Reform: Who's Making the Grade

A performance review for CEOs, boards, analysts, and others

On a humid morning in late July, lawmakers, regulators, reporters, and half a dozen TV crews crowded into the usually ample William O. Douglas room in the basement of the Securities & Exchange Commission in Washington. The mood was jovial, the speeches full of backslapping and congratulations. Republicans paid tribute to Democrats, Democrats applauded Republicans. It was the first anniversary of the signing of the Sarbanes-Oxley Act, the most sweeping overhaul of corporate securities law in 70 years. "This is truly a moment of celebration," gushed Senator Christopher J. Dodd (D-Conn.), the last of four sponsoring legislators to take a turn at the microphone.

There is no doubt that SarbOx had given reformers a powerful tool to scrub down and reengineer the American system of running and evaluating corporations. In the two years since energy trader Enron Corp. went belly-up -- revealing a morass of mismanagement and accounting abuse -- regulators, prosecutors, and Congress have tripped over one another in a push for punishment. Companies, meanwhile, have spent at least $1 billion adopting new Sarbanes-Oxley rules meant to address the crisis of confidence that wiped out $35 billion in investor wealth. Corporate audit committees are gathering more often for longer meetings and asking tougher questions. Auditors are for the first time bowing to the rules of a regulator. Bad analysts are being fined millions of dollars. A few rogue executives are even standing criminal trial.

But hold the applause. For all their apparent victories, there is still an awful lot yet to be done. The Justice Dept. has been pounded for its failure to indict the CEOs involved in the very largest meltdowns, such as Enron's Jeffrey K. Skilling and WorldCom's Bernard J. Ebbers. Even more troubling are the other players, including investors, boards, and CEOs, without whom any hope for permanent change is doubtful. As a group, their performance so far has been disappointing. Boards have yet to rein in executive pay, with one of the most shocking payouts -- almost $140 million -- going to a regulator, Richard A. Grasso of the New York Stock Exchange. Most upsetting is a sense that the scandals continue apace: Freddie Mac's ex-CEO Leland C. Brendsel was accused this summer by the company's board of smoothing earnings to boost future performance. (Even so, they agreed to honor his parting package of $54 million.)

On the corporate front, many CEOs and CFOs have begun to exhibit acute reform fatigue. They argue that the new rules have gone too far, that they are stifling risk-taking, and that companies have been saddled with broader and more expensive audits and higher bills for insuring officers and boards. A recent PricewaterhouseCoopers survey found that the number of executives with a favorable opinion of Sarbanes-Oxley had fallen from 42% last October to 30% this June.

At companies where the tougher reviews have not turned up new problems, CEOs are already questioning the cost. "We have upwards of $6 billion in sales [and] earnings last year of well over $500 million, and our auditors are spending a lot of time documenting items that would be in the several-hundred-thousand-dollar area," complains Stephen L. Baum, CEO of Sempra Energy, which has spent more than $1 million on Sarbanes-Oxley requirements. Are CEOs merely impatient with seemingly petty restrictions or, as some worry, is there a deeper rejection of the corporate cleanup? Says Christopher Davis, portfolio manager at Davis Advisors, which oversees $25 billion in mutual funds: "There is a sense that if the capital markets simply recover and the stock market goes up, this whole focus on governance will lose steam."

That makes this a critical juncture in the time line of reform. As with any hastily drafted legislation, Sarbanes-Oxley isn't perfect. The only chance to avoid backsliding too far, however, is if regulators, auditors, and investors keep the heat on. "What is needed now is ongoing and permanent enforcement and monitoring," says New York State Comptroller Alan G. Hevesi, who's trying to get institutional investors to form a watchdog group. Here's BusinessWeek's report card on how the key players in corporate reform are measuring up:


  Luckily for investors, there is a mosaic of enforcers in high gear today with zealous federal, state, and local agencies wrestling one another for the mantle of reform. Investigations by New York State Attorney General Eliot Spitzer have brought to light shocking conflicts of interest at mutual funds and investment banks, and at a much brisker pace than the usual regulatory trudge. New York City District Attorney Robert M. Morgenthau is bringing Tyco's L. Dennis Kozlowski to trial on Sept. 29. In Alabama, U.S. Attorney Alice H. Martin has gotten 14 plea bargains as she storms through a HealthSouth (HRC ) investigation.

But at the SEC -- the pivotal regulatory agency -- progress has been halting. Last fall, besieged by allegations of favoritism toward the accounting industry by then-Chairman Harvey L. Pitt, the commission was looking like an agency in need of its own overhaul.

The SEC's performance has improved since former Wall Street leader William H. Donaldson finally took over in February. The agency completed its Sarbanes-Oxley rule making, including new requirements that CEOs must attest to the validity of financial statements and disclose off-balance-sheet transactions. It also launched the Public Company Accounting Oversight Board to watch over auditors, and it embarked on a number of new investigations into corporate wrongdoing. "I do think there has been a gradual recognition that the policeman is on the beat," says Donaldson. He's even contemplating reforms that go beyond the law, including allowing investors to nominate candidates for boards of directors.

Still, in one vital area -- enforcement -- the commission's grade is, at best, an incomplete. In the past 23 months, the SEC has filed 1,141 enforcement actions, compared with 987 in 2000-01. But the SEC has frequently followed its traditional path of allowing individuals and companies to settle charges with a fine, without admitting guilt. The Justice Dept. has also come in for some criticism that it is acting too slowly. Notwithstanding all the executives accused of wrongdoing at Enron, WorldCom, Tyco International (TYC ), Adelphia, Xerox, and HealthSouth, only one CEO, ImClone Systems (IMCL ) Samuel Waksal, has been convicted and sentenced to jail. "Until you see people paying for this behavior, the jury's still out on reform," says John Keogh, president of National Union, the directors and officers insurance company.


  Corporate chiefs have remained too quiet, reacting to and even resisting the drive for reform rather than leading it. The number of companies fighting to keep shareholder resolutions off their proxies skyrocketed this year. And last month, Pfizer Inc. CEO Henry A. McKinnell wrote to the SEC on behalf of the Business Roundtable opposing proposals to democratize board nominations.

While a few managers have taken steps to improve disclosure beyond SEC requirements, many chief executives ignore easy improvements. Jeffrey Rodek, CEO of Hyperion Solutions (HYSL ) Corp., which makes financial software, notes that fewer than half of the 100 largest companies issue a quarterly cash-flow statement at the same time as income statement and balance sheet, even though cash is an important check on the trustworthiness of the other numbers. Even boards aren't satisfied with their company's disclosure. A recent Hyperion poll of 150 board members found that nearly 40% felt their management was not telling them enough about operations. Some 65% were not satisfied with the accuracy of the forecasts they were getting.

Particularly galling is that it's still standard practice for companies to buy indemnity policies that pay the legal costs of CEOs. Exhibit A: John J. Rigas, accused of using cable company Adelphia Communications (ADLAC ) Corp. as his personal piggy bank, is pressuring the company's insurer to cover his legal costs.


  By all rights, institutional investors should have been charging angrily to the front lines in the battle for corporate reform. They control more than half of U.S. investing dollars, and their clients, the individuals and corporations who entrusted them to manage mutual-fund and pension assets, were the primary victims of the accounting and compensation scandals. Plunging market values even cut into their own fee income and reputations.

There was hope early on that investors might take up arms. Last year, money manager Davis, who represents the third generation in family-run Davis Advisors, set out to organize a group of leading institutional investors who would together press corporate directors and executives for clean accounting, good audits, and compensation tied strictly to performance. He held an initial meeting in April, 2002, that attracted more than a dozen industry leaders, including Legg Mason Funds Management Inc.'s Bill Miller. Meanwhile, John C. Bogle, the founder and former CEO of Vanguard Group Inc., was trying to form the Federation of Long-Term Investors.

But 18 months later, the big investors still haven't agreed on what to do next. Bogle's federation has gone nowhere. The primary problem is that many money managers are too busy trading stocks to care about long-term issues of corporate governance. On average, funds now sell stocks less than a year after buying them. There's a conflict of interest at work: Many money managers also manage pension accounts for the big companies they invest in, making it awkward to criticize management. Fund-industry leaders at Fidelity Investments and the Investment Company Institute have also fought moves to force them to disclose their votes on corporate proxies. "Instead of putting the owners first," says Bogle, "we're putting management first." As the owners of these companies, investors have the heaviest hammer, and they should use it.


  There's no doubt Wall Street research analysts are feeling the heat of reform. Internal SWAT teams are combing through analysts' e-mail. "Chaperons" are listening in on their phone conversations. Ratings changes are being scrutinized by extra layers of bureaucracy. One analyst, concerned about getting caught in the ethics crossfire, even asked a research director whether an analyst would have to leave a dinner party if an investment banker were there.

The brokerage houses that signed the $1.4 billion research settlement are following the new rules to the letter, but it's less certain that they've corrected the core problem: putting out better research. Today, major firms cover less of the market -- only 23,000 companies, compared with 28,500 just three years ago, according to Thomson First Call. But roughly one-third of the research departments of the big firms have been laid off, and those who survived the shakeout are being asked to cover more companies with increased accuracy for less pay. On average, a senior analyst is now expected to cover nine companies instead of six. One element of the settlement -- that banks distribute independent research to balance their own -- has yet to be fully put in place.

On the whole, analysts seem to be taking a more skeptical look at the companies they analyze. In the late 1990s, about 67% of all analyst recommendations were "buys," and 1% were "sells." Now, only 41.7% of recommendations are buys and 10.5% are sells. But not everyone seems to have gotten religion. Despite its ad campaign claiming it was one of the few honest researchers around, Prudential Securities (PRU ) Inc. had sell ratings on only 3% of its companies on Aug. 25. That's far below Morgan Stanley, Goldman Sachs (GS ), and Salomon Smith Barney (C ) which have sell ratings on more than 15% of the companies they cover. Prudential says the 3% reflected their belief that the market would climb. "They [Prudential] haven't changed their spots," worries Charles L. Hill, veteran research director at First Call.

To prove they deserve their role, analysts must follow the lead of those firms working to force a more effective new form of research. At Merrill Lynch (MER ) & Co. and Credit Suisse First Boston (CSR ), analysts are increasingly working in teams that mix bond and stock specialists and that mix analysts who cover suppliers with those who watch their customers. This approach is designed to avoid situations like Enron, where the skepticism of bond watchers was ignored by equity analysts.


  Accountants are climbing out of the mud. After the collapse of Arthur Andersen and a string of billion-dollar accounting breakdowns, auditors were derided as rubber stamps for management, a group that seemed more concerned with milking clients for consulting fees than truly auditing them.

But things are looking up. Auditors seem to be pushing for more financial restatements: Some 158 companies took that step in the first half of 2003, well above the first half of 2002. Certainly some of these are corrections of the often-costly errors of the past, but there is some reason to hope the new toughness is serious. At Freddie Mac, it was auditor PricewaterhouseCoopers that raised questions about the earnings-smoothing being led by then-CEO Brendsel. Whether it was out of fear of going the way of Arthur Andersen or a true commitment to change, the major firms have themselves gone well beyond SarbOx to rethink their business in more fundamental ways. At KPMG, the auditors are now reviewed not only by their boss, who focuses on business growth, but also by risk experts, who rate how well the accountant complied with the firm's rules. At Deloitte & Touche, the partners identified 400 audit clients that appeared to be performing far better or far worse than their industry. They took a hard look at why -- and wound up resigning from more than 70 of the accounts in question.

Determining how truly auditors have reformed falls to the newly minted Public Company Accounting Oversight Board, a creation of Sarbanes-Oxley. The four largest firms are already undergoing inspection. "They are saying the right things. What our inspections will indicate is whether they are also doing the right things," says William J. McDonough, the board's new chairman.


  These days, when an insurance company meets with a director or a corporate executive to discuss directors' and officers' insurance, the hot topic is compensation -- what kind of perks executives get, the loans extended to officers, compensation plans they took to shareholder vote, and how high a percentage they won by. Enough bad answers and an insurer will walk away, mostly for fear of litigation.

Despite plenty of evidence that chief executives didn't come close to earning the outsize paychecks they got during the days of the bull market, not to mention some apparent out-and-out looting, top managers are still getting top dollar. The average CEO made $2.4 million in salary and bonus last year, compared with $2.3 million the year before. And while CEO pay isn't growing as fast as it once did, it's still growing faster than pay for non-execs. Even once-burnt companies are going right along. Despite criticism of its generous exit package for William T. Esrey, for instance, Sprint (FON ) Corp.'s board just gave his successor, Gary Forsee, a welcome-aboard gift of $14.5 million in restricted stock and guaranteed bonus, on top of a $1 million salary. Sprint says most of that award is stock tied to performance and doesn't vest until 2007.

But if boards get an F on pay, they make up ground in their other key role: overseeing the auditor. Board members say they're meeting more often and for longer periods, and auditors say they're asking tougher questions. They need to bring a similar discipline to compensation if they're to do a decent job as the first line against corporate backsliding.

How real is corporate reform? The test will come in the next bull market, when the temptation to cut corners will be back in force. "Just avoiding jail should not be the goal here," says William W. George, former CEO of Medtronic (MDT ) Inc. and a board member of Novartis (NVS ), Goldman Sachs, and Target (TGT ) "It should be building great companies." That will depend on whether these key groups have embraced the spirit of reform or just its letter.

Corrections and Clarifications In "Reform: Who's making the grade" (Management, Sept. 22), the calculation of 158 accounting restatements that occurred in the first half of 2003 should have been attributed to Huron Consulting Group.

By Nanette Byrnes, with David Henry and Emily Thornton in New York and Paula Dwyer in Washington

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