Business Advisory Council Panel Studies Capital Markets, Investor Trust
The Law School Business Advisory Council (BAC) program brought together more than 40 alumni in management and finance for a conference on capital markets and investor trust Oct. 1.
Covington & Burling partner and law professor Bob Sayler moderated two panel discussions, the first entitled “Do the Markets Work? Buying and Selling on Wall Street, Main Street and Capitol Hill,” and the second on “How ‘Private’ are Public Companies? Good Governance and Investor Trust.”
Panelists were members of the BAC—a group of Law School alumni prominent in private industry and corporate law, formed to help the Law School remain alert and relevant to issues of business law. The Law & Business Program, for example, was launched with the BAC’s endorsement.
The panel’s first session began with Sayler broadening the scope of the topic question—“Do the Markets Work?”—by asking “for whom?”
Jim McDonald said the markets work for a variety of entities. “The equities markets in the U.S. provide a lot of liquidity and make capital flows relatively efficient and they are relatively honest, despite the well-publicized challenges. Who do they work for? Done right they work for everybody—but there are enormous tensions in that and inherent conflicts between the interests of the securities firms, the institutional investor, the individual investor, and other disciplines.... From the point of view of an individual investor, fairness in pricing in the purchase and selling of securities is incredibly important. [But] between the buyers and sellers is an enormous world of financial intermediaries who mostly want to make money.”
Barbara Jeremiah qualified her remarks by explaining the two hats she wears as an executive and a director. She represents Alcoa, a $25 billion company, and she is also a board member of an energy company, “which is quite a bit smaller.”
Jeremiah said markets work, but at increasing cost. Companies have to make choices about how and what part of the markets to participate in. From the standpoint of securities regulation, she believes companies try to do the right thing, but due to the regulatory environment in today’s markets they might err on the side of being more risk averse. “It continues to be a challenging environment if you’re a lawyer on a publicly traded company.”
Regina Mysliwec has worked in securities regulation and enforcement her entire career, and she reminded the audience that enforcement is her orientation. “I think there’s a pendulum in regulation—sometimes the markets are not regulated enough and the regulatory authorities are either not funded or not vigorous enough to do the hard job that they have to do—and then abuse will grow.” Mysliwec noted that after a period of strain, the pendulum swings to more regulation. “But you have to be careful that it doesn’t swing too far—that it doesn’t actually stifle capital formation or disclosure or make companies risk averse.”
Sayler followed with the question “Do markets work better today than they did 10 years ago?”
Paul Mahoney said the markets have always worked well—today, 10 years ago, and 200 years ago. “I tell my students that there are two ways of understanding something: to experience it for oneself or by looking at data around it. If we look at market data for the past 200 years, you’ll see that markets work over the long run.” Mahoney’s data, from 1802 to the present, demonstrates that equities markets consistently return an average of seven percent after inflation per year.
Barry Taylor brought the discussion back to corporate practice. Throughout his career he’s been involved in taking more than 100 companies public. But from the investor’s standpoint “You depend on markets to generate returns for your companies and to raise capital—important for the growth of businesses. The markets are critically important and they do work.”
Sayler then asked, “If you could change one thing about the markets, what would it be?”
Jeremiah spoke strongly about changing the role analysts play in the markets. Regulations now separate analysts from the banks for which they work, and the investors rely on the information analysts provide. “But different analysts play by different rules. It’s a challenge for companies. How do you battle misinformation? If something’s out there—some piece of misinformation—a corporation used to be able to track that to an analyst and give informed guidance. But now (in the post- Enron era of Sarbanes-Oxley [SOX]) companies are giving or issuing warnings all over the place.” The challenge now is how to generate information and disseminate it to the public.
Mysliwec said there are rules around analyst behavior—analysts who work for a brokerage firm are supposed to provide opinions that, by NYSE rules, “have a reasonable basis in fact.” She acknowledged that some suggest there should be more regulation.
On the issue of regulating analysts, Mahoney thinks it’s probably an area in which investors must rely on disciplining people who misbehave after the fact. “I think it’s pretty hard to tell an analyst here’s the checklist you have to run down in order to do your job—because what you’re buying is that person’s judgment,” he said. “Now if someone’s making up numbers you have to punish that person ex post to remove the incentive to do it.”
Discussion around industry and investment analysts continued with Sayler questioning if in fact analysts become market drivers. Jeremiah was quick to agree that they do. A company’s projected earnings become an issue, and an analyst’s words can move valuations up or down billions of dollars.
Analysts, though, provide critical information to potential and current investors. Taylor said, “Research is critical for private investors and small companies. The big guys get analyst’s attention. Small companies—those with $20-30 million in revenue—want to access the markets and aren’t heard. To take a company public you need the research—analysts create interest in and knowledge about companies. If analysts create enough knowledge and interest, then there will be results.”
There is dissonance in what investors want versus what analysts give at times, agreed Myslewic. “An unintended consequence of regulation may be that it’s uneconomical to cover smaller unknown companies. But the sophistication of industry has changed. A company’s own information is not enough now—people want analysts to say a stock will go up or down.”
Are the financial services and markets over-regulated, asked Sayler? Mysliwec didn’t think so. “I think the SEC would take the view that you can’t have too much disclosure of financial information. Generally I think the federal regulatory structure and the self-regulatory structure have worked well for the largest, most important, biggest capital market in the world. And although we occasionally need incremental regulation and occasionally we need to reinvigorate some of our processes, this generally has been a fairly good model.”
Mysliwec continued, “I think that the level of regulation is probably sufficient and not too much, but we continue to find areas where regulations have to be tweaked or extended. I learned in law school how difficult it is to write a rule that anticipates all of the practical applications of the rule.”
Mahoney added that there is no consensus on regulations. But there is a built-in bias that regulation will always appear to be effective, because regulation increases during troughs in the market. When the markets are performing poorly, people look for more regulation and enforcement. Then market performance improves and investors give credit to the regulation and enforcement—not considering that the market bottomed out and had to get better—the placebo effect. SOX put more regulations into the marketplace. But Mahoney doesn’t believe that these regulations would have prevented Enron or Tyco, and they are costly to enact. He said regulatory agencies can be the same as “helicopter parenting”—if a parent helicopters in and out of his teen’s world to solve problems, then the child will have no internal mechanism to self-regulate. “The government is a sort of helicopter parent to the financial services industry—and those in industry are always trying to comply. They can be overlooking their own objectives by spending that time and energy on compliance,” he added.
Jeremiah said that “companies are already doing self-assessments and regulating, but now have to work toward [SOX] regulations—is that better for the company? These regulations may in fact be so big that they might deter new companies from going public, therefore inhibiting capital formation and attraction. It may simply be too expensive for companies to survive, especially those non-U.S. companies trying to raise capital.”
McDonald expanded on the attitudes of non-U.S. companies. “Global
capital is definitely affected by over-regulation combined with geopolitical
issues. There are so many factors affecting global capital flows. Non-U.S.-based
companies perceive these regulations, combined with tort and litigation
issues in this country, as something they want to avoid.”
“How ‘Private’ are Public Companies? Good Governance and Investor Trust
In the second session, Sayler moderated the same panel discussing two topics: how “private” are public companies, and good governance and investor trust. Responding to the first topic, McDonald said that disclosure is a key component of SOX, especially full disclosure of executive compensation, and certainly there is a lot more transparency. He saw a danger, though, that the transparency is becoming a “check-the-box” kind of transparency, leaving out critical information such as knowledge of a deteriorating fundamental business model, or a new form of competition developing. As a result, a company may have properly checked all the boxes but left out significant information that will leave many of the least-sophisticated shareholders “holding the bag.”
Mysliwiec said the SEC expected the discussion in the annual report would go beyond the problem with “check-the-box.” “If everyone is doing their job,” she said, “then the information presented should be accurate and sufficient.”
Taylor recounted a “teenager” approach to regulation: set a line and expect the markets to go slightly beyond it. He cited the problems in the auditing role and the integrity of financial statements. “The process is dysfunctional and puts too much pressure on the auditors who have trouble issuing opinions in the face of so many rules and regulations.” He said that investors need integrity in the preparation of financial statements, but the regulations have made it too difficult. With Arthur Anderson gone, and the business community having to rely on a Big Four and not a Big Five, he sees even more pressure on the remaining auditors.
Asked if more private information should now be publicly available, Mahoney said regulations can yield only so much information. He posed the unrealistic scenario of a CEO who calls a press conference to say that he’s not really that good of a manager or that the company is not doing as well as he thought it would under his leadership. Since investors can’t expect to hear such information from any company, they should protect themselves by diversifying, and digging deeper for information.
Mysliwiec cited a specific example where the SEC is beginning to look into regulating hedge funds, which she said could impede capital formation. According to Mysliwiec, the SEC has noticed that hedge funds, traditionally the province of very wealthy individuals often with $100 million investment minimums, have lowered those stakes and may start enticing more average investors, triggering an SEC regulatory response. But if the SEC decides to regulate, said Mysliwiec, it will have to have some solid basis, perhaps following on the heels of a major scandal.
Jeremiah said that regulations alone do not make a CEO an honest person. She told of conversations she had in her company before the corporate scandals occurred that revolved around the question, “Would we all be proud of what we are about to do if our kids read about it in the New York Times?” Jeremiah sees that as a simple test where personal integrity and the risk of public shame is more important than any SEC regulation.
Sayler asked if the amount of public information is where it needs to be. The panel believed that it is more a question of investors using wisely the information already available to them in a market climate that now demands greater integrity and transparency.
According to McDonald, in the ‘80s and ‘90s there was intense pressure on business leaders that made them feel that they weren’t doing their job if they disclosed problems appropriately, or if they didn’t hire one of the Big Five accounting firms to aggressively reduce a company’s tax bill. ” If they showed a hint of any integrity, that was the end,” he said. Today, McDonald hears a very different message guiding the market. Corporate leaders are toeing the line because nobody wants to be the next indictment story on the front page of the Wall Street Journal. Between the press and responsible political leadership, McDonald is optimistic that we now have self-correcting mechanisms that will help the market avoid the corner-cutting of the last decade.
Sayler related the recent news about Donald Trump filing for bankruptcy and boasting to the national press that he would be worth much more now as a result. Isn’t there something wrong with that, he asked?
Quite the contrary, according to Mahoney, who said that the Trump example was precisely how the bankruptcy code was intended to operate. “The whole point was a concern that if you gave creditors too much authority you would have too many firms get liquidated. Congress felt that if you let the incumbent managers remain in control throughout the bankruptcy process, they’re not going to fire people. But if you let the creditors take control, they’re going to run in, sell everything, and fire everyone.”
McDonald added a historical note about how America took a very different road than Europe in creating its bankruptcy system and that many believe this has been a key to the success of the American enterprise system. “We have consciously created a system that allows people to take big risks that might not always work out, but they could start over again and try to recover later. It was a conscious decision fostered by Alexander Hamilton not to be like Europe, where you went to jail if you couldn’t satisfy your creditors.”
Sayler asked how much long-term effect Enron had on the stock market, and the panel felt that it was too hard to measure investor confidence and, in fact, the Enron scandal has had positive repercussions on the market.
“It has had a beneficial effect going forward,” said Jeremiah, “because no officer or director wants to be in the middle of something like that.” She believed that the new rules and regulations have pushed officers and directors to work better together and they are also better informed.
Mysliwiec believes that “all the things done in [SOX] and the stepped-up enforcement actions ultimately have had a positive impact on investor trust.”
Mahoney disagreed with the premise that investor confidence ever was a problem. Rather, there was a time “when investors thought it was a good thing for management to go to extremes, get close to the line, and perhaps step over it. Showing investors that was not a great idea was good for them and probably a lesson worth learning.” He cited an article that analyzed all the spectacular corporate scandals of the past—Enron, WorldCom, BCCI, Tyco, the S&Ls, and others—and found that every single one fit almost perfectly into the same pattern. Each one experienced a period of explosive growth, followed by lavish spending on things unrelated to the core business. Each had a very autocratic management style that often resembled a personality cult around the CEO, along with a tremendous amount of time spent cultivating political contacts. “Looking at this pattern,” he said, “it doesn’t take much brilliance to think there are some things there that ought to make the reasonable investor nervous.”
McDonald recalled when “Tom Bergin told our Property class back in the early ‘70s that ‘you can’t trust anything in the stock market.’ That was a bad time for the market, and nobody had much confidence in anything, much less the stock market. But these markets go in cycles, and investor confidence has a lot to do with momentum. This is the way markets work. It’s good for some people to be scared, to lack confidence, and be mistrustful because it will bring valuations down to a reasonable level—which they weren’t in the markets of 1999 and 2000—creating a base for more honest, reasonable capital formation. We’ll probably have another 10 years and some of the abuses will surface again.”
Taylor added that markets are “messy and unpredictable. In the late ‘90s, the pendulum went too far one way, and kept going, until finally it had to come back. It needed a correction, and it got it. It shows the resiliency of our system in how it can rebound from such huge financial debacles. There is not a point in time when you can say you have it right. The pendulum is moving all the time, it’s starting to swing back, and it takes 15-20 years for the next cycle to repeat itself.”
Asking the panel to look forward, Sayler wondered if it is fair to say that the past fraudulent behavior has not suppressed the market and that lack of confidence is no longer a problem.
McDonald feels that if there is a lack of confidence, it will self-correct through normal market mechanics, but Mahoney added that “confidence” is not the right word. “What was lost was a healthy sense of skepticism,” he said. “Individual trader behavior showed that they traded too much, churning their own portfolios without paying attention to fees or costs. They also weren’t skeptical enough about the incentives of the sellers.”
To counter that, Mahoney suggested that every high school in the country
should have a “simple course on personal finance in which every
student comes out understanding that diversification is a good thing,
day trading is not a good thing, and understanding that there is no
free lunch is perhaps the best thing of all.” Mysliwiec agreed
and cited a NYSE program called “Teach the Teachers” where
high school teachers come from all across the country and spend a week
at the Exchange to learn how it works before returning to their schools
to develop course work around their experience.