Technological evolution and the devolution of corporate financial reporting.

• Jurisdiction: United States
• Author: Langevoort, Donald C.
• Date: 01 October 2004

TABLE OF CONTENTS INTRODUCTION I. TECHNOLOGY'S FIRST DIMENSION: THE ISSUERS THEMSELVES II. TECHNOLOGY'S SECOND DIMENSION: THE RISE OF THE UNSTABLE RETAIL INVESTOR III. TECHNOLOGY'S THIRD DIMENSION: BREAKING THE TRADITIONAL BOUNDARIES OF THE FIRM A. Derivatives and Synthetics B. Business-to-Business Relationships IV. THE FEEDBACK LOOP A. Testing the Limits B. Evaluating the Harm V. EFFECTIVE REGULATORY REFORM A. The Starting Point B. The Philosophy of Financial Reporting VI. A FRESH LOOK AT THE ENFORCEMENT AND REMEDIES CONCLUSION INTRODUCTION

Technology's fingerprints are found all over the recent financial reporting scandals involving Enron, WorldCom, Tyco, Global Crossing and the like. The firms caught up in the scandals were disproportionately either in the technology sector or were technology-driven competitors in related product markets. They were especially attractive as investments to a generation of investors using on-line brokerage accounts and financial websites--an information-rich environment that promised to empower the retail trader vis-a-vis the dominating mutual funds, hedge funds, and pension plans.

Just as important, many of these firms were innovators in how they used technology in both financing and conducting their businesses. Enron is now the best-studied example, (1) with massive utilization of structured finance techniques and derivatives to create an "asset lite" strategy wherein both assets and liabilities were quickly moved one step outside the formal boundaries of the firm to numerous affiliated special purpose entities. (2) These financing techniques themselves would be impossible without sophisticated technology that enabled Enron to become more an energy-based investment bank than a traditional supplier of natural resources. And even business-to-business relationships structured by many of these firms were innovative, with firms using information and communications technology to create more embedded relationships with customers and suppliers characterized by "just in time" production and delivery.

My claim is that the technology link to the recent disclosure scandals is no coincidence. (3) To be sure, cheating tempts all who seek wealth, in whatever line of business they find themselves. I want to show, however, how the rapid pace of innovation at a number of levels offered motive, opportunity, and rationalization for a downshift in financial reporting norms, which in turn made outright fraud more probable.

Understanding the root causes of the scandals is important because of the need for care in choosing a response. The popular story of the scandals, born out of a great deal of frustration and anger, is one of corporate greed--misreporting as a stark form of corruption and hence "evil." While greed certainly had a role, the misreporting was far more complicated and ambiguous, both in terms of underlying motivation and its impact on investors. Technology's multiple dimensions set in motion a feedback loop in which many managers came to believe that aggressive reporting--close to the line and perhaps over it--was both necessary and justifiable. During most of the 1990s, the SEC and the courts did relatively little in response even though the practices were becoming more and more notorious--thereby sending a message of tacit acquiescence. Putting aside the most egregious cases, the story may thus be more of mixed signals and situational pressures run amok than anything unusually corrupt about the dispositions of the managers involved. As Warren Buffett said in 1997, well before the scandals ever emerged, the inclination to engage in deceptive earnings management had made it "very tough to cleanse the system . because you don't have good guys and bad guys anymore." (4)

If that is so, then the right reaction is probably not moral outrage and the right regulatory response is not necessarily the broad-brush criminalization threatened by the Sarbanes-Oxley Act of 2002. (5) This is not to trivialize or to excuse financial misreporting: it causes serious harm and requires a potent remedy. And in some of the cases--Enron, for example the misconduct went way out of bounds. The point is simply that choosing the right forum for adjudication and remedy requires a more nuanced analysis of what happened and why, not the lumping of all the scandals together into an undifferentiated mass. That story begins with the state of technology and innovation in the 1990s.

1. TECHNOLOGY'S FIRST DIMENSION: THE ISSUERS THEMSELVES

   Enron, we know, was an energy business that transformed itself into an investment bank making markets in energy trading, broadband, and many other synthetic assets--an extraordinarily sophisticated, technology-based task. (6) WorldCom was one of the major players in telecommunications, and Global Crossing was an innovator in the trans-oceanic communications business. Adelphia, Xerox, AOL-Time Warner and so many others fit the same mold.

   What could a film's product line have to do with either the motive or opportunity to manage earnings or other financial metrics? I shall explore some of the connections in more detail below, including the simple fact that retail investors became fascinated with stocks that had a technology-based story. (7) At a higher level of generality, however, an important common thread was the perception that cutthroat competition was necessary to grow. There was a strong sense during the 1990s that the Internet and related technological changes provided a short window of opportunity for firms to achieve the scale necessary to be a winner (or survivor) in newly redefined product lines. Many competitors would not survive if they did not fight for growth. Those that succeeded would be lavishly rewarded in something resembling a winner-take-all tournament. "Eat or be eaten" was a common incantation. As a result, both hope and fear--two of the most profound motivators in human and organizational psychology (8)--were strongly at work.

   The connection to financial misreporting here is two-fold, and the duality is important. Growth is financed in the capital markets, either through infusions of capital (IPOs, borrowings, etc.) or through stock-for-stock acquisitions of existing or potential competitors. The higher the perceived valuation of the company, the more it could accelerate its growth through equity-based financing; the more solid its balance sheet and cash flow, the more it could leverage itself in the debt market and avoid default on existing debt. (9) More indirectly, reported measures of strong growth could be of value in other markets, including the attraction of high-quality employees and the gaining of customers. The latter deserves special note. In a market where many firms are likely to disappear quickly, customers naturally seek out the most likely survivors to establish dependable relationships. Firms that demonstrate strong earnings and revenue growth are most likely to survive, which can in turn become a self-fulfilling prophecy. The more firms can convince customers to make long-term commitments, the more they gain resources enabling them to be around for the long term. Of course, once the motivation to demonstrate strong revenue and earnings is seen, the temptation to create illusions of success is equally clear.

   The other connection is managerial motivation. Growth in highly competitive markets is difficult and takes a highly motivated management team. Conservatism, much less sloth, is deadly. Beginning in the late 1980s, firms rapidly increased the use of incentive pay for executives and other key employees as the primary component of their compensation packages. (10) Stock options, in particular, came to dominate in technology-based industries, gradually migrating into many other market segments where growth pressures were increasing. Though not well acknowledged at the time, this trend produced an obvious agency-cost problem because executives could cash out their stock in the near-term stock market. (11) We could expect them, therefore, to focus obsessively on the immediate stock price--and perhaps manipulate it if they could--with less attention to the long term.

   In the aftermath of Enron and the like, this second story has come to dominate, and many of the Sarbanes-Oxley reforms operate on the premise that these scandals simply demonstrated the severity of the agency-cost problem. The popular account was about executive selfishness and greed to the detriment of the firm's shareholders. My suspicion, however, is that while both accounts are important, it is actually the first that takes precedence. (12) An important force that was driving the managers in Enron and WorldCom to create illusions of growth was that any disclosure of weaknesses or problems (shortfalls in customer orders, increases in costs or liabilities, etc.) would have translated into an advantage for the firms' competitors and a potentially lethal loss of competitive edge in the product or capital marketplace.

   That these illusions also directly increased the managers' own wealth is far from trivial--basic psychology teaches that executive inference is heavily self-serving (13)--but hard to disentangle from the connection to financial misreporting. The fact that so many of the executives in these scandals sold only portions of their portfolios before the collapse of their stock prices strongly suggests that the frauds that occurred were not primarily about personal wealth maximization. Executives were betting that the illusions could indeed become self-fulfilling--that the immediate competitive gains from shading the truth would more than compensate for any ha, ills flowing from a loss of credibility were the truth eventually to be discovered. Many of these bets were predictably overly optimistic. (14) Most, however, were probably made with the sense that, at the time, they were aggressively consistent with the firm's interests.

2. TECHNOLOGY'S SECOND DIMENSION...