Lynn Turner: I currently serve on the Board of Trustees of a $40bn pension plan that covers over a hundred thousand employees in the state of Colorado and I also serve on the Board of a Mutual Fund. So today when I speak, I'm going to be talking not only from the perspective that I have fortunately been able to gain as a partner with one of the major accounting firms, but also as a Chief Financial Officer (CFO) and executive and business regulator, and now from a most enjoyable job overseeing two major investment funds. In the case of the public pension fund, it is one that obviously impacts a lot of Americans today.
One of the things that I have found as we talk about these issues affecting public companies and their investors is that I very seldom see anyone ever stand up and say that they were responsible for the problems. I do not think Jeff Skilling has done that. Joe Nacchio certainly did not do it. So I find it somewhat interesting that despite the scandals that we have gone through, seldom does any individual accept responsibility. There has been a lack of responsibility and accountability, I think, acknowledged from those who acted improperly.
There have been some executives who have demonstrated leadership. People like Jeffrey Immelt at GE have gotten out there and spoken out and have done a very nice job. No doubt though the reason that we are here is because of situations such as that with the New York Islanders owner who will have to give back half a billion dollars, hopefully, to the shareholders where that company took a hit. Of course, as we look at the slide of faces, we recognise all these names or faces.
And what about those audits in which a lot of billion-dollar misses occurred? As I used to tell my students in auditing classes, if you cannot get the numbers right to the nearest billion dollars, you've got a problem. Well, obviously, a lot of people had problems. It would be nice if that was on your list, but you can go on with this list time after time, and people wonder why we needed regulation or why we had problems. At the same time, because of some of those misses and losses, investors obviously took some big hits. And quite frankly, in lawsuits, they have not recovered a whole lot of what they lost. The recoveries have not been sufficiently high because the losses were high. People talk about the cost of SOX. Well, the costs of Enron to investors were up close to a hundred billion dollars, those of WorldCom were significantly higher than that. When they start talking about cost–benefit though, almost universally, you never hear anyone say, 'We want to talk about those costs'. Well, those were costs to the members in our pension funds who saw their investment in Enron disappear overnight. So, this is the type of thing that keeps me up at night and makes me worry as a fiduciary responsible for overseeing those $40bn in assets. And quite frankly, that is why we have some litigation today, amazing as some people may think it is. In the last panel, we heard people complaining about the litigation. Well, I guess if you have Enron and WorldCom happening and people ripping off people, you are probably going to have some litigation, amazing as that might be. And now, here we are again.
This reminds me of a story my daughter told me. My daughter is blonde, so I apologise in advance if this goes overboard. But my daughter is the first one who told me the story; she was telling me about how one night at her condo, they were watching the 11 o'clock news. And there was another brunette sitting there with a friend of hers who was blonde and they were watching. Before long, all of a sudden an alert came on, and it talked about a guy up on the top-storey of a ten-storey building about to jump off. The brunette looked at the blonde and turned around and said, 'I bet you 20 dollars, the person jumps'. And the blonde says, 'You got a bet. You are on'. And sure enough, a few minutes later, the guy jumped. He jumped off the building down to his demise. And the blonde reached into her purse, pulled out 20 dollars to give the brunette. The brunette said, 'No, I cannot take that'. The blonde said, 'what do you mean?' The brunette said, 'Well, I was watching the six o'clock news and I saw the guy jump off'. And the blonde turned around and said, 'Well, I watched the six o'clock news too, but I could not believe he would do it twice'.
So here we are yet again. We are back with the subprime fiasco deeply affecting the economy. We are doing it twice, folks. You know, it is amazing to watch us as we go through this stuff and absolutely learn no lesson whatsoever. Here we are, we have just gone through the corporate scandals of a lifetime — problems with the mutual funds, problems with Wall Street, the analysts, the auditors missing by a billion dollars or more — and now all of a sudden, where are we? We are right back into the same thing all over again with the subprime-related issues, which is nothing more than a repeat of what we saw a couple decades ago — two decades ago, for those of us who lived through the demise of the S&Ls and the problems there. You know, deja vu, but we jump. I'll tell you what, we jump and we jump and we jump, and then people say, 'Why do we need any safety net?' It is absolutely amazing. We have the debacle with credit rating agencies all over again. We had the SPEs, the three per cent SPEs with Enron, and we are right back to the same thing all over again with the securitisations and the conduits and what they call CDOs. I call them 'CUs' because I think everything seems to go through them and nothing gets caught.
Wall Street is the bigger facilitator of the structured finance all over again as they were with Enron. People on Wall Street, people involved with this, do not seem to be stopped by the damage and pain they have inflicted on American investors in the past. And now, we have 2.5 million of our fellow Americans looking at losing their homes. And for the rest of us that own homes — and homes are the single largest asset of wealth for people in America — everyone is now wondering what their home is worth, or was worth.
At the same time, we hear all the complaining about SOX and it certainly continues to go on. And yet, I want to hit on some points about this because you have heard some points this morning, some points that I think people really tend to mislead people on.
First of all, there is a notion that SOX was a rushed-to judgment, which could not be further from the truth. A good piece of that legislation was directly picked up from the legislation that was introduced decades earlier, after you had the collapse of Penn Central, as well as Equity Funding. Legislation that was introduced and went through a series of hearings in both the Senate and House in the mid to later '70s. And of course, the SOX 404 provisions were first introduced in Congress in the 1980s. In fact, Senator Shelby, who now is the ranking member on the Senate Banking Committee, was one of the people who signed on and introduced the SOX 404 legislation for the first time back in 1986. It actually passed the House in 1990, became included in the Fidicia legislation as it relates to banks back in 1991–1992 time frame, and then the SEC also proposed similar regulations in 1978 and again in 1988.
And yet some people say, 'Oh, we have not debated it. We rushed to judgment'. If it takes you two decades to get something out of Congress — and sometimes it is good to take two decades to get things out of Congress as I always say they do their best work on recess — then needless to say, this thing has been thoroughly debated and discussed.
People were given more than ample opportunities to fix their internal controls. In fact, when the SEC introduced a regulation much along the lines of SOX 404 in 1978, they withdrew it in '81 because the industry had told them that they would get their act together and make sure the controls required by the Foreign Corrupt Practices Act passed in December '77 worked as they should. And as we now know, that absolutely did not occur.
And so, while industry and many of these cases were given a first and second shot to get things done and done right, it just never occurred. Instead, they just keep jumping off the buildings.
There were 10 days of Senate hearings on the SOX legislation. There were weeks of hearings over in the House at the same time. Over 40 people testified in the Senate itself, many of the people from up here in the New York area. Among the 535 members of Congress, only three voted against SOX when it got passed. Only three, and the reason there were only three was because of the outcry from the American public demanding this legislation.
I work with the American Association of Retired People and they have done a survey of average American investors this last year. The survey clearly showed that the average American investor, still to this day, says they are more than willing to pay the cost of SOX 404 and SOX in general, to be able to get reliable financial statements. And certainly, the investor community, people who are in positions similar to mine, have constantly come out and said investors are willing to pay the price for SOX to be able to get the type of information we need to properly make investment decisions.
It is also important to note that many of the provisions in SOX have been adopted around the globe in one form or another; not all the same but many similar provisions. There are provisions like 404 in Japan and in Germany. The PCAOB has been modelled in other countries as well, and people are moving towards it; hence it has gained some acceptance.
Yet we still hear people say, 'Hey, this is impacting the competitiveness of the US markets'. Well, let us think about how that is hurting the US markets. If you look at the top five investment firms — we are talking about Goldman, Morgan, Lehman Brothers, Merrill Lynch — all of these had record profits in 2006. They all had record revenues in 2006. They had record assets under management, and their employee count was up significantly. And all of these firms went through major layoffs in the 2000, 2001, 2002 time period when they were hit by the corporate scandals as the markets declined. And yet, they are back up to and above those levels at this point in time. And of course, we know that those firms paid out over $30bn in bonuses for 2006. Does that sound like an industry that is in trouble?
I have to tell you: I do not know other industry doing this well and yet for some reason, people in New York are running around saying, 'We are in trouble. We are having problems'.
And of course, the Dow has gone from the 7,000 that it hit in about October of '02, all the way back up to 14,000 here a month or two ago. Of course, it took the dip with the subprime debacle as Wall Street and financial institutions, and credit rating agencies in particular, 'jumped' again. And hopefully, we will get back on track although that remains to be seen.
What we are really talking about here when we talk about the opposition to SOX is the fact that we have people out there who just flat out prefer the markets be unregulated, and they fail to realise that when you can have phenomenal amounts of wealth transfer each day, and someone coming out of these deals can earn so much money that it allows them to live a phenomenal lifestyle thereafter without working again, then that drives people's behaviour. And without regulation in the markets and without full transparency and disclosure, people do not always behave rightly. As a result, you have to have something that deals with the conflicts, deals with the transparency, or behind closed doors you get some very, very bad behaviour and a market, as we saw in 2001–2002, that people just will not invest in.
Barack Obama — on this slide is a quote he gave just Monday over on Wall Street — he spoke from NASDAQ, and I think he pretty well said it right when he said, 'The quick kill is prized without regard to the long-term consequences to the financial system and the economy. While it may benefit a few who push the envelope as far as it will go, it does not benefit America and it does not benefit the market. Just because it makes money, doesn't mean it's good for business'.
There is nothing in capitalism — and we've got a fantastic capitalism system here in the United States that we should always protect — that should ever endorse the type of behaviour by individuals on Wall Street, corporations, or gatekeepers that we have seen over the last ten years here.
People also cite the London AIM Market. Often you hear it referred and cited as a model. If you put a dollar in that market back when it originally started in the middle of — I think it was '95 — as of a few months ago, you would still have the dollar. There had not been significant returns and that market has not performed very well for investors, and I think that is why SEC Commissioner Campos likened it to playing with your money at the craps table at a casino. And of course, many of the companies that have listed on there could never list in the United States. Not because of SOX. It has nothing to do with SOX, but rather the NYSE and the NASDAQ themselves have chosen through their listing standards not to allow those companies to list here in the United States.
Interestingly, through August of this year, AIM had 201 new listings on that stock market but 150 delistings. The companies come and go on that market, just like they used to come and go on our penny stock markets here in the United States. And of course in 1990, Congress had to pass legislation because investors, especially older investors, were losing so much in the penny stock market. And so much money damage was being done to the capital market system that they put a halt to that type of behaviour.
And here is an example of the stock chart (see Figure 1). And, of course, you can see where the Dow and the NYSE and NASDAQ have gone up there at the top. Going back to the last ten years, you can see how Japan has done, not all that great. And of course, the FTSE is down there next to the very bottom in terms of overall returns. As I mentioned, here is the zero point return level. You basically would still be sitting there with your investment in the AIM market with the dollar that you have invested ten years earlier.
Figure 1.
Market performance (ten-year) United States vs UK vs Hong Kong vs Japan
Source: Capital IQ. As of 6/5/2007
Is that a market that you as an investor want to put your money in? If you want to put your 401K money in the AIM go ahead and do it but I do not know that you are going to be really happy with it. It would probably do better in social security, but it is not going to do a whole lot better than social security at that type of return over the respective time frame. And yet, that is what some of these people are heralding we ought to be doing and we ought to be following in the United States. It makes no sense, whatsoever.
As far as initial public offerings (IPOs), people talk about the IPOs' competitiveness of the US markets. We had 83 IPOs in 2001 before SOX but after the corporate scandals. So far this year, as of yesterday, we have had 152. We have had ten of the largest Chinese IPOs this year. Many of those Chinese IPOs, by the way, relate to their banks or to solar energy companies that they are developing. You go back to 2000, when at the height of the market we had 406 deals raising $240bn. The after-market return on those was a negative 38 per cent. And yet once again, you hear people say, 'Let's go back to the good days. Let's remember a lot of those were dot coms'. Yes, the markets had a lot of IPOs and a lot of people lost a lot of money, lost billions from those investments. Close to a thousand of dot.coms shut down, costing Americans over a hundred thousand jobs, which led to the downturn in the economy and only 83 IPOs in 2001 — nothing related to SOX.
A recent Thomson Financial Study showed that after they went through IPOs in the last 20 years, they found little evidence of foreign companies shying away from US exchanges. As I mentioned, ten of the largest Chinese IPOs this year listed here in the United States, despite the fact that the IPO fees here are twice what they cost a company over in Europe.
Ernst & Young (E&Y) study of IPOs have found that companies tend to list in their home countries. US companies tend to list here. Having been a CFO and been up close to this process, there are things that affect your decision. Certainly, Chinese companies as they come here have to learn a different language, deal with the different currency, cultural differences, time zone differences. There are serious reasons why these companies, as E&Y found, tend to go to their home markets.
The reality is that the competitiveness of US markets has nothing to do with SOX. The issue with the competitiveness of the US markets deals with the economy. We have heard this before back in 1992 — it is the economy, stupid. And that is exactly what Goldman Sachs said in a very well distributed and known report that they issued back in February of 2007. As they know, the relative decline in the United States is not new. It has been underway for several decades, and it really reflects the growth of capital markets and establishment of capitalism in foreign countries, the growth markets in China, in India, the growth of the global economy.
Is Wall Street doomed? Certainly not. It has a bright future, but are we the only game? Are we always going to be the only game? With the Chinese economy that has 1.2 billion people, it is foolhardy to think that we are going to be the only game in town. What you want to do is be the best game in town, so if people are going to consider going elsewhere, there is a reason to do so.
Another thing that drives the IPOs and drives the markets is how fast business is growing. When we look as investors at the funds where I'm at, when we want to invest in a company, we have an obligation to get the highest possible returns for the people who participate in our funds. That means we have to go find those economies where the businesses are most likely to grow and expand because that is what drives shareholder value. If you look at growth and you look at the real growth in China you see this ten-plus percent growth in GDP. They are literally growing at five times the rate we are. The chances of finding a company that is going to grow and really expand is much greater in China, so the investment opportunities are much greater there. The chances for higher returns are going to be much better there. And they have improved the quality of their markets, adopted some of the provisions of SOX, started to deal with enforcement.
But look at the growth in the United States and in fact, in 2006, it actually ended up at 3.2 per cent. I was just with the economist at one of the largest banks here in the United States; they expect 2.2–2.5 per cent growth in 2007 now, and yet people for some reason think there is just as much investment and upside opportunity here as in China. I have got to tell you folks, that is not dealing with reality. That is back to people playing to an agenda, a political agenda, and their own tune and, ultimately, they could not care less about the people who actually have to do the investment.
Another thing that hurts us is the devaluation of the dollar. If I have the choice of investing a dollar in the markets here vs foreign currency over in Europe, I have got to have a great concern because the dollar is devaluing so fast and so deeply here that I have to be able to make extra returns in the United States to make up for that devaluation of the dollar vs investing in the European or Asian markets.
And yet as you just saw in the slides, I have got an uphill battle doing that because our GDP is growing only a fifth as fast as some foreign countries. This is tied in part to our large deficit spending with our debtor nations such as China and Japan. Mexico, folks, is the tenth largest holder of our debt. We are trying to build a wall up across Texas and hold out the country that is lending us the tenth largest amount of our debt. We have so much debt owed to China that we have absolutely no leverage whatsoever on a trade basis.
Secretary Paulson goes to China and argues for a revaluation of the renminbi. What did the Chinese do in April? The Chinese government actually does a net withdrawal out of US Treasury Bonds. It sends a very clear message: Do not mess with us. And we cannot do anything about it because we owe the Chinese government so much debt. If they were to pull out, it would be a disaster for us today; they will not do it though because we are buying so much of the goods they produce.
People talk these days about the past success of private equity, with debt as cheap as it has been until the last few months. Why would one not use debt if one is a CFO and had to redo one's balance sheet? Of course, one would be using debt because debt has a lower cost of capital than equities, especially here lately. So whenever we had a low cost of debt like this, just like we did in the '80s, it has always fueled a large private equity market. Again, it is the economy. If we really are going to talk about the competitiveness of the US markets, we got to get back to our spending on things that will create jobs in this country and allow the economy to grow, such as spending on technology.
The Chinese are graduating four times more engineers than we are. Where do you think is the growth is going to be in the future — in technology? It certainly is not going to be here in the United States with our lack of investment in research and education. And how about those college degrees, the percentage of US 24-year-olds with college degrees — we are sitting down there between Bulgaria and Costa Rica. And people are wondering where we are going to be in the future, even in the business community. We have a real shortage of PhDs that we are facing and that is going to be a tremendous problem. And yet, what are we arguing about? SOX 404? And that is going to solve the problem? You know, it is absolutely beyond reason that a rollback of SOX is what is going to turn around and make the US markets competitive. As Tony Blair said, 'It is going to be the talent in the 21st century'.
The reason those Chinese companies are coming here and listing their solar companies is that down the road as we deal with global warming, you are going to have to be on the leading edge of solar. You are going to have to be on the leading edge of a replacement for oil, which we have an insatiable appetite for but which the countries acknowledge we are going to run out of.
I was talking to the Dubai government about three years ago; they had asked me to serve on the Dubai Securities and Exchange Commission. And the reason they were setting it up is because they figured they had 20 years worth of oil supply left in the ground and then that was going to be gone. By that point in time, they wanted to have business and jobs created that they could replace oil with, and so they were going to create a stock exchange. And they have been smart about it. They have been very smart and now, they are going to own a significant part; up to 40 per cent of the actual equity in the NASDAQ. You heard about the 20 per cent voting interest in the paper. I do not think the papers necessarily pointed out that they may actually own 40 per cent of the equity of our second largest stock exchange. They are thinking about jobs. They are thinking about that economy and we are thinking about SOX.
The other thing any successful businessman knows is that you have got to have a quality product. We have sold investors overseas stock in Enron. We sold them stock in WorldCom and others. Now, we have turned around and sold them subprime. And you see it on television, the run on the banks in London, where you had close to US$8bn being pulled out as people stood up in lines for three days running to get in and get their money out.
Now, think about it. Do you honestly think those people are going to think about coming and investing in the United States again, when that is the type of product that we give them? Would you go and invest in that type of product? It is like us going and investing into lead in China. Now maybe we do, but not with full knowledge about it.
And in the case of Europe, they have so many more shareholder rights than investors in the United States have when it comes to electing directors or trying to deal with issues, or trying to have a say on pay and the exorbitant compensation of executives. Unfortunately, the current SEC is refusing to give investors rights here that foreign investors have in their home markets; why would they come here?
Investment banking fees are half the price overseas as here. They get a lot more shareholder rights. They will not suffer the losses on our structured financial products or structured deals and companies like Enron. Think about it: the hope that they would come here is not going to be driven by that type of product. Again, we have got to have a product that beats the rest of the world's markets. And today, if we were to go down the path that many people would try to persuade you that we should, resulting in a significant reduction in protection for investors, improving the competitiveness of the US capital markets will not happen.
In fact, I will tell you on the Mutual Fund Board I sit on, we had a meeting in Boston just within the last two weeks and we are actually going to look at allocating more of our assets, more of our investors' assets to foreign markets and to foreign companies. And was there any discussion around — well, if we do that, we are going to take it away from the exchanges here in New York — there was not even a mention of that. There was not even one iota of such discussion. The whole discussion was around returns to investors and could we maximise our returns given what the GDP growth was in some of those foreign economies and increase our returns for our investors. So when they got to retirement, they would have more money and better ability to pay their bills, including those home mortgages. That is why we turned around and said, 'Yes. We are going to make a reallocation here and go foreign with our investments to improve our returns'. And as the fiduciary on that board, I have a legal obligation to turn around and do just that.
We heard this morning that there has been a lot of litigation. It would be wrong to say that we do not litigate in this country. Obviously, some members of the legal profession acted in a very despicable way. They were supposed to be officials of the court and upholding justice, and they did everything but that. And yet, we have seen the same thing with general counsels of some of these companies with option backdating or outside counsels who have withheld the information during some of the investigations. It seems like liars who are supposed to be in the business of justice these days are anything but that.
We have heard about the 'Big Four' and the need to protect them from liability. Let me ask you, would any of you support giving auditors a legal protection against liability if they cannot find a billion dollar error? Or as literally in almost every one of those cases that are up on that screen (see Table 1), it was found they actually knew about the error but never told us about it. So when the auditor firms, the 'Big Four' talk about they need protection, you have to turn around and think. If they know about a problem and do not tell you, for what are investors paying them if they cannot even find a billion dollar error, I've got a better way to deal with the liability. Do we even need their audits? As an investor at that point in time, I do not want their audits, I do not want to pay for it because it is adding nothing to value and nothing to my confidence.
Fortunately, and to their credit, I think the audit firms are getting better these days and I think that is good, but they still got a long way to go. But as far as a liability cap, I have yet to run across a single person — you can come up afterwards if you disagree with me — but I have yet to see a single person that when those two questions are asked, say they would give the auditors a legal liability cap.
But, they say, there are only four of them. Well, there are only four of them because all of them have gone through a merger, every single one of them. I can tell you if you went down to the Federal Trade Commission files, you would find in those files submissions from those same firms saying 'if you let us merge, there will be plenty of competition. You do not have to worry about it'. So now, that we are just down to four firms after all the mergers they are turning around and saying, 'You know, what we told you before was not really true. There are only four of us, so now you got to protect us'. That is somewhat hypocritical.
And how about Wall Street? I think Floyd Norris at the New York Times said it best. He had a column a few weeks back and said, 'Is it okay to help out a little bit with the fraud?'
I did part of the investigation for the US Senate when Enron blew up, and so I had the ability to access and get into the records. We found e-mails from the banks, including the largest banks in the United States that were involved with those deals. In one particular case, they had loaned Enron a billion plus dollars and their credit department was getting nervous about whether or not they would get repaid and the credit quality. That bank turned around and agreed to do a private placement of debt — billion and a half, two billion dollars — to an unknowing group of investors.
So the bank, on the investment banking side, actually went out and underwrote that offering of those debt securities and the proceeds were then used to pay off their own loan. The offering document lacked transparency as to that the real reason this was being done which was they were so worried about getting paid off on their loan. They wanted someone else to take on that and pay off that particular bank. And of course, those people who invested in the private debt offering lost all their money, or a good portion of it. And yet Wall Street banks are saying, 'You should not be allowed to sue us'. Is there anyone in here who thinks you should not be allowed to sue that bank?
We actually found e-mails, too, among the attorneys. Arthur Andersen had actually requested the information about the special purpose entities, as they should have. There are e-mails from the banks, from the attorneys talking about how they could never allow Andersen to learn about certain information. Information with respect to special purpose entities and some of the related agreements that had been done, that had not been shown to Andersen. Actual e-mails — and these are not from lowly people, folks. These are people at the managing director, VP level and attorneys outside creating this documentation, as set forth in the US Senate report.
You have to ask yourself: When they were conspiring to do that and were conspiring to do it with full knowledge, why would you ever shield them from liability? Why would you, as an investor, ever want to invest your money in a market place where people can engage in such behaviour to line their own pockets at your cost and you have absolutely no recourse against them whatsoever? That is the question before the Supreme Court right now in what is known as the Stoneridge Case and the follow on Enron case. To his credit, SEC Commissioner Cox voted to submit a brief to the Supreme Court opposing that type of thinking, that type of behaviour. And this administration turned around and said, 'We are not going to let you file it with the Court. We would not even let that argument be put in front of the Court'. That is a travesty in justice.
We have also heard discussion about complexity and how the accounting rules are so complex. Think about it. Think about it, those of you — and I see a few in here that have been around long enough — go back about three decades and think about what business was like three decades ago in this country. By far and away, the largest automobile makers were from here — still a lot of manufacturing industry, a lot of jobs. If you go back in time, you understand the technology industry really never took hold until about '78 in this country, about three decades ago when IBM unbundled their software from their hardware for the first time. Until then, you really did not have much in the way in technology. Jobs were not outsourced. The AT&T operator you could get on the telephone line. And if you needed support and service, you could understand the person that you called up.
Things have dramatically changed in the past three decades since the Financial Accounting Standards Board was put in place. We have structured finance and derivatives. I remember working on Wall Street back around 1983, 1984 and being in a meeting where there is a slide by Salomon Brothers saying, 'It is a record; we now have US$7 billion in interest rates swaps in the United States'. Today, some companies do more in US$7bn in interest rates swaps in a single transaction with a push of a button. Yet in the early '80s that was a new and innovative thing out there.
We have certainly increased the volume of securitisations and different types of derivatives. We have got totally different inventory management systems. Back then, if we built inventory, we actually got the parts in advance, then we had people who build the product, then had it in inventory until we got sales. A lot of the sales were gathered through sales people, not through an intranet or internet; I mean, people actually called in to place sales through that AT&T operator who was in the United States and not in India.
Today, none of that happens; everything is built offshore. At Sun Microsystems, the order comes in directly via the internet to an outsource manufacturer in the Far East, who had all suppliers on-site at the manufacturing sites so they do not have to carry the inventory. The inventory is built, then immediately shipped into the United States directly to the customer. Sun may never build, manufacture or own a piece of the product beginning to end. The sales channels are totally different today than what they were 30 years ago — much more complex than sales channels as recent as a dozen years ago. Yet for some reason, we think accounting should still be simple like two plus two equals four, although sometimes it is two plus two equals five in some of these financial statements.
It is unrealistic to expect that if accounting is going to reflect the economics of these transactions and the transaction documents on securitisations and other financial instruments and structured finance are several feet deep, that you are always going to have very simple, very easy-to-read financial statements. It just does not go hand in hand, especially with global markets. Why would anyone think it is going to be that simple?
It is also often a failure to adhere to standards. We had very principled, simple-based accounting standards for derivatives, FAS 80. It basically said if you are going to hedge, hedge; if not, mark to market. Yet the reality and the bottom line was people did not hedge and they did not mark to market.
We had a lot of losses that cost the American taxpayers close to a trillion dollars on the S&L debacle. Then we had American Greeting Cards, Procter & Gamble getting in trouble, and Bankers Trust whose derivatives debacle basically caused them to be forced to be sold. So FASB wrote a new standard, FAS 133, because people did not adhere to the old standard.
On leasing, in the old Accounting Principles Board opinion there is actually one paragraph — a key paragraph — in a very short document that says, 'If you are going to buy equipment using a lease, put it on your balance sheet as a financing'. I do not know that we had one company in the whole United States follow that standard. As a result, we got the convoluted FAS 13 that has been broken for three decades and never fixed by the FASB. Same thing with FAS 12 on how to account for marketable securities; we are still arguing about it and regulators are still having to write letters to tell you, 'Yes, if you got a marketable security, you got to adjust the value to what it is worth'. Industry did not appropriately follow FAS 12, so it got FAS 115. Yet people are still writing articles and letters over to Wall Street saying, 'Hey guys, we honestly mean it if the value goes down, you ought to put the loss in the P&L'.
Exceptions — FAS 133 is the most complex document we have, and tremendously long due to all the exceptions carved out in it for extremely complex financial instruments. Many teachers just skip that chapter in the accounting books and move on. Were those brought about by investors? Were they brought about by the FASB? No. The business community led by FEI and the then controller of General Electric negotiated for the exceptions and carve outs. They did not want it simple; they wanted all these exceptions and carve outs and that is why FAS 133 is complex today.
Yet when I served as an adviser to OFHEO, the regulator of Fannie Mae and Freddie, Fannie had no systems that could adequately keep track of all of their derivatives. They could not tell you what they had. They had no idea if they were actually hedging or not. They did not have the computer systems that could give them the basic data they needed to manage the company.
They could not properly hedge their risks, yet they used the wrong accounting knowingly. Yet people said, 'Why did they have to restate?' It was not so much accounting issue at Fannie; it was a fact you had an organisation that has a trillion dollars in assets and the management team could not tell you how billions in derivatives properly offset risks and price movements. That should scare any investor given the way those things work. As Warren Buffet said, 'They are basically toxic waste'.
Of course, we all know about the 3 per cent rule at Enron and the special purpose entities created by Wall Street for securitisations. That is why we have a very complex accounting today. Yet we have basically failed to provide a customer-based product. All too often, the accounting has developed up in Norwalk. Former SEC Chairman Arthur Levitt used to call the FASB 'the gnomes of Norwalk', and I think perhaps he was right. The FASB does not make a product that is written for investors and for CFOs, and that is a sad commentary. The FASB process is one where the majority of the people sitting on the board tend to be technical accountants. Of the seven people, you got two CFOs and only one investor. That is a problem; it ought to be just the opposite. That board needs to be completely redone, restructured. If it needs to be put out of business and start afresh, then so be it. That board should have four investors on it because they know what they want, and it should have three CFOs on it — they know what they want — and we should consider getting rid of the technical accountants, once and for all.
Technical accountants had been writing our accounting standards in this country for eight decades. What has that eight decades got us? I would personally give the accounting standard-setters an F on many standards. We have a good system but I would still give them an F. Why would you ever, from a common sense perspective, leave people in place who are giving you accounting that generated us the Enrons of the world and made it possible to do the subprime transactions that lack transparency? Certainly the accounting that was generated up in Norwalk has facilitated both of those.
It is time for a change and sooner rather than later. Arthur Levitt wrote a column about changing the FASB back in March of this year in the Wall Street Journal. I think he was directly on target and it is long past time to turn around and make changes.
We have some things that are right, errors that have been caught and corrected, and controls are getting better. By the way, the level of restatement and control weaknesses has dropped this year for the first time in a number of years and we are starting to see a notable drop. It appears that, finally, we are getting financials done right the first time (Figure 2).
Figure 2.
Restatements by year, US public companies
Source: Glass, Lewis & Co., LLC., company filings
Again on the financial statements, we have seemingly jumped off the roof a couple of times. It is amazing to me that people sit there and say, 'Why? Why do we have all those restatements? There has got to be a problem; there is a reason. Let's form a committee and go dig into it'.
Hey, how about the fact that companies and their accountants were wrong? They did not get it right — a lot of restatements, not just a few, a lot of restatements. Way too high.
Many of these are in simple areas; they are not in the complex areas of accounting. The inventory is not right; things being capitalised that should be expenses, revenue recognition before its time. It is just not that tough to get it right.
At Glass Lewis this spring, we picked up a filing. Just by reading that public filing — which the audit partner hopefully read before he signed the opinion — we could figure out that their accounting for restructuring charges and revenue recognition was wrong and we wrote a report on it. This is a firm audited by a Big Four firm, and so we put out a report saying their accounting is wrong. They were not really happy about it. That company is now going through a restatement though, and an SEC investigation. All we had to do was pick it up from a public filing. And people are saying, 'Why do we have restatements?' It is simply amazing to me. They raise the question and don't understand or don't want to understand the answer.
Obviously, the good news is that the number of restatements is gong to be down and down significantly. This year, we are finally getting these things cleaned up. If you think about it: If we did not have controls; if we did not have the people who knew what they were doing in some of these jobs; if we had not invested in the finance department, which we did not during the 1990s; if we did not beat the auditors to death during the 1990s to get them to lower their fees; and if they had not lowered them for fear we would try to change to another audit firm with the audit committee sitting there supporting management, then it is likely we would not have the current level of restatements and be wondering why. They were not done right the first time, and yet we are jumping the second time.
When you look through the restatements, you can see that in the nature and the type of restatements. Some of the accounts affected probably deal with some complexities; some down in the other comprehensive income area. Some people just cannot get things on the right line in the balance sheet or income statement, though. I cannot tell you how many times I have seen this — the SEC putting out a letter saying, 'Here is where you are supposed to put certain items in the cash flow statement'. Then for over a year, companies continue to put them on the wrong line. I do not know that you can really help out people like that. They are going to jump. If the guy is going to jump, he is going to jump at six; he is going to jump at 11, folks.
A lot of it is in the small companies. They say, 'Let's not make the micro caps do it', as in do SOX 404, but a lot of the problems have been down in the small companies. We certainly see that in some of these numbers in the slides.
Here is something, though, and this is why I get very concerned about controls and restatements, as an investor and as a trustee of these funds. If you look at these companies that have gone through restatements and also had material weaknesses, and you look at what their returns were and compare it to, for example, what some of these other columns in the slide show you in terms of what the S&P did, what the Russell 3000 did, what the NYSE did, these companies are underperforming the indexes including the Russell 3000. They are costing my investors. They are underperforming that index by nearly 20 per cent in that group, nearly 14 per cent in that group, and nearly 17 per cent in that group. That is why I want to know who these companies are that are going through restatements. I want to know who all of them are because it tells me I need to watch those companies. I need to be talking to them. We need to be reaching out and touching the management team and board on those, and get that fixed because that is costing my members cash.
Once again, when you hear companies talk about the SOX cost, you do not hear them talk about the cost of accounting. You never hear them talk about the costs shown in Table 2, because at the end of the day, folks, when you add up all those costs, it is significantly more. That is a cost that everyone in this room who is investing in the market has — it is a cost to you. They do not want to talk about it. They only want to talk about the cost to them.
There was a drop in material weaknesses last year and it will be the same this year. What were the two biggest problems? Companies did not have systems in place and they did not have competent people in place. Whose fault is that? Think about it: if you do not have adequate systems in place — and by the way, this is not mine, this is disclosure from the companies themselves — if you did not have the systems in place that you needed and you did not have the people with the competencies that you needed in place, why do you think there were restatements? Does anyone have doubts about that in here? Most importantly, when you have that type of inadequacy in your systems, having been a business executive I know you cannot get the timely and accurate information you need to successfully run the business. This is not so much an accounting issue; this is a business issue. These guys or ladies are just flat out poor managers. They cannot be managing their business, and that is why we saw those negative returns in Table 2. And management wants to continue with what they are doing.
By the way, on most of the material weaknesses, material weaknesses were never ever reported to the public by the executives until the auditors forced them to. We first had reporting on the financials and controls in August of 2002, then every fiscal year thereafter. For nine out of ten of the companies never told the public that there was a problem until the auditors came in. And people say, 'Why do we need the auditors?' Let's get the honest truth.
In the following slides are just some examples of companies that did not have adequate controls, again, from their own disclosure. In one case, they did not even have an audit committee — God forbid — they did not have adequate financial or accounting organisation, or lack of controls against fraud. Here is another one — cash apparently on the front desk with a secretary starting work before they even got a contract in place. Some of the companies cannot make sure that they have their receivables or cash booked in the right period. I do not think this one came from Parmalat; they were a little over a billion dollars off on their cash but I do not think this is them. In another case, they could not invoice and record customer billings. Yet people say, 'Why do we have restatements?' I could turn around and spend the next week showing slides like this. These are not isolated occurrences; it is one after another like this. Then people say, 'Why do we have restatements? It is complex, it is too complex'. Well, I got to tell you: If you cannot record invoice and record your billings, then you probably got problems. If that is a complex problem for you, you probably have real problems and I want to know about it as an investor because I want to make sure I stay as far as I can away from your stock.
Today there were earlier discussions about the Big Four and the too big to fail issue. I just want to touch on one thing real quick. People have said, 'Oh, why do we not get more than the Big Four?' It will never happen, folks. It is not a possibility, not even remote. The capital that it would take is too large given available returns. Some real numbers on the Big Four and their revenues are shown in Table 3. Here are the actual real numbers directly off their websites. I have not audited these numbers. I take no responsibility for these numbers; it is from their websites.
Look at the number of offices and the number of people in those offices. Then you look down at the number of people of BDO Seidman and Grant Thornton. Unfortunately, they do not have the worldwide coverage that many Fortune 500 companies need. There is no possible way — even if you combine these firms — that they would even remotely get close up to the Big Four. The amount of capital that it would take to go hire and start up a company that would have a hundred and twenty thousand, a hundred and fifty thousand people in it, in 140–150 countries around the globe would be phenomenal. It is not going to happen.
So we are stuck with the Four that we have, whether we like it or not. People always ask me, 'Well, what if another one fails?' I said, 'I hope for divide by two ending with six'. I think you could actually, having gone through or been inside the firms, I think you could break one up as fast as they put them together. Tyco broke itself up into three or four different groups and they are of this magnitude or bigger. There is no reason you cannot do it with one of these Big Four firms.
We have had a lot of changes in auditors. One of the things you do hear the auditors say these days is they are getting better. That they are much better in picking the clients that they take. However, we found that for the most part, they are just playing musical chairs. In Table 4 is the number of the companies they audit. It also shows new audits the firms picked up where the Form 8-K disclosures said the former auditor had just said they cannot rely on the old management team, they had disagreements with them; they have restatements from material weakness (Table 4). Almost all of these went in to the Big Four so they just switched, so it appears the Big Four risk management is not really what it is cut out to be. We just said they are supposed to use a risk-based approach to auditing especially with SOX 404. They cannot even get the risk-based approach right for themselves. It will be interesting to see how well they do under SOX 404.
I do think we got to protect, finish off and get the detection of fraud right with respect to audit firms. Again, if they cannot find a billion-dollar problem, or if they find it, we have seen instances where they do not tell us. Then basically, in such circumstances we just do not need the auditing profession anymore and I speak from an investor's perspective. At that point in time, I'm better off just staffing up the enforcement group at the SEC and letting them do more enforcement work and save me the cost of the auditors — and let the SEC go in and nail these people who cannot turn around and get it done right.
For the sake of time, we are going to cut it off here. I will say the auditors have got to get a lot smarter and we have to redo the education system in the United States as it comes to accounting. We talked about the changes in business in the last three decades. We still teach pretty much the same curriculum as we taught 30 years ago. We had not expanded to train students on all aspects of derivatives and structured finance, on all aspects of the impacts of marketing channels and distribution and order management and inventory management. A lot of that just is not touched on in the classes. But it is the information necessary to being able to perform a competent audit.
For those who are going to be CPAs, I firmly believe, as Manny Cohen, the SEC Chairman appointed by John Kennedy indicated, we have to go to professional schools of accountancy. There needs to be a minimum of three years undergrad and then a three-year professional degree. People are talking about accountants as professionals. In this country, we can call ourselves professional, but you are only a professional if you are viewed as such by the public. We can have our licensures, we can have our test, but you are a professional in name only, if the public accepts it. Unfortunately, throughout the corporate scandals, we, as an accounting profession, have had our reputation dinged and damaged.
Currently, we are certainly in higher esteem than we were a few years ago but we are certainly not where we need to be, and we certainly do not have the expertise to go where we need to go. The only way we are going to get there is if we change the system of education, go through a full three years of professional accountancy education, depending upon the career path the you want to go into, whether management or auditing or whatever, with a very good, difficult test at the end that shows you know what you are doing. As we saw on the slides about systems and people, we got too many people out there not knowing what they are doing resulting in too many restatements that is causing those of you in the audience here who have invested money in the markets to suffer losses. We need to stop that if we really want to establish ourselves as a profession. So with that, I'll cut it off and take questions.
Question: What about the criticism that was raised about 404 earlier that it is not pitched towards identifying or prioritising on the basis of risk? I was wondering if you would speak on this.
Lynn Turner: First of all, if you go back and look at SOX, SOX says, 'Management is supposed to test and make sure controls are in place', which obviously they did not get done in some instances and companies. Auditors are supposed to go in and make sure that those controls are, in fact, there and working as management has told you. The problem with SOX was in the implementation. The problem is the audit firms did not train their people sufficiently and leading up to SOX, auditors had been doing very little testing of controls.
When I went on the Board of a Fortune 500 company, on my first year I found that our auditors — Big Four — the only thing they were doing with controls was once every three years they would come in and check out the controls mostly by inquiry. They were coming in to our people and turning around and saying, 'Hey, are your controls working?' Our people were not dumb; they turned around and said, 'Yeah, our controls are working', you know, and went home. Yet on a chart, the auditors had this thing that said, 'By the way, on revenue recognition, the biggest risk with a hi-tech company was revenue recognition', and yet they only tested that by inquiry once every three years. Given we were a Fortune 150-sized company, think what they might have been doing on the small ones.
So you have an audit staff that did not have a clue. In fact, when I was teaching my auditing class at the grad level at Colorado State, I remember the first year — I started talking about COSO and saw these blank looks. And so, I said, 'Well, have you not read COSO? You have heard about COSO, you know, C-O-S-O, COSO, you know?' It was like these bright blue eyes looking around, and I realised then it had not been taught in undergrad about it. This was in 2002, so I forced them all, much to their dismay, to go out and buy a copy of all the COSO books and manuals and then start reading them.
The bottom line is the accounting firms did not go out and train those auditors. Hardworking, dedicated, energetic young auditors, gave them no or too few wools to do the work competently and basically threw them out there and turned them loose on the CFOs and controllers and said, 'Go, get them!' And they went and got them and they got every dollar they could get out of them. And they were able to do so because the public companies and their staff had similar shortcomings including a lack of controls. It was always an implementation problem So now, we have come back to a standard.
Quite frankly, I do not particularly like the SEC or PCAOB Standard that they rewrote because it basically says, without any real guidance, 'Go do whatever you want to do. As long as you call it a risk-based approach, you are okay'. If the auditors and companies do training, we will be fine and this standard will work out fine if they focus on it. If they do not do training and do not focus on the right things and there is nothing in that standard that will ensure they will, we will have a total flop again.
Question: Actually, this is a problem. We, as researchers, do not know how to pick up the structure of controls and say, this is 90 per cent reliable. Now, it makes it a little bit more difficult for us to teach our students how to do it. So we are finishing up the implementation of what in 404 has been 'Document controls'. So you said a lot of people are out there, consultant firms came out and they document the controls. And with that, they found some anomalies. But understanding, really, what is an objective methodology — it would take ten years for us to develop ways that we can measure that reasonably well.
Lynn Turner: I hope that does not take us ten years and I doubt any CFO or controller would say, 'Oopps, it takes ten years'. I hope we can get that documentation done quickly and efficiently. I mean, it is amazing. We have had this law (FCPA) on the books mandated by Congress since the Watergate days with all the foreign corrupt practices and bribes. The law has said, since December 1977, 'Thou shall have good controls'. One of the questions some of us were talking about earlier today and the question I focused on is, if you really know what you are doing, you are CFO and controller or director of financial reporting or director of internal audit — and we have had that requirement for so long — why is it that you really needed any guidance? Why can you not go in and make sure you have good documentation and controls? You are supposed to have been doing this for 20, 30 years. My fear is it is that column in Table 4 on that material weakness line that says these people were incompetent and did not know what they were doing. If you have got incompetent people that do not know what they are doing and are not staying on top of this issue, do not really know what controls are, then you got a problem. And quite frankly and all too often, that is what auditors found that we existed.
So not only did you have the auditors not prepared to go in and do the testing and get educated, you have way too many companies that have old outdated systems. At a Fortune 150-sized company operating in over a hundred countries around the globe, we delved into this and we found we had over 200 legacy computer systems. We had over 200 legacy systems in a tech company involved with computers and software whose own systems were about as poor as you could get. That was a major problem. If that is where you are starting from, you are going to have a lot of work to do and it is going to cost you a lot. And at the direction of the Board the company has now gone in and put in a new system to replace all those. But the Board should not have to tell management that. It should not have had to tell management that in any number of companies. But we got so focused on driving cost down during the 1990s. In cutting back, we did not invest in the finance group, hence the restatements. Thank you.
