Getting Investors to Trust Again

The revolt of the investor class is gaining momentum as companies begin to bow to growing demands for greater financial disclosure. Post-Enron Corp. investor doubts about the true quality of corporate earnings has infected the entire stock market, forcing even blue-chip companies such as IBM (IBM ) and General Electric Co. (GE ) to shift policy and provide financial data previously buried in their balance sheets. The worry is that even more bad news has been hidden in opaque financial statements. Companies must now come clean and provide investors with clear explanations for the quality of earnings and not just reams of financial data.

The notion that Enron is an exception to the prevailing business culture--put forth by the Business Roundtable--is not going down with the investing public. The risk is that if Corporate America fails to reform itself quickly, investors could go on an all-out strike against stocks. That would significantly raise the cost of capital and hurt prospects for the recovery. Worry over a credit crunch is already beginning to seep into the debt markets. To restore investor trust, corporate executives, regulators, and legislators should act fast.

Investors are realizing that the Wall Street firms with whom they entrusted their savings have been, at times, the chief enablers of earnings chicanery. We now know that in the late 1990s companies began to contract out the management of their earnings to Wall Street and accounting firms. Through acquisitions and creative accounting, companies were able to hide debt, lower costs, and boost profits. Enron used most of the tricks of the trade, but other companies practiced many of them as well, moving debt off the balance sheet and increasing earnings by masking asset sales and pension-fund gains that were buried in balance sheets. A study by Kenneth A. Petrick, "Comparing NIPA (National Income & Product Accounts) Profits with S&P 500 Profits," in the April, 2001, issue of Survey of Current Business, shows that after tracking reported taxable earnings for years, the Standard & Poor's 500-stock index earnings began to diverge sharply in 1999 and 2000 from this baseline. This suggests that the most egregious management of earnings occurred in 1999 and 2000. From 1992 to 1998, higher productivity did lead to higher real earnings. The bubble was probably limited to only two years.

The rift between the 100 million-strong investor class and Corporate America is far more critical than Big Business lobbying groups acknowledge. It could threaten the economic edifice of high-risk, high-gain democratic capitalism that propelled business for most of the '90s. Securities & Exchange Commission Chairman Harvey L. Pitt is right to throw his weight behind investors and warn that confidence in America's capital markets can't be maintained if people believe it is all a game with rules they cannot see or control.

Message to Corporate America: Times have changed. We now live in an era of honesty and openness. What is genuine is valued. What is fake is not.

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