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1/17/2002
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Taking Stock: The Games People Play With Your Money Need More Oversight

The SEC, exchanges, auditors, and directors bear watching

'Every now and then, I get on my soapbox. The new year is a good time to climb back on and preach about governance.

Think Enron. Think of Larry Ellison's recent comments about blaming the media for the Enron meltdown (see "IT Confidential"). No wonder I don't trust him.

Who protects investors when we buy shares of a publicly traded company? There are four layers of protection. The first one is the best known: the Securities and Exchange Commission. Usually, the SEC gets involved after there's a problem. An unfortunate "event" will occur, and the SEC steps in to prevent it from happening again, usually through regulation.

The second layer is also familiar--the exchanges where shares trade. All exchanges have requirements, and companies are de-listed if they don't conform. But neither of these oversight layers protect the investor day to day.

At the company level, investors have two primary safeguards. The first line of defense is the auditor of the company. Auditors such as Arthur Andersen or PricewaterhouseCoopers, are hired to accurately and independently portray the company's financial well-being. They achieve this lofty goal by reporting company financials based on generally accepted accounting principals set by an accounting standards board. For publicly traded shares, these audited financials are reported once a year. The quarterly statements that are used by so many analysts and investors aren't audited and often are restated. I believe that most auditors try to do their jobs well. However, there's always room for error and the potential for conflicts of interest.

It's the last line of defense for shareholders that hasn't gotten the press it should: a company's board of directors. The directors are supposed to be independent and act on behalf of shareholders. These days, directors behave more like patsies for the CEO and senior management than activists for shareholders. Let's consider some of the more egregious issues.

The SEC doesn't require financial disclosure of all relationships among corporate directors, senior management, the company, and entities affiliated with directors. Clearly, if this had been a requirement, the Enron situation might have come to light much sooner. For example, current rules don't force companies to disclose financial connections with directors if they're deemed "immaterial" to the company. Unfortunately, many of these immaterial relationships may be quite material, both economically and emotionally, to the well-being of the director. This isn't necessarily a low-paying job. Enron's board members made more than $300,000 per year, for just one board job. Many of Enron's directors sat on multiple boards, and we won't talk about all the additional perks, such as travel expenses, conferences, health benefits, and very lucrative retirement plans. Directors are supposed to be independent, but it's hard to remain that way when you're essentially serving at management's pleasure and most of the perks and salaries are defined by management.

To maintain control, management often uses a technique called staggered boards, where only a portion of the total number of board seats come up for re-election each year. To see why this can work against shareholders, just look at the recent takeover battle between Weyerhaeuser and Willamette Industries. Weyerhaeuser said it would run a proxy fight for the four board seats available at the 2001 annual meeting. Willamette immediately reduced the total number of board seats from 10 to nine and reduced the number of seats up for election from four to three. Obviously, management didn't trust shareholders to make the "right" decision.

I could also talk about poison pills, which theoretically prevent unsolicited takeovers. Can you say "job security?" Investors and shareholders need to be more proactive about their voting rights. We should all be more active in requiring the SEC to demand more disclosure from publicly traded companies, especially regarding compensation and conflicts of interest. Remember, it's your money.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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