Commentary

Expect the Unexpected

This article was published in the Washington Times, Aug. 18, 2002.

Requiring corporate executives to certify the accuracy of financial statements was supposed to “restore investor confidence.” After a massive drop just before the big day arrived, the market did seem to breathe a sigh of relief when this event finally ended uneventfully on Aug. 14.

But recall that Dow stocks were above 9,200 before the certification scheme was announced on June 26 by Securities and Exchange Commission Chairman Harvey Pitt. Anyone who seriously believes stock prices mainly depend on confidence would have to conclude that investors had less confidence at the end of this game than they had before it started.

Certification has been widely advertised as a device to punish or prevent fraud, but that claim is itself a fraud. It was always a crime for the chief executive officer or a chief financial officer to deliberately release fraudulent financial data, and this gimmick does not change that one whit. Criminal charges still require proof that corporate officers “knowingly” submitted false reports, and that is not easy to prove. That does not mean certification will have no effect, only that the effects will be entirely different from the intent.

The real purpose of certification has nothing to do with public law against fraud and everything to do with private law. As CNBC noted, when Mr. Pitt initiated this crusade, he emphasized that “CEOs and CFOs must stand by their earnings statements, adding that any false certifications will result in personal liability.” Personal liability means cash, not criminal sanctions. Mr. Pitt is a lawyer, after all, and lawyers are instinctively attracted to anything that results in more “personal liability” - that is, a greater number of more lucrative lawsuits.

Increasing the risk that corporate officers and directors may be sued for mega-millions means decreasing the risk that business leaders will be willing to take. It is another step toward criminalizing failure and risk.

Certification amounts to promising the impossible - indisputable accounting. That promise of perfection invites disputes and regulatory harassment, which invites lawsuits. As a result, executives will naturally become ultra-cautious, even timid. Bold new ventures are to be shunned, particularly if they are too complicated to account for with simple figures.

By penalizing risk, in short, certification threatens chronic economic paralysis. “In a zero defect culture,” wrote columnist David Ignatius, “the engine of economic growth begins to freeze up. For this is a barren landscape, where only lawyers can survive for long.”

This whole certification game is mainly a political gift to trial lawyers who chase sick companies just as ambulance chasers pursue sick people. CEOs and CFOs have just become an inviting new target for class-action suits.

Class-action suits are ostensibly on behalf of stockholders, but there is rarely more than small change left over after the attorneys split the booty. Class-actions suits generally have no class.

This added risk of litigation has scared the stock market ever since late June. Why? Because it must shrink future profits by inflating the cost of insurance and compensation. Companies are going to have to pay much more for insurance to cover the risk their executive might be sued. But insurance has limits, so a fat new risk premium must also be added to executive pay. Financially troubled companies, in particular, will have to offer top executives much more costly pay packages than otherwise to attract the unique talent needed to turn things around.

Note well that certification applies only to those companies foolhardy enough to sell shares in their future profits to the public. It would not apply to Arthur Anderson, for example. In the future, we can expect more of the promising new companies to stay private and more public firms to be taken private. Staying private is a simple way to avoid regulatory harassment and the associated expenses of battling frivolous lawsuits. As a result, stockholders may miss out on some of the best opportunities.

Despite a few encouraging rallies here and there, stocks are still much cheaper today than on June 26, when this certification scheme was first announced. Investors did indeed lose confidence at that time. They lost confidence in bureaucratic regulations that increase the cost of corporate insurance and compensation, discourage risk and discourage private companies from going public. The only investors who might have benefited from that sort of help were those who bet stocks would fall by shorting the market. But most of the likely damage is already capitalized in lower stock prices, as is true of all stale news. It is time to put such political publicity stunts behind us and get back to business.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.