The Wrath of the Investor Class

There's an unusual kind of mass protest going on in America. A new investor class feels betrayed by the financial manipulation, managerial arrogance, and political connivance now revealed to be widespread in the aftermath of Enron Corp.'s collapse. These investors are educated, suburban, married, well-off, white- and blue-collar workers who placed their trust and their future in the stock market in the 1990s. They eagerly embraced the high-risk, high-growth economy of deregulated markets and individual choice and now feel deceived by insiders who hid the truth and rigged the odds against them.

The credibility of the populist capitalism created in the '90s may be at risk as investors ponder their future participation. Sensing that, Wall Street and Washington are racing to clean up the mess. Time is short. The investor class is taking its revenge by crushing certain stocks and pummeling companies. This is all to the good, as the market strives to cleanse itself. But if investors lose their faith in stocks and pull out in a big way, they could seriously hurt the economic recovery.

A new American social contract arose in the past decade as millions tied their future to the stock market. They exchanged their sweat equity from working 10- and 12-hour days for options, bonuses, and 401(k)s that tracked their own companies' stock and the market in general. It was a high-risk, high-reward deal promoted widely in the era by corporate executives, Wall Street firms, Republicans, New Democrats, the business press, and management gurus. The idea--a good one--was for the economy to grow more rapidly as rising stock prices generated higher capital investment, greater productivity, more jobs, and bigger incomes. Those who most avidly supported the social contract, the new investors, liked the idea of being in control of their lives, of having choices and the freedom to invest. This vision was, after all, an analogue of the American frontier dream of independence, individual responsibility, opportunity, and striking it rich.


The betrayal that class now feels comes not from the two-year bear market that followed the booming '90s nor the bursting of the tech bubble. Until Enron, most people waited patiently for the business cycle to turn up, as it always does. What enraged investors was the revelation that Enron executives and other corporate execs had stacked the deck against them and played by a separate set of rules. Investors were stunned to learn of CEOs using their companies as private piggy banks and getting loans to cover bad personal investments; top brass cashing in huge numbers of options without telling shareholders; and employees being locked into 401(k) plans while execs sold company stock. Investors were appalled by the extravagant behavior of these executives who bestowed upon themselves special rules and special rewards.

Then investors were shocked to discover that they had also been misled about the level of risk they had taken on by tying their futures to the market. Disclosures revealed that the enormous corporate profits of the '90s were actually accounting mirages. Huge writedowns and hundreds of restatements wiped out billions in earnings. Off-balance-sheet partnerships turned out to have concealed enormous debt. Acquisition costs were much higher; income was lower. Accountants and analysts, the watchdogs of the market, were unmasked as stock promoters and corporate cheerleaders, not guardians of the investor.

The final straw came when investors learned that many of the nation's politicians had betrayed them as well. Companies were able to get regulations changed in the shadows for their private benefit. Laws protecting shareholders were undone by politicians, both Democrat and Republican, beholden to corporate campaign donors.

The good news is that investor wrath has pushed the market rushing to clean things up. Companies with questionable financial statements are becoming pariahs and are straightening their books as fast as they can. Even Krispy Kreme Doughnuts Inc. (KREM ) is being forced to shift $35 million off a "synthetic lease" and back onto its income statements. Accounting is finally changing as well. The Big Five have agreed to split off some of their service businesses from auditing, reversing years of opposing such action. Wall Street is taking small steps to return some credibility to its analysts. They are talking about disclosing hidden investment banking relationships in research reports and limiting stock ownership in companies that analysts cover.


Washington, terrified of angry investors as the November elections approach, is moving with unprecedented haste. Congress, the Bush Administration, and regulators are all lining up behind investors. The House is proposing a bill to strengthen auditing standards, give more funding to the Securities & Exchange Commission to oversee corporate finances, and force CEOs to report company stock transactions within 24 hours. The Administration has signalled the SEC to take a much tougher line on accounting standards. The commission is instilling fear in corporate suites by saying it will enforce the spirit of accounting law, not just the letter.

At a remarkable speed, the system is correcting. The financial and political clout of the investor class is making itself felt on Wall Street and in Washington. Investors will soon get better data--faster--from corporations. Chief executives will be made more responsible for their balance sheets and their behavior. Boards of directors will be strengthened. There is even a chance for campaign-finance reform. But that's not enough. If America as a nation is to reap the benefits of a high-risk, high reward economy, then individual investors must take more responsibility as well. They must learn to gauge risk and manage it. Investors appear to have won their protest. Now they must prepare for the future.

    Before it's here, it's on the Bloomberg Terminal.