Let the Reforms Begin

As America's anger grows, the time for talk is long past

At the core of every American reform movement there is the short, smoldering fuse of populist resentment--outrage over an arrogant elite of corporate malefactors and, often, alarm over an industrial octopus whose tentacles seem to menace the unprotected worker. In bygone days, symbols of unchecked power included land-grabbing rail barons, Midwestern meatpacking combines, the steel trust, Standard Oil, and rapacious Wall Street financiers.

Compared with the errant tycoons of yesteryear, Bernard J. Ebbers, former CEO of WorldCom Inc. (WCOM ), seems a wan pretender. But give Ebbers some credit: He may just be a fulcrum of U.S. economic history. The brash Mississippi exec is proving to be a catalyst for what some call the New Reform Era--the most ambitious drive to overhaul financial practices in generations.

Timing is critical, of course, and Ebbers' was exquisite. Coming on the heels of a wave of accounting scandals that demoralized investors and weakened the economy, WorldCom's $4 billion stunner did what legions of Democrats could not: It lent a bipartisan cast to the budding reform drive and compelled a reluctant White House to join the campaign for revamped business ethics.

Perhaps more important, it shocked CEOs into accepting reality: Anger over shady bookkeeping and stock promoting is not a transitory irritant that lobbyists can soothe with the traditional emollients. That means Big Business has to embrace new ethics guidelines or face the specter of rules drafted by a panicky Congress.

The response has been electric. Among the corporate ethics policies sprouting up are voluntary codes of conduct from the Business Roundtable, the U.S. Chamber of Commerce, the Securities Industry Assn., and the stock exchanges. These changes from deep within the business culture, coupled with heat from Washington, mean that CEOs are in for a fairly hefty slug of reform.

At a minimum, accounting practices seem destined for systemic change. Corporate-governance standards are in the offing, and the drumbeat for accountability grows louder by the day. In this new climate, when even a hint of irregularities can send a stock plummeting, investor activists have greater leverage. They will use it to lobby against abuses such as bloated executive-pay packages, massive stock option grants that aren't counted as compensation expenses, and snoozing directors.

Business' drive for a "best practice" code of conduct is laudable but not sufficient, declared the new Reformer-in-Chief on July 9. "Self-regulation is important, but it's not enough," President Bush told Wall Street execs. "We must usher in a new era of integrity in Corporate America."

True, many of his remarks sounded like a Sunday morning morality lecture. But Bush did more than sermonize. He backed proposals to compel CEOs to guarantee the accuracy of financial statements. He called for doubling jail terms, to 10 years, for wire and mail fraud. He asked for an emergency $100 million for Securities & Exchange Commission enforcers. And he unveiled a new Justice Dept. "SWAT team" aimed squarely at the executive suite. "My Administration will...end the days of cooking the books, shading the truth, and breaking our laws," Bush vowed. And lawmakers go the message: On July 10, the Senate approved Bush's tougher financial-crimes penalties 97-0.

Clearly, the President would like to bury the perception that there are two classes of criminals. "The public doesn't distinguish between corporate scams involving billions of dollars and street crime," says Matthew Dowd, the Texan's campaign pollster. "But up until now, it seemed like the Wall Street guys were less likely to get punished."

Although Bush's "hang 'em high" tone was telegraphed days in advance, the financial markets weren't wowed. A new round of disappointing earnings reports sent stock indexes plunging. "A lot of these reforms will end up lowering expected earnings," says Thomas D. Gallagher, senior managing director of consultants International Strategy & Investment Group. "CEOs are going to be personally liable for certifying financial statements. That's going to produce earnings reports that err on the low side."

Undeniably, Bush's latest action plan falls short of Democrats' demands for more sweeping measures. "A fresh coat of paint on rotten wood," huffs Representative Lloyd Doggett (D-Tex.).

But partisan jousts aside, the speech still marks a turning point. Suddenly, Democrats and Naderites aren't the only ones calling for real change in Corporate America. The converts to investor-class populism now include: arch-deregulator George W. Bush; a big bloc of Senate Republicans who have switched gears and now support the accounting-reform bill of Senator Paul S. Sarbanes (D-Md.); a growing group of House conservatives who sense a political risk in defending corpocrats; and business leaders who have come to accept reforms in corporate governance and accounting as vital to restoring confidence. Says CEO Richard H. Brown of Electronic Data Systems Corp.: "This has been a painful but necessary wake-up call. In the long run, we will all benefit."

In the short run, execs are dutifully falling in line behind Bush. "He did the right thing," says Charles D. Morgan, CEO of Acxiom Corp., a Little Rock data-mining outfit. "As we gain more confidence in business leaders, we'll gain more confidence in the economy."

Still, there is unease about increasing managers' liability--not to mention the galling thought that Democrats keep upping the ante on financial regulation. Cautions CEO Arthur D. Levinson of Genentech Inc.: "We need to be careful that we don't put into place mechanisms that will stifle the growth of the majority of companies that are honorable."

While there is some reason for skepticism about how effective the current reform drive will be, there is no doubt at all about what is driving the nation's fervor for change. On the economic front, the news that even a blue-chip outfit such as Merck & Co. (MRK ) has boosted revenues with aggressive accounting is keeping many investors on the sidelines. "The healing process is going to take time," says Lynn Reaser, chief economist at Banc of America Capital Management. "Investors need to be convinced that [corporate] abuse is not widespread and that accounting standards are being improved. This problem can't be solved with a single speech."

What will it take? Bush advisers hope the new SWAT team can quickly round up some high-profile villains to parade before cameras. "The most important thing is to get a bunch of CEOs and directors and throw 'em in jail," says one exec who is close to Bush.

On the political front, the pervasive nature of the scandals has the potential to transform an issueless November election into a referendum on corporate reform--a development that could capsize some pro-business Republicans. Now that Democrats are vying to make the GOP's deregulatory permissiveness and its supposed indifference to worker pensions the galvanizing issues, Republicans are starting to worry that the opposition has finally found a way to frame an economic assault against the GOP. In a June 28-30 Gallup Poll, 77% of respondents called business scandals either a crisis or a major problem. "The debate has shifted," says GOP pollster William D. McInturff. "It's now: `They cheated. The system is broken. How much do we need to do to fix it?"'

The answer: a whole lot. With everyone from House Energy & Commerce Committee Chairman W. J. "Billy" Tauzin (R-La.) to Senate GOP maverick John McCain of Arizona calling for a crackdown on corporate crooks, it certainly looks as if far-reaching reforms are on the horizon. But reality is more complex. Most Republican lawmakers hope that unleashing the cops will compel CEOs to clean up their act and lessen demands for new laws. Democrats, however, have momentum on their side. In a strategy shaped by Senate Majority Leader Tom Daschle (D-S.D.), they are pushing tougher reform measures and are daring Republicans to side with Big Business.

After the partisan head-banging, how strong will constraints on companies, auditors, and analysts be? The outlook:

-- Accounting. With the Sarbanes bill a cinch to breeze through the Senate, odds for an independent accounting oversight board have brightened. The House has passed an industry-friendly alternative, and the fireworks will start with negotiations over key details. Democrats will push for a totally independent body with wide investigative powers and the ability to set audit standards without domination by the accounting industry. GOP leaders will be hard-pressed to resist.

The shift toward a stronger oversight board represents a rebuke to SEC Chairman Harvey L. Pitt, who contends that creating a new agency with quasi-legal authority will muddy the regulatory waters and impede fuller disclosure. But increasingly, Pitt is isolated by bipartisan criticism of his past work as a top accounting-industry lawyer. Although Bush continues to back him, pressure for Pitt's resignation is bubbling up on Capitol Hill. "He should be a trouper and take one for the team," says a House GOP staffer.

Pitt is also on the run on another front: Democrats' demands for a legislative ban on accounting firms' performing both auditing and consulting for the same corporate client. Bush now wants the SEC chief to quickly issue rules to restrict the practice, giving a boost to the Sarbanes measure, which would make such a ban permanent.

Meantime, Democrats have mustered the votes to force another big change: a requirement that companies rotate their lead auditor every five years. That could discourage sweetheart relationships from developing between auditors and client companies, such as the one linking Enron (ENRNQ ) and Arthur Andersen.

-- Corporate Governance. One Bush proposal with some bite is the call for CEOs to attest to the accuracy of company financial reports. By demanding accountability at the top, the Administration hopes to prevent execs from passing the buck, as at Enron, where head honcho Kenneth L. Lay insisted he had no knowledge of financial engineering at his company. "We have to stand up for what we say," agrees CEO Daniel P. Burnham of Raytheon Co.

But other execs worry they'll be targeted by trial lawyers and disgruntled shareholders--a fear that Bush advisers and many experts claim is misplaced. Ira M. Millstein, a senior partner at law firm Weil, Gotshal & Manges, says that, in time, CEOs will find a way to adjust to the routine. "It would be a mistake to push this as the end of the world," he says. "Yes, it's more of a burden but properly handled, it can be discharged."

Investor advocates applaud Bush's belated embrace of changes they have sought for years, such as forcing boards to have a majority of independent directors, granting audit committees power to hire and fire accountants, banning sweetheart loans to officers and directors, and requiring shareholders' O.K. for stock option plans.

The New York Stock Exchange is already calling for most of these reforms. Many corporations, such as Walt Disney Co. (DIS ) and Goldman, Sachs & Co. (GS ), have taken preemptive steps to improve the independence of their boards. And Citigroup (C ) CEO Sanford I. Weill is proposing one major move that Bush shies away from. "You want to know what I would really like to do with options?" asks Weill. "Expense them for the top five executives."

If companies don't clean up their act, Bush says he's ready to send in the posse. By stiffening the penalties for corporate malfeasance and document-shredding, he is giving SEC and Justice Dept. enforcers new tools to use against crime in the suites. But legal experts say investors are unlikely to see legions of corporate bigwigs busting rocks on the local chain gang. Even though CEOs will sign those financial attestation statements, proving intent to defraud is tough for prosecutors in complex business fraud cases--a job not made any easier by executives' access to the top defense lawyers.

Reformers such as McCain and Senate Judiciary Chairman Patrick J. Leahy (D-Vt.) say the Administration should go much further by creating a new felony, with a maximum sentence of 10 years, for obstructive tactics such as destroying records and creating phony documents. Some dream of overturning a 1994 U.S. Supreme Court case that makes it impossible for private litigants to sue lawyers and accountants for aiding and abetting corporate fraud. Others want to modify the 1995 Private Securities Litigation Reform Act, which makes it hard to bring civil suits against top officers and directors. "This has been devastating to investors," says ex-Representative John Bryant (D-Tex.), now a private lawyer. "It encouraged reckless behavior by companies."

Still, any changes seen as helping trial lawyers will face heavy flak from corporate chieftains, pro-tech New Democrats, and a President who despises the plaintiffs' bar. "Will we open up a Pandora's box of lawsuits, civil or criminal? That's my biggest fear," says the CEO of a major national bank.

-- Wall Street Analysts. Although he lashed out at research analysts who say "buy" when they mean "sell," the President is playing catch-up with Eliot L. Spitzer: The New York Attorney General won a $100 million settlement from Merrill Lynch & Co. (MER ) over allegations that the firm's analysts misled investors. And state regulators are now pursuing other brokerage firms on similar charges. Calling the President's remarks a "profound disappointment," Spitzer said that "until the issue of analyst conflicts is addressed [by putting more distance between researchers and bankers], it is incumbent on state regulators to...protect the investing public from continued abuses."

What's more, on the very day Bush spoke, new rules proposed by the stock exchanges and adopted by the SEC took effect. The rules prevent investment bankers from interfering in analyst recommendations or from playing any role in setting analysts' compensation. Trouble is, Wall Street firms are still resisting taking the extra step--completely separating research from investment banking--that would grant the President's wish of transforming analysts from hawkers to truly independent researchers.

In many respects, the 10-point corporate-accountability plan that Bush unveiled on Mar. 7 and his July 9 addendum are imperfect blueprints. But the details are less important than the fact that both Bush and business are now being swept along by the reform tide. Even as he moves closer to the Democratic position, the President makes his familiar rejoinder that only a few "bad apples" have sullied the reputation of a business leadership that he accurately describes as fairly straight arrows. "The vast majority of CEOs in America are good, honorable, honest people who have nothing to hide," he said on July 8. "It's the fewthat have created the stains we must deal with."

But as America's corporate leadership has found out, it only takes a few rotten apples to spoil the barrel. As for the MBA President who glorified the entrepreneurial culture--until Enron triggered the corporate crime wave--fate has been cruel. Now, Bush has had to stop proselytizing and start reaching for the mop and bucket. As the cleanup begins, much is at stake for George W. and the GOP. But even more is on the line for executives struggling to rebuild shattered confidence in Corporate America.

By Lee Walczak, Richard S. Dunham, and Paula Dwyer, with Laura Cohn, in Washington; Wendy Zellner in Dallas; Geoffrey Smith in Boston; Ciro Scotti with the President on Wall Street; and bureau reports

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