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 of regulation appeared a little earlier--during the economic woes of the end of the 19th century. An "irrational exuberance" 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 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 and the establishment of the Federal Reserve, the central bank that Alexander Hamilton had advocated shortly after the American Revolution. 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 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, down went Herbert Hoover and along came Franklin Roosevelt and the country's first substantive financial regulation, a desperate attempt to instill 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). 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, 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 and former chairman of the 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 (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 (CPA) 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 again--the SEC called for a reassessment of how standards were set. By 1973, the APB was replaced by the 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," 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 and an inability to write a standard in plain English that reflects economic reality.

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"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 by disappointed stockholders, so in 1995, the Private Securities Litigation Reform Act 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 (FCPA) 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) 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) 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 (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), made up of five major professional organizations--Financial Executives International, The Institute of Internal Auditors, AICPA, National Association of Accountants (now the Institute of Management Accountants) and American Accounting Association--set benchmarks for internal controls, de facto standards used to comply with SEC regulations and, later, the Sarbanes-Oxley Act of 2002.

Banking scandals erupted in the late '80s, touched off by a recession in the Oil Patch and a wave of savings-and-loan failures. Reforms followed, among them the 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 (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) 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 of the Public Company Accounting Oversight Board (PCAOB), apparently reversing the SEC's earlier belief that the private sector could set and oversee auditing standards.

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, president of the University of Rochester 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, 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 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 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 ([e-mail]) 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."

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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 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. 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:

* 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 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