Business: In Nothing We Trust

July 8, 2002 -- "In God We Trust," it says on the back of a dollar bill. That may be the only bit of trust left in the U.S. financial system.

Enron. Andersen. Tyco. Qwest. Global Crossing. Adelphia. Now WorldCom. Or should that be WorldCon? Where can anyone have any confidence in the probity of corporate America if a company's accounts aren't worth the paper they are printed on?

As Francis Fukuyama argues in Trust: The Social Virtues and the Creation of Prosperity, high levels of trust facilitate economic interaction and lower transaction costs, thus encouraging development of large-scale corporations which help a society compete in the global economy.

Low trust entails higher transaction costs, as suspicious people protect themselves with negotiations, detailed contracts and lawyers. Development lags accordingly.

The Reason for Rules

There is nothing inherently trustful about business. That is why there are rules. Accounting rules, corporate governance rules, antitrust rules, anti-corruption rules, rules of contract and property.

Capitalism couldn't work successfully without them. The system is based on everyone — investors, executives, consumers and employees — making informed decisions based on information they can trust. Fraud undermines capitalism just as much as theft by violence.

That is why companies have to file financial statements in standard formats that comply with generally accepted accounting principles. That is why stock exchanges require information that could affect a stock's price to be disclosed to all investors simultaneously. Insider trading is illegal for a reason.

But the system only works if the penalties outweigh the potential gains from breaking the rules. In the tech bubble years they simply didn't.

The numbers were so big, the enforcement so lax that the temptation became too great for too many top executives who started treating their companies like personal piggy banks.

Help yourself to stock options. Keep the share price high to cash in. Keep the earnings growing to keep the stock price up. Just do what it takes to get the numbers to come out right. Smart accountants write accounting rules. So hire even smarter ones to get around them. And everyone was getting rich so it seemed no one cared.

Just Follow the Regulations Already in Place

Now, like Claude Rains in Casablanca, Americans from the president downwards are shocked, shocked, to find improper accounting was going on here.

The solution is straightforward.

Sure, some already proposed technical changes would help: stronger auditing rules and a Glass-Steagal-like separation for accounting firms of auditing and consulting; tougher corporate governance rules to ensure the rotation of auditors and that non-executive directors act as the guardians of shareholders' interests — not as management's cronies.

More radically: Modify the purely rules-based accounting of the United States to include the principles-based accounting used elsewhere in the world.

But more important: Make the rules we do have stick and the penalties for breaking them effective deterrents.

Case in point: The SEC's lawyers and accountants have been investigating WorldCom for three months. Still, it took the company to 'fess up publicly to its accounting misdeeds for the agency to file charges.

A Little Jail Time

The SEC's chairman, Harvey Pitt, himself a former Wall Street lawyer, is now writing to the chief executives and financial officers of America's 1,000 largest companies asking them to certify the accuracy of their company's financial accounts. If those accounts turn out to be false, top execs could end up in jail, he says.

If all CEOs were to face serious jail time for fraud if their accounts were bogus and were sure they had little chance of getting away with cooking the books, you'd find trust in the numbers and corporate America restored faster than you can spend that dollar bill.

A previous generation of white-collar crooks learned that lesson the hard way. The abuses of the junk bond era came to an end once the likes of Michael Milken were put behind bars. That lesson needs to be taught to a new generation.