Getting the Message, Finally

They are lining up to take the pledge. Douglas N. Daft, CEO of Coca-Cola, publicly promises to treat stock options like other forms of compensation, expensing them and taking the hit on his company's earnings. Then, Washington Post CEO Donald Graham vows to do the same. Bank One CEO James Dimon follows suit, saying expensing stock options will help "provide clarity, transparency, and accuracy to our shareholders."

Growing numbers of CEOs around the country, however reluctant they may be, are responding to angry investors who no longer trust any financial numbers in the face of widespread fakery and fraud. Some, such as Michael D. Eisner at Walt Disney (DIS ), are finally reforming their crony boards of directors and separating their auditors from their consultants. Pushed by the heckling from Warren E. Buffett to clean up their books, prompted by the cajoling of Goldman, Sachs CEO Henry M. Paulson Jr. to take action, the movement for corporate reform is picking up steam. But time is of the essence. Investor disillusionment is perilously high, and the bearish stock market is becoming more and more volatile.

CEOs face a gargantuan task. They have dragged their feet for months, ever since Enron (ENRNQ imploded. Even as scandals spread to Global Crossing (GBLXQ ), Xerox (XRX ), Tyco (TYC ), Dynegy (DYN ), ImClone Systems (IMCL ), and Adelphia Communications (ADELQ ), they resisted change. It wasn't until the enormous $3.8 billion fraud at WorldCom (WCOM ) caused investors to back away from the market, sending it into a deep swoon, that CEOs began to wake up. Now, none other than Federal Reserve Chairman Alan Greenspan is excoriating the "infectious greed" of CEOs, saying that their behavior directly threatens an otherwise solid economic recovery.

He's right, but it doesn't get us anywhere to simply demonize CEOs, as some politicians in Congress have done in recent weeks. The goal must be to get on with reforms.

BITING THE BULLET ON REFORM. The most important of these is the tough Senate accounting-reform bill proposed by Senator Paul S. Sarbanes (D-Md.). It establishes an independent oversight board to watch accounting, forces companies to rotate the accounting partner who does audits every five years, limits conflicts of interest within the industry by restricting consulting services firms that can offer to audit clients, and mandates CEOs and CFOs of publicly traded companies to certify their financial statements. This would go a long way toward reestablishing the credibility of financial statements.

To date, President Bush has backed the much weaker House version of the bill. It's time for him to bite the bullet and put his support behind the Sarbanes bill. So should House Republicans. The markets and the nation's economy would benefit tremendously if a tough piece of accounting-reform legislation is put before the President and he signs it before Washington takes off for recess in August. Waiting for September risks further alienating investors and sending the stock market to even lower levels.

Expensing stock options is clearly the second reform action that needs to be taken to restore credibility to earnings statements--and CEOs. The experiment of using options to align management and shareholder interests clearly has failed. It may take some time to figure out the best way to value options. In the end, they will have to be deducted from earnings, just as all other kinds of compensation. The need for full disclosure, transparency, and credibility overwhelmingly demands options reform, even in high-tech industries. If stock options are valuable as employee incentives, then CEOs should be willing to pay for them or find alternatives.

Finally, checks and balances must be restored to corporate governance. The New York Stock Exchange should go ahead with its plan to require that a company's board has a majority of independent directors and that audit committees should consist entirely of outside directors. The NYSE should also consider requiring that the chairman be separate from the CEO. The chairman should represent shareholder interests, not commingle them with management's. And Wall Street should follow through on its early efforts to make analysts independent thinkers once again by divorcing them even further from investment banking. Analysts should not be going on road trips to sell stock or initial public offerings to potential investors for the firm. Period.

A SLOW, EXPENSIVE PURGING. Don't expect the corporate cleansing under way to be cheap or quick. The super-earnings of the '90s are being repriced sharply downward by the markets. Standard & Poor's says that if all companies in its 500-stock index expensed their options, earnings per share would be down 24.5% for 2001 and 17% in 2002. S&P is already expensing options in calculating core earnings for corporations. Bottom line: The truth about earnings will be expensive.

The repricing of equity--and debt--may well take some time. The market is clearly struggling with valuation. Many CEOs of public companies will personally sign off on their financial statements to the Securities & Exchange Commission by Aug. 14. It will take months longer for others to go back and examine their books and verify their veracity. Accounting and governance reforms will also take time to implement. And there is as yet no agreement on valuing options when expensing them: Boeing (BA ) uses one method, while Coke (KO ) uses another.

In the end, the cleansing of Corporate America will be worth it. The economy is coming back to life, with productivity rising and profits for many companies looking healthier. Companies seeking to keep their competitive edge will, at some point, have to replace their old Y2K-era hardware and software with the best available technology. Once investors believe that they can again take reasonable risks and make honest evaluations, they will return. Stocks will rise, and the bear will go back into hibernation.

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