Technological Evolution and the Devolution of Corporate Financial Reporting

TABLE OF CONTENTS INTRODUCTION I. TECHNOLOGY'S FIRST DIMENSION: THE ISSUERS THEMSELVES II. TECHNOLOGY'S SECOND DIMENSION: THE RISE OF THE UNSTABLE RETAIL INVESTOR III. TECHNOLOGY'S THIRD DIMENSION: BREAKING THE TRADITIONAL BOUNDARIES OF THE FIRM A. Derivatives and Synthetics B. Business-to-Business Relationships IV. THE FEEDBACK LOOP A. Testing the Limits B. Evaluating the Harm V. EFFECTIVE REGULATORY REFORM A. The Starting Point B. The Philosophy of Financial Reporting VI. A FRESH LOOK AT THE ENFORCEMENT AND REMEDIES CONCLUSION INTRODUCTION Technology's fingerprints are found all over the recent financial reporting scandals involving Enron, WorldCom, Tyco, Global Crossing and the like. The firms caught up in the scandals were disproportionately either in the technology sector or were technology-driven competitors in related product markets. They were especially attractive as investments to a generation of investors using on-line brokerage accounts and financial websites--an information-rich environment that promised to empower the retail trader vis-a-vis the dominating mutual funds, hedge funds, and pension plans. Just as important, many of these firms were innovators in how they used technology in both financing and conducting their businesses. Enron is now the best-studied example, (1) with massive utilization of structured finance techniques and derivatives to create an "asset lite" strategy wherein both assets and liabilities were quickly moved one step outside the formal boundaries of the firm to numerous affiliated special purpose entities. (2) These financing techniques themselves would be impossible without sophisticated technology that enabled Enron to become more an energy-based investment bank than a traditional supplier of natural resources. And even business-to-business relationships structured by many of these firms were innovative, with firms using information and communications technology to create more embedded relationships with customers and suppliers characterized by "just in time" production and delivery. My claim is that the technology link to the recent disclosure scandals is no coincidence. (3) To be sure, cheating tempts all who seek wealth, in whatever line of business they find themselves. I want to show, however, how the rapid pace of innovation at a number of levels offered motive, opportunity, and rationalization for a downshift in financial reporting norms, which in turn made outright fraud more probable. Understanding the root causes of the scandals is important because of the need for care in choosing a response. The popular story of the scandals, born out of a great deal of frustration and anger, is one of corporate greed--misreporting as a stark form of corruption and hence "evil." While greed certainly had a role, the misreporting was far more complicated and ambiguous, both in terms of underlying motivation and its impact on investors. Technology's multiple dimensions set in motion a feedback loop in which many managers came to believe that aggressive reporting--close to the line and perhaps over it--was both necessary and justifiable. During most of the 1990s, the SEC and the courts did relatively little in response even though the practices were becoming more and more notorious--thereby sending a message of tacit acquiescence. Putting aside the most egregious cases, the story may thus be more of mixed signals and situational pressures run amok than anything unusually corrupt about the dispositions of the managers involved. As Warren Buffett said in 1997, well before the scandals ever emerged, the inclination to engage in deceptive earnings management had made it "very tough to cleanse the system . because you don't have good guys and bad guys anymore." (4) If that is so, then the right reaction is probably not moral outrage and the right regulatory response is not necessarily the broad-brush criminalization threatened by the Sarbanes-Oxley Act of 2002. …