A Perfect Storm: Changing a Culture

Abstract:     
In October, 1991, there occurred off the coast of Massachusetts a perfect storm, a tempest created by a rare coincidence of events. In the late -90s, there was another perfect storm, an also rare coincidence of forces which caused huge waves in our financial markets, as the NASDAQ index, for one, soared from 1200 in 1997 to 5000 in 2000 and back to 1100 in 2002.

These were the days of the New Economy - low inflation and unemployment, government surpluses, and the Internet that would change how we work and play. Suddenly, all of us were watching crawlers on CNBC to see how rich we were. But the bubble triggered a period of unmatched and pervasive corporate fraud. Using academic blessings of stock options as the link of pay for performance, executives took huge helpings and then manipulated reported earnings to achieve the stock gains that would bring their compensation to stunning heights. In the five years ended 2003, over 1300 companies, many major, restated their earnings, and those were only the more egregious cases.

It was a broad-based, cultural failure, one that enlisted the active support, nay connivance, of the various gatekeepers, notably of course auditors, but also analysts, audit committees, bankers, and, yes, the lawyers who crafted the hollow transactions that would enable debt to disappear from balance sheets and create revenues from thin air. But then, we all wanted so much to believe.

The author brought to the article his background as a member of the Panel on Audit Effectiveness, appointed in 1998 at the instance of Chairman Levitt of the SEC, and also his longstanding skepticism about efficient market theory.

Working Paper Series