“Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion.”
September 28, 1998 The “Numbers Game” – Remarks by SEC Chairman Arthur Levitt for the NYU Center for Law and Business
The 1990s was a decade of impressive economic performance. Booming technology and communications sectors drove the Dow-Jones Industrial Average from below 3,000 to well over 10,000 by decade’s end. Although disputes continued about proxy access, good times quieted questions about corporate governance.
An exception and a reversal by the SEC framed the boom years. In 1991, the national restaurant chain Cracker Barrel announced that it would not employ gays or lesbians. The New York City Employee Retirement System submitted to the directors a resolution rescinding the policy. In 1992, the SEC issued a no-action letter, agreeing with Cracker Barrel that employment policy was subject to an “ordinary business exception” and not a shareholder matter. The next year, NYCERS filed suit against the SEC, arguing that narrowing the pool of potential applicants limited Cracker Barrel’s ability to gain the best management. The issue festered until 1998, when the SEC reversed itself, permitting shareholder proposals on corporate discrimination and marking what one scholar called “a moderate victory for shareholder democracy.”39
Meanwhile, corporate observers, among them SEC Chairman Arthur Levitt, began to suspect that the numbers touted in company earnings reports were increasingly the product of accounting tricks, designed to meet Wall Street earning expectations and please shareholders, rather than accurately reflecting corporate performance. A new constellation of corporate governance issues – making auditors more independent of their clients, strengthening audit committees, and thus restoring integrity to financial reporting – became a priority for Levitt. He convinced the New York Stock Exchange and the NASD to form a Blue Ribbon committee, headed by John Whitehead and Ira Millstein, to examine the exchange rules on audit committees. In 1999, the committee recommended that companies have audit committees solely comprised of independent, financially-knowledgeable directors with powers clearly enunciated by the board. It also suggested that audit committees evaluate their own effectiveness. Levitt believed the work of this committee “did more to change the culture of corporate governance than almost anything else we did at the SEC.”40
Beyond encouraging private sector audit committee reform efforts, Levitt put the SEC, guided by Chief Accountant Lynn Turner and General Counsel and Special Advisor Harvey Goldschmid, to work on assuring audit firm independence. The rationale was that, with accounting firms offering an ever-wider range of consulting services to corporate accounting clients, there was powerful incentive to provide “helpful” audits. The SEC proposed rules limiting the non-audit services accounting firms could provide. The accounting profession rallied against the rules, a series of contentious hearings left Congress reluctant to make changes, and the SEC compromised. For the time being, accounting firms could continue providing non-audit services, although under stiffer disclosure requirements. But Levitt’s suspicion that there was a growing reality gap between financial reporting and actual performance soon proved accurate.41
(39) Phillip R. Stanton, “SEC Reverses Cracker Barrel No-Action Letter,” Washington University Law Review, Volume 77, Issue 3.
(40) Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance, 3rd Edition, 2003.
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