The Era of Bad Apples

The last 10 years may someday be known as the decade when the “few bad apples” theory of the problems in American business was replaced by the realization that the bad fruit was everywhere. The age of fraud arrived, exemplified by the following:

Big Businessu00e2u20ac”Enron, WorldCom, Adelphi, Global Crossings, Tyco, etc.

Professional Servicesu00e2u20ac”Arthur Andersen and other major CPA firms and lawyers yet to be adjudicated
Wall Streetu00e2u20ac”Investment firms from Smith Barney to Merrill Lynch, 10 in all, for corrupting independent analysts

Regulatoryu00e2u20ac”The oversight failures of the SEC and its chairman, Harvey Pitt, in all areas
Mutual Fundsu00e2u20ac”Leaders like Putnam, Alliance, and Strong as well as many others that failed to prevent trading forbidden by their own rules

Health Careu00e2u20ac”HealthSouth for its manufactured-income fraud
Government GSEsu00e2u20ac”The accounting failures (or worse) that came to light at Freddie Mac

Market Exchangesu00e2u20ac”The New York Stock Exchange’s failure to regulate members and control the pay of its CEO
I’m sure the list will get longer, but the foregoing is enough to indicate that the U.S. business community has had a pervasive problem.

I must admit that when I list them like this, I am surprised and, despite all I’ve seen in my regulator’s role, even a little shocked.

I travel abroad a great deal and I used to be asked how we did things in the U.S. Questions like, “How did we achieve such a competitive, clean, honest, and efficient business economy?” were common. Lately, the conversations are somewhat gleeful and gloatingu00e2u20ac””I guess you Americans are not as ethical as you appeared to be.” In fact, something has gone wrong, as it almost always does in a period of bubble economy like we had in 1995-2001.

Reflecting on the situation, it seems to meu00e2u20ac”and this will shock my pro-deregulation friendsu00e2u20ac”our problem is that a free market doesn’t work well without a lot of government.

First, let me note that the problems of fraudulent misbehavior have not hit the banking, savings and loan, and credit union institutions. (Yes, I know Smith Barney is part of Citicorp, but it’s not banking to us old-timers.) Perhaps the reason the banking system has done better than other areas is because of the regulatory reform and vigilance that grew out of the S&L crisis and other economic problems of the late 1980s. The experience of that period led to tougher and better supervision and regulation, which proved pretty effective in the boom period of the late 1990s.

Further, many of the weak bankers were removed during the late 1980s. But, most important, the banks themselves took action to improve their internal control, governance, and responsiveness to regulators and shareholders alike.

Many government agencies have been created to correct past abuses, such as the FDIC, SEC, FCC, OCC, the Federal Reserve, the Consumer Products Safety Commission, and now the new Public Company Accounting Oversight Board (PCAOB). When we identify a problem in the system, a government entity is created to fix it. And most of the time, the new regulator does help deal with the problem it was created to control.

The difficulty is that in almost all the cases, a majority of businesses are operating ethically and yet they, too, must bear the burden of more costly supervision as new regulators perform their assigned tasks. And, once the regulators’ posts are created, these new entities naturally want to grow and regulate deeper and broader, creating the potential for overregulation. So the battle between deregulators and regulators continues. Each side is right, part of the time.

The recent outbreaks of fraud must be corrected by additional regulation (the new mutual fund regulatory bill is already moving through Congress), and one can only hope the new entity will be an effective answer to the problems it was created to control.