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Commentary: The Fault is Not in Our Stars

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Over the past couple of decades, there has been a disproportionate focus on trying to obtain a larger slice of the total economic pie, rather than an emphasis on growing the total pie. Related to this as well was a desire for (almost) immediate gratification and an attempt to eliminate downside risk. These tendencies appeared throughout society, from corporate executives to individual consumers, and led to the accumulation of burdensome levels of debt; the passing off of risk as quickly as possible (i.e., packaging and selling of toxic debt); misaligned compensation structures; and, most disturbing, increasingly widespread fraud. This fraud ranged from lying on mortgage applications to lying on corporate financial statements (e.g., WorldCom, Enron), and from the spreading of false rumors in the financial markets to the outright fabrication of customer statements (e.g., Bernie Madoff).

The specific solutions for many of these problems are relatively straightforward and have already been discussed in detail. They include proper loan underwriting, with potentially the sharing or required retention of some of the risk; compensation which is longer-term in orientation and which also includes some sharing of the risk; the reinstatement of the uptick rule and the allocation of more resources to SEC investigatory efforts; and a more centralized and better-coordinated regulatory structure for financial markets.

But beyond these reforms, I believe that a broader change of attitude is needed. Corporate fraud is a significant drain for the economy and the country, as it leads to a misallocation of resources; an overall increase in the cost of capital; the need to pay significant resources to intermediaries to try to prevent or remedy the fraud; a societal decline of ethics; and a general decline in satisfaction or utility, as individuals feel less satisfied when they cannot trust companies, and corporate executives feel less satisfied when they are perceived as belonging to a group that is mistrusted. Due to the negative effects of fraud, we should all work together to move to a position in which trust in our corporations and our corporate leaders is reinstated.

Corporate executives must play a key role in this transformation, leading by example in how they treat all stakeholders, including employees, customers, shareholders, creditors, suppliers, distributors, and neighbors. They should also help prevent or expose fraudulent and misleading behavior, not only because it is the right thing to do, but also because it will benefit their companies and themselves. A reduction in the amount of fraudulent and misleading behavior would reduce the overall cost of capital, as investors would be able to reduce the required risk premium related to such possible behavior. These corporate leaders would also be viewed more favorably by the public.

Investment managers such as myself have assumed a more significant role in helping to shape the corporations in which we have invested, primarily through proxy voting, but also through our interaction with company management. There has been a growing acknowledgment by investment managers of their fiduciary obligation to assist their clients by using the appropriate tools available to help increase the value of their investments. However, there has also been an almost universal failure on the part of investment managers to assist in situations in which corporate fraud has occurred, most likely due to a desire to disassociate themselves from the fraud and therefore prevent negative reactions from their clients regarding the investment, and to avoid spending time and effort to expose and remedy the fraud. I believe this lack of involvement is a failure by investment managers to properly act upon the fiduciary duty they owe to their clients.

Given their detailed understanding of the companies involved and the financial markets, investment managers are in a unique position to help uncover and remedy corporate fraud. I feel it is time for investment managers to more broadly interpret and act upon their fiduciary duty to their clients, especially given their unique talents, knowledge, and experience. This action should improve the returns for their clients due to potentially better, more timely, and more likely remedial payments, as well as through the likely reduction in the frequency and magnitude of fraud.

Fraud and misbehavior should not be accepted as an inevitability. We may not be able to totally eliminate it, but we should certainly be able to reduce its rate of occurrence, especially if we all take seriously our collective responsibility to work together to expose and prevent it.

–Joseph E. Stocke, CFA, is the managing director and chief investment officer of StoneRidge Investment Partners.

As an impartial, nonprofit forum for the finance and banking industries NYSSA encourages discussion and debate among its member and other professionals. Commentaries, however, should be taken as the sole opinion of the author(s) and not of NYSSA. If you would like to submit a commentary to the Finance Professional's Post, send your article to the editor.

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