are working; and
* Audit committees have been told in equally certain terms that they must be independent and competent and they must take control of the audit process.
If I Could Turn Back Time
What I failed to do in that 30-year old article is offer any ideas about how to create a "truly independent character" on corporate boards of directors, and there continues to be today a suspicion that too many boards are unwilling to replace the CEO (1) (Chief Executive Officer) The highest individual in command of an organization. Typically the president of the company, the CEO reports to the Chairman of the Board. who placed them on "his" or "her" board.
The paradox in corporate America is that, in theory, shareholders choose directors who choose management. But, in fact, in many, if not most, cases management chooses the directors.
In reaction to this fact, efforts have been made in recent years to allow large shareholders with, say, 3 percent to 5 percent of a company's stock, to directly nominate candidates to compete with the management slate. In essence, such action would both make proxy fights a lot easier and elect directors actually opposed by management.
I, and others, have objected to these efforts on two principal grounds. First, it is impossible to believe that a board formed by one or two proxy fights will be either cohesive or effective. Second, there is plenty of evidence that demonstrates that shareholders owning something like 5 percent of a company's stock may well have objectives in a proxy fight that are not in the best interests of all shareholders.
A far better approach to the problem was endorsed by the Committee for Economic Development in its March 2006 report: Private Enterprise, Public Trust: The State of Corporate America After Sarbanes-Oxley.
"The best approach to building high-quality boards is to assign to truly independent nominating committees the responsibility for recommending new board candidates and evaluating the performance of existing board members."
I only wish today that I had made a similar comment 30 years ago when I held the SEC chair. If I had, we might be a lot closer today to having the "truly independent character" on most, if not all, of our corporate boards.
By Roderick M. Hills